LAURENTIAN UNIVERSITY

SCHOOL OF COMMERCE AND ADMINISTRATION

RISK MANAGEMENT [COMM 4736/RK1/RK2]
FINAL EXAMINATION
Time: 3 hours
Note:
This notice is to inform you of your responsibilities regarding confidentiality as it relates to
this exam. It is understood that all aspects of the exam including case information and
examination question(s) and answer(s) should not be disclosed or discussed with any
individual following the examination. The examination paper, the answer booklet(s), and
any notes must be handed in to the invigilator at the end of the examination.

PART A: Multiple choice (60 marks)

Select the best answer for each of the following items. Answer each of these items by giving the
letter of your choice. For example, if the best answer for Item 1 is a, write 1 a in your
examination booklet. If more than one answer is given for an item, then that item will not be
marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations.
Note:
1 1/2 marks each
1. Consider two stocks A and B with standard deviations 0.18 and 0.29, respectively. The
correlation between the two returns is 0.2. Which of the following portfolios has the
highest risk?
a. 100% in A
b. 75% in A, 25% in B
c. 50% in A, 50% in B
d. 25% in A, 75% in B
The following information pertains to questions 2 and 3.
An investment portfolio is formed by investing $350,000 in stock X and $250,000 in stock Y.
The characteristics of each stock are summarized in the table below.

Stock X
Stock Y

Expected
Expected
Annual
Value
Annual
Standard
Return
Deviation
$350,000
10.70%
12.50%
$250,000
13.20%
15.70%
xy = 0.4

2. What is the expected annual return of the portfolio?

a. 11.95%
b. 11.74%
c. 10.93%
d. 10.12%
3. What is the expected annual standard deviation of the portfolio?
a. 14.10%
b. 13.83%
c. 12.55%
d. 11.58%
4. What is net interest income?
a. The interest earned on an investment
b. The interest earned on an investment, net of tax
c. The excess of interest earned over interest paid
d. The interest earned on a bank deposit
5. What is a public offering?
a. An arrangement between a corporation and an investment bank whereby the
corporations issued securities are sold to the general public
b. An arrangement between a corporation and an investment bank whereby the
investment bank invests the corporations fund in selected portfolios
c. An arrangement between a corporation and an investment bank whereby the
corporations issued securities are sold to a large institutional investor
d. An arrangement between a corporation and an investment bank whereby the
corporation accepts to deal exclusively with the investment bank
6. What is one of the advantages Dutch auctions have over IPOs?
a. Dutch auctions guarantee high shares prices.
b. Dutch auctions guarantee a better stock-price performance in the long run.
c. Dutch auctions allow corporations to avoid situations where only the favoured
clients of the investment bank are offered the stock.
d. Dutch auctions allow corporations to take advantage of the investment banks
relations with investors to sell the IPO quickly.
7. Which of the following represents the risk that interest rates will decrease and
consequently the loan will be paid off earlier?
a. Interest-rate risk
b. Market risk
c. Prepayment risk
d. Credit risk

8. What is enterprise risk management?

a. The process of identifying and managing a firms expected profit sources
b. The process of identifying and managing all of a firms risk exposures within a
unified framework
c. The process of identifying and managing all of a firms commodity risks
d. All of the above
9. Which of the following are possible responses to significant risks?
(I)
Tolerate
(II)
Treat
(III) Transfer
(IV) Trace
a. (I), (II), and (III)
b. (II) and (III)
c. (II), (III), and (IV)
d. (I), (II), (III), and (IV)
10. In terms of the likelihood of occurrence and the possible consequences, what can risk
ranking be?
(I)
Quantitative
(II)
Semi-quantitative
(III) Qualitative
(IV) Semi-qualitative
a. (I) and (II)
b. (II) and (IV)
c. (I), (II), and (III)
d. (I), (II), (III), and (IV)
11. Suppose that you are considering buying an annuity contract that tracks the S&P 500.
The current level of the S&P 500 is 1,600; however, economists are anticipating that if
drought hits the agricultural areas in the country in the coming year, the S&P 500 is
expected to undergo a significant decrease, reaching as low as 1,424 one year from today.
Otherwise, the index is expected to reach 1,712. Assuming that these are the only two
possible expectations of the index level, which of the following annuity upper- and
lower-limit rates are most favourable for you as a contract holder?
a. Lower limit = 3.0% Upper limit = 7.0%
b. Lower limit = 2.0% Upper limit = 15.0%
c. Lower limit = 1.5% Upper limit = 17.0%
d. Lower limit = 1.0% Upper limit = 23.0%

