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ECON40315-WE01
Financial Risk Management
Format of Exam Take home exam
Duration: 2 hours
Word/Page Limit: 3000 words
Additional Material provided: None
Expected form of Submission Word Document using template provided or PDF of Handwritten
Work
Your uploaded file should be named with your anonymous ID
and the Exam Code e.g Z012345ECON11111-WE01
Submission method Turnitin
Instructions to Candidates: Answer all (three out of three) questions.
For this 2-hour exam, the expectation is that
the answer sheet should not exceed 2700
words. There is no benefit in writing long
answers without clear content. Well-written
answers will have a clear structure and will
cover all important elements needed to fully
answer the question.
Page 2 of 3 ECON40315-WE01
Question 1:
ABC Inc stock is launching a new product tomorrow and a trader wishes to exploit this opportunity
by holding options. The current stock price is trading at $30. The trader following the stock expects
the news to cause the volatility over the next three months to be either 10% or 40%. He believes
that there is a 30% chance of the first outcome and a 70% chance of the second outcome.
The trader calculates the call prices for three-month options using 10% and 40% volatility. Then
using the weighted-average price (from the two prices), the trader creates the implied volatilities.
The output table is in the following:
A
Strike price
B
Call Price
(calculated with 10%
Vol)
C
Call Price
(calculated with 40%
Vol)
D
Implied
Volatility of the
Weighted
Average Price (of
Columns A and B)
24 6.519 6.943 25.53
26 4.358 5.224 23.13
28 2.341 3.765 20.77
30 0.867 2.598 19.80
32 0.195 1.716 20.68
34 0.025 1.087 22.67
36 0.002 0.661 24.67
(i) Discuss the characteristics of the options markets from the output table.
[25 marks]
(ii) If the trader were to calculate the above table for three-month put options instead of call
options, how will the results compare to the above output table?
[25 marks]
(iii) Would you recommend the trader to use call options or put options or both to exploit the
product launch opportunity? Provide the trader with a suggestion and discuss the reasoning
behind your suggestion. Discuss the profit/losses he could incur if he follows your suggestion.
[50 marks]
Page 3 of 3 ECON40315-WE01
Question 2:
Jon is a bond market investor, who holds $5 million in a portfolio of bonds. He wants to estimate the
20-day 99% Value at Risk for the portfolio.
(i) (a) Design two alternative approaches that Jon can use to obtain the Value at Risk (based
on what you have learnt in the module).
(b) Provide appropriate numerical examples for the two approaches, such that you can
demonstrate the steps you will take to estimate the Value at Risk.
[75 marks]
(ii) Since you have designed two alternative approaches, are they equivalent in terms of
accuracy or is one approach better than the other? Discuss your reasoning.
[25 marks]
Question 3:
(i) Outline an application of Monte Carlo Simulation for estimating the Credit Risk of your
portfolio. Clearly provide an example to illustrate the steps to be undertaken.
[80 marks]
(ii) In terms of accuracy, do you expect a Monte-Carlo-Simulation-based credit risk estimation
approach to be better than a non-simulation-based approach? Discuss any differences
between the two types of approaches.
