Fnancial Risk Management (FRM)

Unit II: Measurement and Management of Risk

2.1. ABC Limited had provided the following information. (MBA Apr/May 15)
Market value of Liabilities Rs. 275 crores
Market value of Assets Rs 325
Duration of Liabilities 6 years
Duration of Assets 5 years
Expected change in interest rate increase of 1%.
(i) You are required to access the change in market value of Assets, Liabilities equity and capital ratio
of the firm due to an increase of 1% in interest rate.
(ii) Demonstrate how you can immunize the market value of the firm against interest rate fluctuation
by asset duration approach and duration mismatch approach.
2.2. A portfolio has three assets with market value as below: (MBA Apr/May 15)
Stock of 10,000 shares Rs. 40 lakhs
Bond Rs 1.70 crores
Currency swap Rs 20 lakhs
The variance co-variance matrix is below
Swap
Bond
Stock
Swap 0.00090 -0.00008 0.00007
Bond -0.00040 -0.00010
Stock --0.00300
You are required to find value at Risk of the portfolio.
2.3. ABC ltd has invested Rs. 1,000 million portfolio over 2 years period at 95% confidence level. The
standard deviation of the rate of return is 20% per annum. You are required to measure VaR
(Reporting worst loss). (MBA Apr/May 11)
2.4. The daily return of a portfolio follows a normal distribution with a mean of Rs. 2,000 and a standard
deviation of Rs. 1,000. You are required to calculate the VaR number at 99% confidence level. (MBA
Nov/Dec 10)
2.5. The possible profits and losses on a portfolio has a mean of $1.2759 million and a standard deviation
of $5.6845 million. You are required to calculate VaR at 95% confidence level.
2.6. ABC bank Inc of USA would like you to measure the risk of its long position of FFr 500 million on
the spot market. The volatility assume at 10% annualize and the exchange rate is 1$=5FFr.
2.7. The investment company has a portfolio of shares of XYZ Inc purchased recently at $500 per share.
Assuming the volatility at 20% per annum. Calculate VaR at 95% level of confidence.
Unit III: Techniques and Tools of Risk Management-Forward contracts and Futures contracts
Forwards:
1. Suppose that the spot price of gold is $250 and the two-year risk-free interest rate (with annual
compounding) is 10%. If there are no arbitrage opportunities, what is the forward price?
2. The price of gold is currently $500 per ounce. The forward price for delivery in one year is $700. An
arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the
cost of storing gold is zero and that gold provides no income.

3. Suppose that you enter into a short futures contract to sell July silver for $ 5.20 per ounce on the New
York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is 4,000$
and the maintenance margin is 3,000$. What change in the futures price will lead to a margin call?
What happens if you do not meet the margin call?
4. Suppose that the spot price of soya-beans today is $80 per bushel and that the forward price for
delivery one period from the present is $96 per bushel. Assume that: markets are frictionless, the
interest rate for borrowing and lending over the period is 10% that storage costs for soya beans are
zero, and that there is no convenience yield from holding soya-beans.
(a) Show that there is an arbitrage opportunity at the given prices.
(b) Assume, instead, that it costs $4 per bushel to store soya-beans over the coming period. How
would your answer to (a) change?
(c) Suppose that the possession of an inventory of soya-beans provides its holder with a (positive)
convenience yield. How would your answer to (a) change?
(d) Assuming again that storage costs and the convenience yield are zero, under what circumstances
would your answer to (a) differ if the futures price for delivery in one period from the present is
$96?
Futures:
1. The sd of monthly changes in the spot price of live cattle is 1.2 cents per pound. The sd of monthly
changes in the futures price of live cattle for the closest contract is 1.4. The correlation between the
futures price change and the spot price change is 0.7. It is now Oct. 15. A beef producer is committed
to purchasing 200,000 pounds of live cattle on Nov. 15. The producer wants to use the December live
cattle futures contracts to hedge the risks. Each contract is for the delivery of 40,000 pounds of cattle.
What strategy should the beef producer follow?
2. Yesterday, you bought 10, December live-cattle contracts at CME, at the closing price of $0.7455/lb.
Contract size 40,000 lbs. agreed to buy 400,000 pounds of live cattle in December.
Value of position yesterday:
No money changed hands.
Initial margin required (5%-20% of contract value).
Today, the futures price closes at $0.7435/lb, 0.20 cents lower.
3.1. You are asked to compute the price of the following forward contracts.
(a) Suppose that you enter into a 6-month forward contract on a non-dividend paying stock when the
stock price is $30 and the risk-free interest rate (with continuous compounding) is 12% per annum. What
is the forward price?
(b) A stock index currently stands at $350. The risk-free interest is 8% per annum (with continuous
compounding) and the dividend yield on the index is 4% per annum. What should the futures price for a
4-month contract be?
(c) The spot price of silver is $9 per ounce. The storage costs are $0.06 per quarter payable in advance.
Assuming that interest rates are 10% per annum for all maturities, calculate the forward price of silver for
delivery in 9 months.
3.2. A stock is expected to pay a dividend of $2 per share in 2 months and in 5 months. The stock price is
$50, and the risk-free rate of interest is 8% per annum with continuous compounding for all
maturities. An investor has just taken a short position in a 6-month forward contract on the stock.
(a) What are the forward price and the initial value of the forward contract?

