Chapter Ten

Market Risk
Solutions for End-of-Chapter Questions and Problems: Chapter Ten

4. Follow Bank has a $1 million position in a five-year, zero-coupon bond with a face value
of $1,402,552. The bond is trading at a yield to maturity of 7.00 percent. The historical
mean change in daily yields is 0.0 percent, and the standard deviation is 12 basis points.

a. What is the modified duration of the bond?

MD = 5 ÷ (1.07) = 4.6729 years

b. What is the maximum adverse daily yield move given that we desire no more than a 5
percent chance that yield changes will be greater than this maximum?

Potential adverse move in yield at 5 percent = 1.65 = 1.65 x 0.0012 = .001980

c. What is the price volatility of this bond?

Price volatility = -MD x potential adverse move in yield

= -4.6729 x .00198 = -0.009252 or -0.9252 percent
d. What is the daily earnings at risk for this bond?

DEAR = ($ value of position) x (price volatility)

= $1,000,000 x 0.009252 = $9,252

5. What is meant by value at risk (VAR)? How is VAR related to DEAR in J.P. Morgan’s
RiskMetrics model? What would be the VAR for the bond in problem (4) for a 10-day
period? With what statistical assumption is our analysis taking liberties? Could this
treatment be critical?

Value at Risk or VAR is the cumulative DEARs over a specified period of time and is given by
the formula VAR = DEAR x [N]½. VAR is a more realistic measure if it requires a longer period
to unwind a position, that is, if markets are less liquid. The value for VAR in problem four
above is $9,252 x 3.1623 = $29,257.39.

The relationship according to the above formula assumes that the yield changes are independent.
This means that losses incurred on one day are not related to the losses incurred the next day.
However, recent studies have indicated that this is not the case, but that shocks are autocorrelated
in many markets over long periods of time.

6. The DEAR for a bank is $8,500. What is the VAR for a 10-day period? A 20-day period?
Why is the VAR for a 20-day period not twice as much as that for a 10-day period?

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 For the 10-day period: VAR = 8,500 x [10]½ = 8,500 x 3.1623 = $26,879.36

For the 20-day period: VAR = 8,500 x [20]½ = 8,500 x 4.4721 = $38,013.16

The reason that VAR20  (2 x VAR10) is because [20]½  (2 x [10]½). The interpretation is that
the daily effects of an adverse event become less as time moves farther away from the event.

7. The mean change in the daily yields of a 15-year, zero-coupon bond has been five basis
points (bp) over the past year with a standard deviation of 15 bp. Use these data and
assume the yield changes are normally distributed.

a. What is the highest yield change expected if a 90 percent confidence limit is required;
that is, adverse moves will not occur more than one day in 20?

If yield changes are normally distributed, 90 percent of the area of a normal distribution
will be 1.65 standard deviations (1.65) from the mean for a one-tailed distribution. In this
example, it means 1.65 x 15 = 24.75 bp. Thus, the maximum adverse yield change
expected for this zero-coupon bond is an increase of 24.75 basis points in interest rates.

b. What is the highest yield change expected if a 95 percent confidence limit is required?

If a 95 percent confidence limit is required, then 95 percent of the area will be 1.96
standard deviations (1.96) from the mean. Thus, the maximum adverse yield change
expected for this zero-coupon bond is an increase of 29.40 basis points (1.96 x 15) in
interest rates.

9. Bank Alpha has an inventory of AAA-rated, 15-year zero-coupon bonds with a face value
of $400 million. The bonds currently are yielding 9.5% in the over-the-counter market.

a. What is the modified duration of these bonds?

Modified duration = (MD) = D/(1 + r) = 15/(1.095) = -13.6986.

b. What is the price volatility if the potential adverse move in yields is 25 basis points?

Price volatility = (-MD) x (potential adverse move in yield)

= (-13.6986) x (.0025) = -0.03425 or -3.425 percent.

c. What is the DEAR?

Daily earnings at risk (DEAR) = ($ Value of position) x (Price volatility)

Dollar value of position = 400/(1 + 0.095)15 = $102.5293million. Therefore,
DEAR = $102.5293499 million x -0.03425 = -$3.5116 million, or -$3,511,630.

