Question Answers On Financial Risk Assessment

QUESTION 1: (15 marks) 

Determine and analyse the duration and convexity approach to interest rate risk. 

QUESTION 2: (15 marks) 

Operational risk can be assessed either by using a quantitative approach. Explain and analyse that statement. 

QUESTION 3: (15 marks) 

Value-at-Risk (VaR) is defined as the probability of suffering a loss in excess of a given threshold or confidence interval. Can you analyse and appreciate the existing VaR methodologies in terms of market risk evaluation? 

QUESTION 4: (15 marks) 

The Basel 2 Agreement defines Counterparty Credit Risk (CCR) as the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. Do you think the new Credit Value Adjustment (CVA) methodology is the most appropriate approach to assess the CCR related to over-the-counter transactions? 

PART 2 (40 marks) 

You have been asked to write a financial risk brief report for National Trust Banking Corporation's senior management. Your work should both address the bank's potential concerns and questions, and take into account the fact that your audience's participants are NOT necessarily risk management experts. 

Your brief report will have to answer the following questions: 

Determine and analyse the bank's liquidity risk situation, between 2010 and 2011, by using traditional liquidity ratio analysis, and evaluate its potential change with respect to the new Basel 3 approach of liquidity (See Exhibit 1, 2, and 3). 

Total 100 marks

Guidelines Please read all questions and information provided carefully. Answer should be made in appropriate length keeping in view the requirement of each question and total word counts allowed.  

In addition, your assignment should demonstrate the following qualities: 

A critical appreciation of relevant literature and its use to support argument, substantiate calculations and other aspects of the assignment. 

Taking ownership of the content, being prepared to debate and argue a personal position, and providing evidence of evaluative skills. A submission made up of extracts from published sources which is descriptive or simply just theoretical regurgitation is not acceptable. 

Logical flow of ideas and treatment; appropriate selection of real world factors related to the companies under scrutiny. 

Evidence of additional personal research, and the ability to analyse material from a variety of appropriate relevant perspectives.  

Presentation, structure, appropriateness of methodology, breaking into section headings/subheadings, tidiness. 

Marks will be awarded for proper referencing and originality of work. Also note that plagiarism is a serious offence and your submission will be electronically checked. 

Answer 1. 

Concept of Duration

In analyzing the bond or fixed income security, it is important to know that what impact a change in interest rate will have on the price of the bond. It is important to determine that due to change in interest rate in the future, by how much the price of the bond will get change. The risk of a decline in the bond value due to changes in interest rate is known as interest rate risk.

 Duration is a concept that provides us information regarding the time period in which the repayment is received. 

Essentially, Duration is a measure which guides us for the time to wait before receiving the cash payments. Consider an n year bond (zero coupons), having fixed payment at the end of n years. In this case, the duration of the bond is n years. However, in the case of a bond with coupon payments, the duration will be less than n years.

Here all coupon payments are discounted at the same yield of discount rate y. 

Relationship between change in bond price, ΔB, and, changes in yield rate, Δy is 

ΔB=This refers that when interest rate increases with Δy the price of the bond decreases. The Duration measure was given by Frederick Macaulay in the year 1938 and is a popular measure. 

Modified Duration (D*) is, when, we consider the yield rate to be having to compound in discrete sense and frequency m times per year.

If coupon payment is paid half yearly and interest rate yield is half yearly then m = 2

And change in price of the bond due to change in interest rate yield 

Bond Portfolio and Duration

The duration of a bond portfolio equals the weighted sum of durations of individual assets and weights are proportional to the bond prices. An assumption here is that yields of all bonds will remain same during the period. Further, when there is a number of bonds having different maturities, there are parallel shifts in zero coupon yield curve (Δy). 

Application of the Duration concept

The parallel shifts in yield curve cause a financial institution exposed to interest rate risk. To hedge against the risk, a financial institution opts a portfolio of liabilities such that the duration of assets become equal to the duration of liabilities. For example, if we have a bond portfolio and exposure to interest rate risk. In that case, to hedge the assets' risk position due to interest rate risk, the asset manager may short bond futures having equal durations. 

The Concept of Convexity

Duration concept is used when the small changes in yields have been estimated and different bonds have comparable yield rates. Portfolios with a large change in yield rates behave differently and the duration estimate of assets and liabilities do not match perfectly. In this situation, when there is a large shift in yield rates, a new measure called as convexity is used by the asset manager.