3.3. Suppose that you enter into a 6-month forward contract on a nondividend paying stock when the
stock price is $30 and the risk-free interest rate (with continuous compounding) is 12%. What is the
forward price?
3.4. A 1 year long forward contract on a non-dividend paying stock is entered into when the stock price is
$40 and the risk-free rate of interest is 10% with continuous compounding.
a. What are the forward price and the initial value of the forward contract?
b. Six months later, the price of the stock is $45 and the risk-free interest rate is still 10%. What are the
forward price and the value of the forward contract?
3.5. The current price of a futures contract that matures 6 months from now is $ 100. The futures contract
is for one stock of the ABC Corporation. ABC Corporation is not expected to pay dividends for the
next year. The annual risk free interest rate (with continuous compounding) is 10%. There is no
uncertainty about future interest rates. What is todays price of ABC stock?
3.6. Stock BBB has a spot price equal to 80$ and a dividend equal to 10$ will be paid in 5 months. The
one year interest rate is equal to 8% (c.c).
1. Calculate the 6 month forward price?
2. Calculate the value of the contract for the short position if after 3 months the spot price of the
stock is equal to 75$, the interest rate is still at 8%
3.7. A stock trades at 10$ and will pay a 0.50$ dividend in 3 months. Risk-free rate is 6% cc for all
maturities.
1) Determine the 2-month and 4-month forward prices of the stock
2) Now assume that you buy 100 stocks forward for the 4-month maturity at the price you just
determined. The stock trades at 12 $, interest rates have dropped to 4.50% and the company has
announced that the dividend will be of 1$ and not just 0.50. Determine the market value of your deal (i.e.
the original forward purchase of 100 stocks)
3.8. Its December 1st 20xx. A stock trades at 400 $ and will pay a known dividend of 15$ on the 1st of
May 20xx+1. The c.c. risk-free rate is 6% for all maturities.
1) Determine the fair price of a 1-year forward contract on the stock.
2) Now assume an intermediary quoted a 1-year forward price of 415 $. Explain how you would build an
arbitrage transaction in order to exploit the differential, if any, between market and fair price.
3.9. The two-month c.c. interest rates in Switzerland and the United States are 3% and 8% respectively.
The USD/SFR rate (number of USD for 1 SFR) is 0.65. The futures price for a contract deliverable in
2 months is 0.66. What arbitrage opportunities does this create (assume forward and futures prices are
the same). Show how you would build the arbitrage transaction.
3.10. A Swiss company is importing goods from the US and has to pay 500,000 USD in four months.
The companys bank offers it the following exchange rates:
Bid
Ask
Spot CHF/USD (number of CHF per one USD)
1.32
1.33
Forward 4 months CHF/USD (number of CHF per one USD)
1.29
1.31
The 4 months CHF interest rate is equal to 2.0% and the 4 months USD interest rate is equal to 5.4%.
1) Explain how the Swiss company could hedge its currency risk and how much (CHF) will have to pay
at the end of the 4 months;
2) Using the FX bid rates only, determine whether the forward FX rate is an equilibrium one or not;

