AMME5105 Risk Management Analysis- Overall Portfolio Volatility

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Formulae and Data:

• For bond futures: ????? = 100(1 − ?????)
• “The average annual snowfall in Minneapolis, Minnesota is 45.3 inches (115.1 cm), with anaverage of 100 days per year with at least 1 inch (2.5 cm) of snow cover.”, source google.com

Question 1. (10 marks)

Why should a risk management framework be rules based?

Question 2. (8 marks)

a. What is the volatility (variance σ) of the following portfolio where the correlation between Asset1 and Asset2 is 0.4:

b. What would you expect to happen to correlation and volatility if these assets were linked and there was a systemic failure?

c. If a third asset with a value of \$1,940 and volatility of 6.0% were added to the portfolio, what would the overall portfolio volatility be?Page 3 of 6

Question 3. (10 marks)

Diversification vs. specialisation? Discuss.

Question 4. (8 marks)

About 40% of new businesses fail within two years of starting. Of those that remain viable after this point, 80% make modest returns (~10%) and 20% make extraordinary returns (~1,000%).

Come up with an expression and measure of the expected long-term return for a new business under this framework.

Question 5. (6 marks)

Using the case study you completed in this course:

• How can you prepare the enterprise or situation in your study for a systemic failure?

Question 6. (10 marks)

For high returns, you need to take on a high level of risk. Discuss.

Which stock above provides the best risk adjusted return?

Please calculate this (assume that the risk free rate of return is 0.5%). To answer this question, use the definition of Sharpe Ratio from the lecture notes to measure risk adjusted return.

Explain in a paragraph what risk adjusted return is.Page 4 of 6

Question 7. (8 marks)

a. Describe (without using numbers) how you would hedge the interest rate risk in a bond portfolio using three- and ten- year bond futures?

b. What are the limitations of this hedge?

Assume a corporation has debt (ie borrowings) of \$50,000,000 in the form of the 5y bond in the table above:

c. If you hedged this exposure using 3y bond futures ONLY. What quantity of futures would you buy or sell to achieve an effective hedge?

d. What combination of 3y and 10y bond futures would provide an optimum hedge for yields moving in unison, and also for steepening and flattening of the yield curve? (assume maturities of the 3y and 10y Bond Futures are exactly 3 and 10 years respectively, and the 5y Bond maturity is exactly 5 years).

e. What risks will this hedge not protect you against?

f. What are some ways to hedge the risks you described in part e) above?Page 5 of 6

Question 8. (10 marks)

Using the framework above, categorise the following risks:

Risks

a. Normal fluctuations in the price of aviation fuel for an established airline (ie price moves are around the level of long term volatility)

b. A massive spike or fall in the price of aviation fuel for the same airline

c. As above, but the airline has an active fuel hedging program

d. A large piece of space junk falling to earth

e. A pandemic

f. A snowstorm in Minneapolis (which completely halts all transport) on the profitability of Amazon.com

g. The same snowstorm for a Minneapolis based Uber driver

h. Winning the lottery

i. A large fall in superannuation asset values for a 30 year old engineer with a stable income

j. The same fall as in i) above, for a retiree living on their superannuation

k. Climate change

Answer using a table like this:

Question 9. (10 marks)

Is the negative perception around the Astra Zeneca COVID vaccine justified (look at this from the perspective of the risks vs. the benefits).Page 6 of 6

Question 10. (6 marks)

What is the difference between gambling and taking a risk?

Question 11. (6 marks)

Use a simple everyday situation to illustrate risk appetite.

Question 12. (8 marks)

Hypothetical: Due to a systematic Failure, all or part of this exam paper were made publicly available for a short time last week. During that time, it was downloaded one or more times. The ip address, identity details and other information about who downloaded it has been collected. As a result, some, or all of the questions in the exam have been rewritten.

Part 1: Knowing that part of the cohort taking this exam may have seen some of the questions before: Here is a prisoners dilemma type situation:

“Have you seen or been shown any part of the original exam paper intended for this course?”

Discuss the risk and return of answering yes and no to the above if:

• You answered yes and declare that you didn’t’ use it to prepare your answers you will receive a 5% bonus (provided no evidence to the contrary is found)
• You answer no and no evidence is found to the contrary, then you will receive no penalty or bonus

(Note1–the answers to this part are for discussion in the context of risk and return and do not assume any actions or relate to your specific circumstances)

(Note2 – a bonus or penalty will be applied by multiplying your mark by 1 plus or minus the relevant factor. For example, your mark will be multiplied by 1.15 in the case of a 15% bonus and 0.95 for a 5% penalty. Marks will be capped at 100%).

Part 2: Did you download or see any part of the paper originally intended for this exam?

AMME5105 Risk Management Analysis

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