12. Which of the following statements is NOT true about insurance policies with an annual
renewable term?
a. With this type of contract, the insurance company guarantees the annual renewal
of the policy.
b. With this type of contract, the fees of the policy change in a way to reflect the
policyholders age.
c. With this type of contract, the fees of the policy change in a way to reflect the
policyholders health conditions.
d. With this type of contract, the premium payments increase yearly.
13. The probabilities that a man survives to be 50, 51, 52, and 53 are respectively 0.92077,
0.91557, 0.90995, and 0.90395. What is the probability of the man dying between his
51st and 53rd birthday?
a. 0.00965
b. 0.01162
c. 0.01289
d. 0.01353
14. Suppose that an insurance company has an exposure of $500 million to earthquakes in the
state of California. The company is planning to expand its business in new states.
However, before doing that, it needs to ensure that the maximum costs that it could incur
in California do not exceed in any case $300 million. What does the company need to do?
a. Enter into annual reinsurance contracts that cover on a pro rata basis 60% of its
exposure
b. Enter into annual reinsurance contracts that cover on a pro rata basis 40% of its
exposure
c. Enter into annual reinsurance contracts that cover on a pro rata basis 120% of its
exposure
d. Enter into annual reinsurance contracts that cover on a pro rata basis 80% of its
exposure

15. The graph below represents the annual premium and the cost per year for an insurance
company issuing a certain whole life insurance contract.

Which of the following represents the surplus for the year when the policyholder is 47
years old? (Refer to the values (I) and (II) marked on the graph.)
a. (I) + (II)
b. (I) (II)
c. (I)
d. (II)
16. Suppose that XYZ fund realized a return before fees of 22%. The funds fee scheme is 2
plus 30%. What return after fees did XYZ investors realize?
a. 14.0%
b. 15.7%
c. 19.4%
d. 20.0%

17. An investor bought 175 shares in a fund for $14 per share. He realizes $1.5 per share
during the first year and $0.5 per share during the second year (that is, the price
decreased during the second year). During the third year, he sells 100 of his shares at
$15.25 per share. What are the capital gains (or losses) the investor has made during the
third year?
a. $25 capital losses
b. $0 capital gains
c. $25 capital gains
d. $47.50 capital losses
18. How would non-investment grade bonds be rated by the S&P credit rating agency?
a. Higher than BB
b. BB or lower
c. CCC or lower
d. D
19. If a fund balances its long and short positions in the high-tech industry, then this fund is
said to maintain which of the following?
a. Factor neutrality
b. Equity market neutrality
c. Dollar neutrality
d. Sector neutrality
20. Which of the following statements are true about defined contribution plans?
(I)
They involve no risk for the employer.
(II)
All contributions are pooled, and the payments to retirees are made out of this
pool.
(III) Contributions are made by the employer and the employee.
a. (I) and (II)
b. (II) and (III)
c. (I) and (III)
d. (I), (II), and (III)
21. Suppose that ABC fund realized a return before fees of 17%. The fund charges all its
clients at 5 plus 15%, and includes a 14% hurdle-rate clause in all of its agreements.
What is the clients after-fees return?
a. 10.20%
b. 8.50%
c. 7.65%
d. 6.25%
The following information pertains to questions 22 and 23.
Suppose that the end-of-year S&P 500 levels for the years 2007, 2008, 2009, 2010, and
2011 were 1,200, 1,140, 1,254, 1,442, and 1,382.

22. What is the average yearly return for the investors of an S&P 500 index fund for the
years 2008, 2009, 2010, and 2011?
a. 3.3%
b. 3.6%
c. 4.0%
d. 5.6%
23. Suppose you invested $150 in the S&P 500 fund at the beginning of 2008. What would
be the value of your investment by end of 2011?
a. $150
b. $173
c. $195
d. $204
24. A trader shorted 300 shares of a stock at $115 per share. He bought them back a few
months later at $110 per share. Dividends of $3 per share were distributed during the
period of the short position. Which of the following statements is true about the trader?
a. He realized a net loss of $1,200.
b. He realized a net loss of $600.
c. He realized a net profit of $1,200.
d. He realized a net profit of $600.
25. Which of the following uses of derivatives involves risk taking?
a. Speculation
b. Hedging
c. Arbitrage
d. All of the above
26. Which of the following is NOT an advantage of exchange markets as compared to OTC
(over-the-counter) markets?
a. Exchange markets are highly regulated.
b. Transactions in exchange markets involve lower credit risk.
c. Contracts traded in exchange markets have flexible and customizable terms.
d. Exchange markets rely heavily on electronic trading.
The information below pertains to questions 27 and 28.
Suppose that a trader buys 200 shares of company As stock on margin at $150 per share.
The initial margin stated by the broker is 40%, and the maintenance margin is 25%.
27. What amount should the trader deposit with the broker in the form of cash or marginable
securities?
a. $6,000
b. $8,000
c. $10,000
d. $12,000

