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ANSWERS TO QUESTIONS AND PROBLEMS

23.7 (a) It is unlikely that an individual would not look after his or her health
because of the existence of a life insurance contract. But it has been known
for the beneficiary of a life insurance contract to commit murder to receive
the payoff from the contract! (b) Individuals with short life expectancies are
more likely to buy life insurance than individuals with long life expectancies.
23.8 External loss data is data relating to the losses of other banks. It is data obtained from sharing agreements with other banks or from data vendors. Vendor data is used to determine relative loss severity. It can be a useful indicator
of the ratio of mean loss severity in Business Unit A to mean loss severity
in Business Unit B or the ratio of the standard deviation of loss severity in
Business Unit A to the standard deviation of loss severity in Business Unit B.
23.9 The Poisson distribution is often used for loss frequency. The lognormal distribution is often used for loss severity.
23.10 Examples of key risk indicators are staff turnover, number of failed transactions, number of positions filled by temps, ratio of supervisors to staff, number of open positions, and percentage of staff who did not take 10 days of
consecutive leave in the past 12 months.
23.11 When the loss frequency is 3, the mean total loss is about 3.3 and the standard
deviation is about 2.0. When the loss frequency is increased to 4, the mean
loss is about 4.4 and the standard deviation of the loss is about 2.4.

CHAPTE R 2 4
24.1 Investors did not know very much about the mortgages underlying the
tranches that were created, and the waterfalls were complex.
24.2 The company or individual providing the quotes is prepared to buy at 50 and
sell at 55. The mid-market quote is 52.5. The proportional bidoffer spread
is 5.0/52.5 or 0.0952.
24.3 The bidoffer spread for the holding in Company A is 0.01 5,000 = $50.
The bidoffer spread for the holding in Company B is 0.02 3,000 = $60.
The cost of unwinding the portfolio is (50 + 60)2 or $55.
24.4 The bidoffer spread for the first holding that we are 95% confident will not
be exceeded is 5,000 (0.01 + 1.645 0.01) = $132.24. The bidoffer spread
for the second holding that we are 95% confident will not be exceeded is
3,000 (0.02 + 1.645 0.03) = $204.04. The total cost of unwinding that
we are 95% certain will not be exceeded is (132.24 + 204.04)/2 = $170.14.
24.5 The amount traded on successive days should be 15.9, 12.9, 10.0, 7.4, 5.2,
3.4, 2.2, 1.4, 0.9, and 0.7. The bidoffer spread cost is $13.4. The total price
variance is 36.6so that the VaR for the market risk with a 95% confidence
level is 1.645 36.6 = $9.9. (The objective function that is minimized is the
sum of these two or $23.3.)
24.6 This is necessary because these assets cannot be converted into cash and cannot be pledged as collateral for additional loans.
24.7 Wholesale deposits are more likely to disappear in stressed market conditions.
24.8 Their hedging led to a loss on the hedge and a gain on the position being
hedged. The loss on the hedge gave rise to margin calls. Unfortunately, the

Answers to Questions and Problems

24.9

24.10
24.11

24.12

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position being hedged, although it increased in value to the company, was

illiquid.
Positive feedback trading refers to situations where traders accentuate market
movements. They buy when prices increase and sell when prices decrease.
Negative feedback trading is when traders do the reverse; that is, they buy
when prices decline and sell when prices increase. Positive feedback trading is
liable to lead to a liquidity problem.
This is a VaR measure that includes an adjustment for the bidoffer spread
costs that are incurred in a close-out of the position.
Liquidity black holes occur when most market participants want to be on one
side of a market. Regulation is liable to lead to liquidity black holes because,
when all financial institutions are regulated in the same way, they tend to want
to respond to external economic events in the same way.
Liquidity black holes are typically caused by too many traders following the
same trading strategy. If traders follow diverse trading strategies, liquidity
black holes are less likely to occur.

CHAPTE R 2 5
25.1 Marking to market involves valuing a position using the prices at which the
same or similar positions are trading in the market. Marking to model occurs
when a model plays a key role in determining the price of an instrument.
25.2 Leverage and crashophobia.
25.3 Uncertain volatility and jumps.
25.4 When plain vanilla call and put options are being priced, traders do use the
BlackScholesMerton model as an interpolation tool. They calculate implied
volatilities for the options that are actively traded. By interpolating between
strike prices and between times to maturity, they estimate implied volatilities for other options. These implied volatilities are then substituted into the
BlackScholesMerton model to calculate prices for these options. However,
BlackScholesMerton is more than an interpolation tool when used for hedging.
25.5 13.45%. We get the same answer by (a) interpolating between strike prices
of 1.00 and 1.05 and then between maturities six months and one year and
(b) interpolating between maturities of six months and one year and then
between strike prices of 1.00 and 1.05.
25.6 The models of physics describe the behavior of physical processes. The models
of finance ultimately describe the behavior of human beings.
25.7 It might notice that it is getting a large amount of business of a certain type
because it is quoting prices different from its competitors. The pricing differences might also become apparent if it decides to unwind transactions and approaches competitors for quotes. Also, it might subscribe to a service where
once a month it obtains the average price quotes by dealers for particular
transactions.
25.8 Within-model hedging involves hedging against changes in variables that the
model assumes to be stochastic. Outside-model hedging involves hedging
against parameters that the model assumes to be constant.