3) If the forward market rate is not an equilibrium rate, state whether the Swiss company would be better
off using this market rate or trying to get the equilibrium rate.
3.11. A one-year-long forward contract on a non-dividend-paying stock is entered into when the stock
price is $ 40 and the risk-free rate of interest is 10% per annum with continuous compounding.
What are the forward price and the initial value of the forward contract?
Six months later, the price of the stock is $ 45 and the risk-free interest rate is still 10%. What are the
forward price and the value of the forward contract?
3.12. A company has a $ 10 million portfolio with a beta of 1.2. The S&P is currently 900 and one
futures contract is on 250 times the index. How can the company use futures contracts on the S&P
500 to completely hedge its risk over the next 6 months? What position should it take to reduce the
beta of the portfolio to 0.3?
3.13. (i) Current NIFTY is 6300 the risk free rate is 7% and the futures period is 6 months. Find the fair
value of 6 months NIFTY futures. (OU MBA Apr/May 2015)
(ii) The NASDAQ closed today at 4862. A stock underlying this index provides a yield of 3% p.a.
The continuous compounding rate of interest is 7%. What would be the futures value of 6 months
NASDAQ?
3.14. Hedging of a long cash position of 10,000 tonnes of wheat by selling rice futures. Assume that for
every Rs 50 change in rice futures price, there is Rs 35 change in wheat cash prices. To establish a
minimum variance hedge, how many futures contracts should be sold? (OU MBA Apr/May 2015)
3.15. A six months forward contract on 100 shares with a price of Rs.38 each. The risk free rate of
interest continuously compounded is 10% per annum. The share is expected to yield a dividend of
Rs.1.50 in 4 months from now. Determine the value of the forward contract. (OU MBA Apr/May
2014)
3.16. Suppose you want to buy a Cow in a forward contract, after one year. The spot price is Rs. 7,000,
risk free rate is 10%, milk value per day is Rs. 150 fixed cost per day is Rs. 100 and other costs are
Rs. 500 per month. Find the contract value. (Assume a 300 day year) (OU MBA May/June 2010)
3.17. A long forward contract on a non-dividend paying stock was entered in to some time ago. It
currently has 6 months to maturity. The risk free rate of interest with continuous compounding is 10%
p.a. The stock price is $25 and the delivery price is $24. Calculate the forward price and the value of
the forward contract. (OU MBA Nov/Dec 2009)

Unit IV: Techniques and Tools of Risk Management-Swaps

4.1. Sun pharma Ltd wishes to borrow Rs. 20 crore at a fixed rate for 5 years and has been offered either
11% fixed or six months LIBOR+ 1%. Cipla Ltd wishes to borrow Rs. 20 crore at a floating rate for 5
years and has been offered either six months LIBOR+ 0.5% or 10% fixed. on the basis of above
figure(OU MBA Apr/May 2015)
(i)
How may they enter into swap arrangement in which each benefit equally?
(ii)
What Risk may this arrangement generate?
4.2. A Bank does a swap of US $ 100000 selling spot and buying two months forward. US dollar is
quoted locally at Rs.42.1900/2200. Two months forward is quoted at 30p above spot rate. Interest in
Mumbai is 12% p.a. and interest in New York is 6% p.a. Brokerage on Swap deal is 1.5 paisa per
Rs.100. Indicate the gain / loss made by the bank on the swap. (OU MBA Apr/May 2014)
4.3. Companies X and Y have been offered the following rate per annum on a Rs.5,00,000 loan for 10
years(OU MBA May/June 2013)
Company
Fix Rate
Floating Rate