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 d. If the price volatility is based on a 90 percent confidence limit and a mean historical
change in daily yields of 0.0 percent, what is the implied standard deviation of daily
yield changes?

The potential adverse move in yields (PAMY) = confidence limit value x standard
deviation value. Therefore, 25 basis points = 1.65 x , and  = .0025/1.65 = .001515 or
15.15 basis points.

10. Bank Two has a portfolio of bonds with a market value of $200 million. The bonds have
an estimated price volatility of 0.95 percent. What are the DEAR and the 10-day VAR for
these bonds?

Daily earnings at risk (DEAR) = ($ Value of position) x (Price volatility)

= $200 million x .0095
= $1.9million, or $1,900,000

Value at risk (VAR) = DEAR x N = $1,900,000 x 10

= $1,900,000 x 3.1623 = $6,008,327.55
11. Bank of Southern Vermont has determined that its inventory of 20 million euros (€) and 25
million British pounds (£) is subject to market risk. The spot exchange rates are $0.40/€
and $1.28/£, respectively. The ’s of the spot exchange rates of the € and £, based on the
daily changes of spot rates over the past six months, are 65 bp and 45 bp, respectively.
Determine the bank’s 10-day VAR for both currencies. Use adverse rate changes in the
95th percentile.

FX position of € = 20m x 0.40 = $8 million

FX position of £ = 25m x 1.28 = $32 million

FX volatility € = 1.65 x 65bp = 107.25, or 1.0725%

FX volatility £ = 1.65 x 45bp = 74.25, or 0.7425%

DEAR = ($ Value of position) x (Price volatility)

DEAR of € = $8m x .010725 = $0.0860m, or $85,800

DEAR of £ = $32m x .007425 = $0.2376m, or $237,600

VAR of € = $138,000 x 10 = $85,800 x 3.1623 = $271,323.42

VAR of £ = $237,600 x 10 = $237,600 x 3.1623 = $751,357.17

12. Bank of Alaska’s stock portfolio has a market value of $10,000,000. The beta of the
portfolio approximates the market portfolio, whose standard deviation (m) has been
estimated at 1.5 percent. What is the 5-day VAR of this portfolio, using adverse rate
changes in the 99th percentile?

DEAR = ($ Value of portfolio) x (2.33 x m ) = $10m x (2.33 x .015)

= $10m x .03495 = $0.3495m or $349,500

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Market Risk, Online Lecture 2
 VAR = $349,500 x 5 = $349,500 x 2.2361 = $781,505.76

13. Jeff Resnick, vice president of operations of Choice Bank, is estimating the aggregate
DEAR of the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX),
and common stock (EQ). The individual DEARs are $300,700, $274,000, and $126,700
respectively. If the correlation coefficients ij between L and FX, L and EQ, and FX and
EQ are 0.3, 0.7, and 0.0, respectively, what is the DEAR of the aggregate portfolio?

0.5
( DEAR L ) 2  ( DEAR FX ) 2  ( DEAR EQ ) 2 
 
  (2  L , FX x DEAR L x DEAR FX ) 
DEAR portfolio   
 (2  L , EQ x DEAR L x DEAR EQ )
 
  (2  FX , EQ x DEAR FX x DEAR EQ ) 
 

0.5
$300,700 2  $274,000 2  $126,700 2  2(0.3)($300,700)($274,000) 
 
 2(0.7)($300,700)($126,700)  2(0.0)($274,000)($126,700) 

 $284,322,626,000  $533,219
0.5

14. Calculate the DEAR for the following portfolio with and without the correlation
coefficients.
Estimated
Assets DEAR S,FX S,B FX,B
Stocks (S) $300,000 -0.10 0.75 0.20
Foreign Exchange (FX) $200,000
Bonds (B) $250,000
0.5
( DEAR S ) 2  ( DEAR FX ) 2  ( DEAR B ) 2 
 
  (2  S , FX x DEAR S x DEAR FX ) 
DEAR portfolio   
 (2  S , B x DEAR S x DEAR B )
 
  (2  FX , B x DEAR FX x DEAR B ) 

0.5
$300,000 2  $200,000 2  $250,000 2  2(0.1)($300,000)($200,000) 
 
 2(0.75)($300,000)($250,000)  2(0.20)($200,000)($250,000) 

 $312,000,000,000  $559,464
0.5

What is the amount of risk reduction resulting from the lack of perfect positive correlation
between the various assets groups?

