LAURENTIAN UNIVERSITY

SCHOOL OF COMMERCE AND ADMINISTRATION

RISK MANAGEMENT [COMM 4736/RK1/RK2]
FINAL EXAMINATION SOLUTION
Time: 3 hours
Note:
This notice is to inform you of your responsibilities regarding confidentiality as it relates to
this exam. It is understood that all aspects of the exam including case information and
examination question(s) and answer(s) should not be disclosed or discussed with any
individual following the examination. The examination paper, the answer booklet(s), and
any notes must be handed in to the invigilator at the end of the examination.
PART A: Multiple choice (60 marks)
Note:
1 1/2 marks each
1. d. Stock B is riskier than stock A. Hence, the riskier portfolio is the one with the highest
weight invested in stock B.
2. b. E(R) = [350 (350 + 250)] 10.7% + [250 (350 + 250)] 13.2% = 11.74%
3. d.
Portfolio Variance
= [(350 (350 + 250))2 12.5%2] + [(250 (350 + 250))2 15.7%2] + [2 0.4 (350
(350 + 250)) (250 (350 + 250)) 12.5% 15.7%]
= [0.58332 0.1252] + [0.41662 0.1572] + [2 0.4 0.5833 0.4166 0.125 0.157]
= [0.34023889 0.015625] + [0.17355556 0.024649] + [0.003815143646]
= 0.013409347
Portfolio Standard deviation = 0.013409347 = 0.1158 or 11.58%
4. c.
5. a.
6. c.
7. c.
8. b.
9. a.
10. c.
11. a. A lower limit of 3% is the best (that is, the highest) among the four lower-limits option.
The 7% is the lowest among the upper-limits options; however, in the best-case scenario
(that is, the S&P 500 reaching 1,712), all four upper limits have the same influence since
the best-case scenario corresponds to 7% returns.
12. c.
13. b. Prob(die between his 51st and 53rd birthday) = Prob(die between his 51st and 52nd
birthday) + Prob(die between his 52nd and 53rd birthday) = (0.91557 0.90995) +
(0.90995 0.90395) = 0.01162

14. b. The maximum cost that the company can bear is 500 200 = $300 million. This is
equivalent to 300/500 = 60% of its exposure. Thus, the company should enter into annual
reinsurance contracts that cover on a pro rata basis 40% of its exposure.
15. d.
16. a. After-fees return = 22% [2% + (22% 2%) 30%] = 14.0%
17. c. Capital gains = 100 (15.25 14 0.5 + 1.5) = $225
18. b.
19. d.
20. c.
21. a. Clients after-fees return = 17% [5% + (17% 5%) 15%] = 10.20%
22. b. Average yearly return = [(1,140 1200) 1,200 + (1,254 1,140) 1,140 + +
(1,384 1,442) 1,442] 4 = 4%]
23. b. The value of the investment would be 150 [1,140 1,200] [1,254 1,140]
[1,384 1,442] = $173
24. d. Gains (losses) = 300 115 300 110 300 3 = $600
25. a.
26. c.
27. d. The trader should deposit 200 150 0.4 = $12,000
28. c. The new margin account is 12,000 + 200 20 = $16,000
29. a. The margin that should be posted is 400 75 130% = $39,000
30. d. Since you intend to buy shares, you need to buy call options with the desired exercise
price as a shield against increases in the stock price.
31. a.
32. b. The one-month VaR is 1.645 105,000 = $172,725.
33. d.
34. c.
35. b. Q(t) = 1 exp((t) t). For t = 1 and (t) = 4.5%
36. b.
37. a. The mid-market value is 2.5 million [(137 + 135)/2] = $340 million and proportional
bidoffer spread is (137 135) [(137 + 135)/2] = 0.0147
38. b. Cost of liquidation is 340 million 0.0147 2 = $2.5 million
39. b.
40. d.

PART B: Problems and short-answer questions (40 marks)

Question 1 (8 marks)
a.
E(Rp) = [100 (100 + 300 + 400)] 9.5% + [300 (100 + 300 + 400)] 6.7% + [400
(100 + 300 + 400)] 5.5% = 6.45%
b.
p = 8.31% and the solution is obtained using the given equation of p with
wx = 100 (100 + 300 + 400)
wy = 300 (100 + 300 + 400)
wz = 400 (100 + 300 + 400)
x = 17.5%
y = 15.4%
z = 13.3%
xy = 0.5
xz = -0.1
yz = -0.3
c.
E(Rp) = [100 (100 + 300 + 400)] 9.5% + [300 (100 + 300 + 400)] 6.7% + [400
(100 + 300 + 400)] 5.5% = 6.45%
d.
p = 9.27% and the solution is obtained using the given equation of p with
wx = 100 (100 + 300 + 400)
wy = 300 (100 + 300 + 400)
wz = 400 (100 + 300 + 400)
x = 17.5%
y = 15.4%
w = 10.0%
xy = 0.5
xw = 0.2
yw = 0.1
e.
The advisors recommendation is a bad idea because replacing stock Z with stock W would
not change the expected return of the portfolio, yet it increases its standard deviation. He
missed the fact that stock W is more positively correlated with stocks X and Y.

Question 2 (6 marks)
a.
Prob(die between 30 and 31) = 0.97146 0.97015 = 0.00131
b.
Prob(die between 31 and 32) = 0.97015 0.96882 = 0.00133
c.
Prob(die between 30 and 31|live till 30) = 0.00131 (obtained in a) 0.97146 = 0.00135
d.
Prob(die between 31 and 32|live till 30) = 0.00133 (obtained in b) 0.97146 = 0.00137
e.
Minimum premium = (0.00135 [obtained in c] + 0.00137 [obtained in d]) 350,000 =
$952
Question 3 (7 marks)
a.
Foreign currency risk or foreign exchange risk: the risk of an investments value
depreciating due to fluctuations in exchange rates.
b.
Buy a 15 million three-month forward contract at an exchange rate of 1.32.
c.
1.33 1.5 million 1.32 1.5 million = $150,000 of savings

Question 4 (9 marks)
a.
The standard deviation over T days is given by
T = 12 [T + 2(T 1) + 2(T 2)2 + 2(T 3)3 + 2T1 ]

In this question, T = 3 days and 20 days, 1 is the one-day standard deviation ($10
million), and is the first order autocorrelation (0.35).
Plugging the given values in the equation above, we get
3-day standard deviation = $21.55 million
20-day standard deviation = $62.97 million
b.
3-day VaR = 21.55 1.645 = $35.4 million
20-day VaR = 62.97 1.645 = $103.58 million
c.
3-day VaR, because the stocks of the portfolio are highly liquid and frequently tradable.
Question 5 (10 marks)
a.
Average default intensity over 3 years = (40 10,000) (1 55%) = 0.89%
b.
Average default intensity over 5 years = (50 10,000) (1 55%) = 1.11%
c.
Average default intensity over 10 years = (110 10,000) (1 55%) = 2.44%
d.
Average default intensity between years 3 and 5 = [(1.11% 5) (0.89% 3)] (5 3)
=1.44%
e.
Average default intensity between years 5 and 10 = [(2.44% 10) (1.11% 5)] (10
5) = 3.78%