X
7.0%
LiBOR + 0.5%
Y
8.8%
LiBOR + 1.5%
Company X requires a floating rate loan and company Y requires a fixed rate loan. Design a swap that net
a bank acting as intermediary at 0.2% per annum and which will be equally attractive to X and Y.
4.4. Companies A and B have been offered the following rates per annum on a Rs 20,00,000 five year
loan. (OU MBA May/June 2012)
Company
Fixed Rate
Floating Rate
A
12.00%
LIBOR+0.1%
B
13.40%
LIBOR+0.6%
Company A requires a floating rate loan. Company B requires a fixed rate loan, design a swap that will
met a bank acting as intermediary at 0.1% per annum and be equally attractive to both companies.
4.5. Companies ABC and PQR have been offered the following rates per annum on a Rs. 100 lacs 10
years loan. (OU MBA Nov/Dec 2009)
Fixed Rate
Floating Rate
ABC
10%
LIBOR+0.5%
PQR
11.8%
LIBOR+1.0%
Company ABC requires a floating rate loan, Company PQR requires a fixed rate loan.
i)
How can the two companies enter into a swap arrangement in which each benefit equally?
ii)
What risk could the arrangement generate?
4.6. Electronic Business Machines (EBM) needs to borrow $20 million immediately. It can borrow for
three years at a fixed rate of 7.5% or at a floating rate of LIBOR+40 basis points. Plain Vanilla fixedfor-floating three year swaps are priced at 7.3% fixed, in exchange for floating LIBOR. If EBM
believes that interest rates are about to rise sharply, what should it do? If EBM believes that interest
rates are about to decline sharply, what should it do? (OU MBA Nov/Dec 2008)
4.7. A bank bought an interest rate swap. Under the swap agreement the bank pays a fixed rate of 8% per
annum (annual compounding) and receives the LIBOR6months over a notional of 100 million $. The
swap has a remaining life of 2 years and 2 months. Payments, both in the fixed and floating leg, are
every 6 month.
4.8. The term structure of interest rates is flat at 6% (annual compounding); The LIBOR 6 month at the
last payment date was 5.8%. Calculate the value of the swap
4.9. Companies A and B have been offered the following rates per annum on a $ 20 million five-year loan
Fixed rate
Floating rate
Company A
12.0%
LIBOR + 0.1%
Company B
13.4%
LIBOR + 0.6%
Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap that will
net a bank, acting as an intermediary, 0.1% per annum and that will appear equally attractive to both
companies
4.10. Companies A and B have been offered the following rates per annum on a $ 20 million five-year
loan
Fixed
Floating
IBM
4.50%
Libor + 0.25%
KDB
4.90%
Libor + 0.80%
a) What is the total possible cost saving?
b) What is the swap range ?
c) If the swap rate is fixed at 4,2% what is the cost saving for the two companies?
4.11. A bank should give a quotation for a three year interest rate swap with semiannual payments both
in the fixed and floating leg. The term structure of zero coupon rates (annual compounding) is given
on the following table.

t (years)
Spot rates
4.00%
4.30%
4.50%
4.65%
4.75%
4.80%

0.5
1
1.5
2
2.5
3

1. Calculate the fixed rate of a 3 years plain vanilla IRS

2. Suppose that the floating part payments are semiannual wherever the fixed part payments are annual.
Calculate the new fixed rate of the swap
3. Now suppose that both the fixed and the floating payments are semiannual but the first payment of the
floating part is chosen to be equal at 3.90%. Calculate the new swap rate
4.12. Given the spot rates of the below table calculate the fixed rate of a plain vanilla interest rate swap
with a life of 3 years and semiannual payments.
t (semiannual)
i(0,t)
(annual rates)
1
4.20%
2
4.30%
3
4.35%
4
4.38%
5
4.40%
6
4.41%
1. Calculate the fixed rate for a two year swap
UNIT V: Techniques and Tools of Risk Management-Options
5.1. Consider a European option on the S & Ps 500 that is two months from maturity. Current value of
index is 930, the exercise price is 900 the risk free interest rate is 8% per annum volatility of the index
is 20% per annum. Dividend yield of 0.2% and 0.3% per month are expected in the first and second
month respectively. Calculate the option value using B-S model? (OU MBA Apr/May 2015)
5.2. The current price of a share is Rs.50 and it is believed that at the end of one month the price will be
either Rs.55 or Rs.45. What will a European call option with an exercise price of Rs.53 all this share
be value at, if the risk-free rate of interest is 15% per annum? (OU MBA Apr/May 2014)

5.3. A share price is currently at Rs.50 Assume that at the end of six months it will be either Rs.60 or
Rs.42. The risk free rate of interest with continuous compounding is 12% per annum. Calculate value
of a 6 month European call option the stock with exercise price of Rs.48. (OU MBA May/June
2013)

5.4.