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 The DEAR for a portfolio with perfect correlation would be $750,000. Therefore the risk
reduction is $750,000 - $559,464 = $190,536.

16. Export Bank has a trading position in Japanese Yen and Swiss Francs. At the close of
business on February 4, the bank had ¥300,000,000 and Sf10,000,000. The exchange rates
for the most recent six days are given below:

Exchange Rates per U.S. Dollar at the Close of Business

2/4 2/3 2/2 2/1 1/29 1/28
Japanese Yen 112.13 112.84 112.14 115.05 116.35 116.32
Swiss Francs 1.4140 1.4175 1.4133 1.4217 1.4157 1.4123

a. What is the foreign exchange (FX) position in dollar equivalents using the FX rates on
February 4?

Japanese Yen: ¥300,000,000/¥112.13 = $2,675,465.98

Swiss Francs: Swf10,000,000/Swf1.414 = $7,072,135.78

b. What is the definition of delta as it relates to the FX position?

Delta measures the change in the dollar value of each FX position if the foreign currency
depreciates by 1 percent against the dollar.

c. What is the sensitivity of each FX position; that is, what is the value of delta for each
currency on February 4?

Japanese Yen: 1.01 x current exchange rate = 1.01 x ¥112.13 = ¥113.2513/$

Revalued position in $s = ¥300,000,000/113.2513 = $2,648,976.21
Delta of $ position to Yen = $2,648,976.21 - $2,675,465.98
= -$26,489.77

Swiss Francs: 1.01 x current exchange rate = 1.01 x Swf1.414 = Swf1.42814

Revalued position in $s = Swf10,000,000/1.42814 = $7,002,114.64
Delta of $ position to Swf = $7,002,114.64 - $7,072,135.78
= -$70,021.14

d. What is the daily percentage change in exchange rates for each currency over the five-
day period?

Day Japanese Yen: Swiss Franc

2/4 -0.62921% -0.24691% % Change = (Ratet/Ratet-1) - 1 * 100
2/3 0.62422% 0.29718%
2/2 -2.52934% -0.59084%
2/1 -1.11732% 0.42382%
1/29 0.02579% 0.24074%

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 e. What is the total risk faced by the bank on each day? What is the worst-case day?
What is the best-case day?

Japanese Yen Swiss Francs Total

Day Delta % Rate  Risk Delta % Rate  Risk Risk
2/4 -$26,489.77 -0.6292% $166.68 -$70,021.14 -0.2469% $172.88 $339.56
2/3 -$26,489.77 0.6242% -$165.35 -$70,021.14 0.2972% -$208.10 -$373.45
2/2 -$26,489.77 -2.5293% $670.01 -$70,021.14 -0.5908% $413.68 $1,083.69
2/1 -$26,489.77 -1.1173% $295.97 -$70,021.14 0.4238% -$296.75 -$0.78
1/29 -$26,489.77 0.0258% -$6.83 -$70,021.14 0.2407% -$168.54 -$175.37

The worst-case day is February 3, and the best-case day is February 2.

f. Assume that you have data for the 500 trading days preceding February 4. Explain how
you would identify the worst-case scenario with a 95 percent degree of confidence?

The appropriate procedure would be to repeat the process illustrated in part (e) above for all
500 days. The 500 days would be ranked on the basis of total risk from the worst-case to
the best-case. The fifth percentile from the absolute worst-case situation would be day 25
in the ranking.

g. Explain how the five percent value at risk (VAR) position would be interpreted for
business on February 5.

Management would expect with a confidence level of 95 percent that the total risk on
February 5 would be no worse than the total risk value for the 25th worst day in the
previous 500 days. This value represents the VAR for the portfolio.

h. How would the simulation change at the end of the day on February 5? What variables
and/or processes in the analysis may change? What variables and/or processes will not
change?

The analysis can be upgraded at the end of the each day. The values for delta may change
for each of the assets in the analysis. As such, the value for VAR may also change.

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Market Risk, Online Lecture 2