RMBI4210 Midterm Answer
Transcript of RMBI4210 Midterm Answer
RMBI4210 Midterm Answer (2021)
Q1(a) 𝐷 = 1 − 𝜃 + '(+
) (* +,-
* '.(+,-
'.( -*' .(
Explain it: before any coupon payment, there is no cash flow incurred. So duration is reduced
by the same amount with passage of time.
(b) Perpetual bond has duration 1 − 𝜃 + '( or 1 + '
( (depends which formula you use), and
explain /0-
1 + 𝑖 ) − 1 + 𝑖 > 0
1) 𝑐 ≠ 0
If 𝑐 = 0, 𝐷 = 𝑇, there is no way a finite maturity bond has a higher 𝐷 than a perpetual bond.
2) 𝑖 > /0-
3) 𝑇 𝑖 − /0-
− 1 + 𝑖 > 0
These two conditions make sure ) (* +
,-* '.(
+,-
'.( -*' .(> 0. So in this case the corresponding D is
higher than perpetual bond’s duration.
The required condition does not depend on 𝜃.
Again, as before any coupon payment, there is no cash flow incurred. So duration is reduced
by the same amount with passage of time. 𝜃 has the same negative linear relationship with
duration of either a perpetual bond or a finite bond (we can observe it through the formula).
The required conditions only affect the last term in the formula as a result it has nothing to do
with 𝜃.
Q2 (a) (Refer to Topic 1 P70 & 79)
When 𝐻 is small, ':
is large and the decreasing factor term is more significant. So it is a
decreasing function of 𝑖. On the other hand, when 𝐻 is large, 0 (0;
*<= becomes relatively less
significant, and the horizon rate of return becomes an increasing function of𝑖.
(b) Financial interpretation: With infinite time of horizon, the immediate change of bond price
is immaterial in the long term, so the horizon rate of return 𝑟: is dominated by the prevailing
interest rate 𝑖.
(c) (refer to P75 and P78)
Price risk and reinvestment risk are offsetting
(d) D is depending on time and interest rate while H only depends on calendar time. So they
do not change the same. As a result, we have to construct the investment such that matching
horizon with duration to achieve bond immunization dynamically.
Q3
(a) Theoretically, yes; but practical No, such as transaction cost; we may not be able to find the
underlying or highly correlated products to hedge in reality; option price depends on volatility,
but the implied volatility for hedging is different from the actual volatility which makes perfect
hedging impossible; other than keeping delta neutral, there are other factors like gamma,
liquidity risk, credit risk and so on.
(b) (Topic 1 P28) Deep-in-the-money, highly likely (almost 100%) to exercise the option, delta
is close to 1.
No, we don’t have to purchase 10% more shares as we already purchased the full amount of
shares due to delta is 1.
(c) Topic 1 P40 as 𝜎A∗C = 𝜎DC − 𝜌DFC 𝜎DC, if coefficient is zero, no variance reduction at all (no
hedging can be achieved); if coefficient tends to 1, variance is reduced to almost 0.
Q4 (a) Proof:
(b) V𝑎𝑅 𝐿JKL = V𝑎𝑅 𝐿' + 𝐿C = 𝜇' + 𝜇C + 𝜎'C + 𝜎CC 𝑁*'(𝛼)
(c) V𝑎𝑅 𝐿' + V𝑎𝑅 𝐿C = 𝜇' + 𝜇C + (𝜎' + 𝜎C)𝑁*'(𝛼), compare with part (b), we just need
to compare whether 𝜎'C + 𝜎CC or 𝜎' + 𝜎Cis bigger. After taking square on both expressions,
we know 𝜎'C + 𝜎CC ≤ 𝜎' + 𝜎C C , so V𝑎𝑅 𝐿' + V𝑎𝑅 𝐿C ≥ V𝑎𝑅 𝐿JKL , subadditivity is
satisfied.
Q5 (a) ES satisfies subadditivity while VaR sometimes violates it.
Expected shortfall reduces credit concentration because it takes into account losses beyond the
VaR level as a conditional expectation.
(b) One minimization calculation can compute both VaR and ES based on the following
function:
Yes, based on the formula on Topic 1 P140, ES is at least as large as VaR.
Q6 (a) EVT is
more trustworthy, as it can be used to improve VaR and ES estimates with a very high
confidence level. It involves smoothing and extrapolating the tails of an
empirical distribution.
(b)