The following information is related to some options. State whether each one of this is in-themoney, out-of-the-money or at-the-money. (OU MBA May/June 2012)
Sl. No.

Option

Stock Price

Exercise Price

Rs.
Rs.
1
Call
58
55
2
Call
48
40
3
Put
112
100
4
Put
104
110
5
Put
12
15
6
Call
37
35
5.5. Mr. Sekhar wants to earn by writing call option on Mahimas corporation stock. The current price of
the stock is Rs. 28 and Sekhar wants to write a 4-month call option with the striking price of Rs. 30.
Sekhar wants to determine the appropriate premium to charge for the call option. The stocks standard
deviation is 3, the risk-less rate of interest is assumed to be 10%. Determine the premium value using
Black and Scholes option pricing model. (OU MBA Apr/May 2011)
5.6. The spot and strike prices for a stock are Rs. 45. The volatility () is 30 percent, and risk free rate is
10 percent per annum. Find the value of a six month call option, using Black and Scholes option
pricing model. (OU MBA May/June 2010)
5.7. Consider the following values, calculate the option value using Black and Scholes option pricing
model. (OU MBA Nov/Dec 2009)
S=Rs. 100; K=Rs.100; T=iyear; r=12% and =10%
5.8. Mr. Anil paid a premium of Rs. 5 per share for a 6 months Call option contract (Total for Rs. 500 for
100 shares) of Madras Rubber Ltd. At the time of purchase MRL share was selling for Rs. 57 per
share and the exercise price of the Call option was Rs. 56. Determine Mr. Anils profit or loss if the
price of the stock is Rs. 53, when option is exercised. And, what is Mr. Anils profit or loss if the
price is Rs. 63, when option is exercised. (OU MBA Nov/Dec 2008)
5.9. Suppose the stock price rises by 50% and drops by 25%. If the current stock price is Rs. 50. If a call
option has an exercise price of Rs. 50 and the risk-free rate is 5%. You are required to calculate value
of the call using BOPM?
5.10. A stocks current price is $160, and there are two possible prices that may occur next period:
$150 or $175. The interest rate on the risk free investment is 6% per period. For an European call
option having an exercise price of $155. You are required to
a) Calculate the price and the value?
b) How could you form a portfolio based on the stock and the call so as to achieve a risk-free hedge?
5.11. A stocks current price is $100. There are two possible prices at the end of the year: $150 $75. A
call option to buy one share at $100 at the end of the year sells at $20. Suppose that you are told that:
(a) Writing three calls, (b) buying 2 stocks and (c) borrowing $140 today is a perfect hedge portfolio.
Calculate the risk free rate of interest?
5.12. You are interested in the computer company HAL computers. Its stock is currently priced at
9000. The stock price is expected to either go up by 25% or down by 20% each six months. The
annual risk free interest rate is 20%.
Your broker now calls you with an interesting offer.
You pay C0 now for the following opportunity: in month 6 you can choose whether or not to buy a call
option on HAL computers with 6 months maturity (i.e. expiry is 12 months from now). This option has an
exercise price of $9000, and costs $1500. (You have an option on an option.)
1. If C0 is the fair price for this compound option, find C0.
2. If you do not have any choice after 6 months, you have to buy option, what is then the value of
the contract?
5.13. From the following information, you are required to calculate the price of the call at the end of
first and second period using BOPM. Currently the stock price is $100. The stock price evolves by either
by rising 50% or dropping 25% each period. The risk free interest rate for the period is 10%. Assume that

a European call is written on the stock with an exercise price of $120 and expiration date at the end of
period 2.