28. Suppose that the price of the stock increases by $20. What would be the new balance in
the margin account?
a. $8,000
b. $12,000
c. $16,000
d. $20,000
29. A trader shorts 400 shares of a stock at $75 per share. What margin should be posted if
the initial margin is 130%?
a. $39,000
b. $42,000
c. $46,000
d. $48,000
30. Suppose that you are the CFO of a company. You know that in two months your
company will need to buy 25% of the stocks of company X (for some corporate reasons).
Which of the following is a likely option transaction as a countermeasure against
undesired fluctuations in the price of the stocks of company X?
a. Writing an adequate number of put options on the stock of company X
b. Buying an adequate number of put options on the stock of company X
c. Writing an adequate number of call options on the stock of company X
d. Buying an adequate number of call options on the stock of company X
31. Let V(X,T) represent the VaR for a confidence interval of X% and time horizon of T.
Which of the following statements are true?
(I)
V(X,T) > V(X,T) for T > T
(II)
V(X,T) > V(X,T) for X > X
(III) V(X,T) could be greater or smaller than V(X,T) for T > T, depending on the
standard deviation of the loss probability distribution
(IV) V(X,T) could be greater or smaller than V(X,T) for X > X, depending on the
standard deviation of the loss probability distribution
a. (I) and (II)
b. (I) and (IV)
c. (II) and (III)
d. (I) only

32. Assume that the change in the value of a portfolio you hold over one month is normally
distributed with a mean of 0. What is the one-month VaR of the portfolio for a
confidence level of 95%, knowing that the standard deviation of the one-month change in
the portfolio value is $105,000? (The inverse cumulative standard normal distribution of
95% is 1.645.)
a. $142,456
b. $172,725
c. $195,635
d. $205,545
33. Suppose that you want to price a European call option on a certain stock using the BlackScholes-Merton model. Which of the following parameters would you need, in addition
to the strike price and time to maturity of the option?
(I)
The riskless rate
(II)
The current price of the underlying stock
(III) The current level of a benchmark index (for example, S&P 500)
(IV) An estimation of the stock-price volatility
(V)
An estimation of the stock-price average return
(VI) A forecast of the dividends earned by the stock
a. (I), (II), (III), (IV), (V), and (VI)
b. (I), (II), (IV), (V), and (VI)
c. (I), (II), (III), (IV), and (VI)
d. (I), (II), (IV), and (VI)
34. What is volatility smile?
a. A period during which the volatility of an asset is relatively low
b. A period during which the volatility of an asset is relatively high
c. The variation of implied volatility with the strike price for a given option maturity
d. The variation of implied volatility with the option maturity for a given option
strike price
35. Suppose that the probability of default of a corporate bond during the first year is 0.044.
What is the bonds average default intensity during the first year?
a. 3.53%
b. 4.50%
c. 5.30%
d. 5.66%

36. The distance to default derived from Mertons model is a decreasing function of which of
the following parameters?
(I)
The value of debt
(II)
The volatility of the assets
(III) The current value of the assets
(IV) Riskless rate
a. (I) only
b. (I) and (II)
c. (I) and (III)
d. (I), (III), and (IV)
The following information pertains to questions 37 and 38.
Suppose that an investment bank has bought 2.5 million shares of a certain company. The
bid price of the share is $135, and the offer price is $137.
37. What is the mid-market value of the position and the proportional bidoffer spread of the
shares?
a. The mid-market value is $340 million, and the proportional bidoffer spread is
0.0147.
b. The mid-market value is $340 million, and the proportional bidoffer spread is
0.0073.
c. The mid-market value is $680 million, and the proportional bidoffer spread is
0.0147.
d. The mid-market value is $680 million, and the proportional bidoffer spread is
0.0073.
38. What is the cost of liquidation in a normal market?
a. $2,250,000
b. $2,500,000
c. $2,750,000
d. $3,000,000

39. Which of the following is the correct sequence of events that describes the deleveraging
loop?
a. Investors required to decrease leverage Investors sell assets Asset prices
decrease Leverage of investors decreases
b. Investors required to decrease leverage Investors sell assets Asset prices
decrease Leverage of investors increases
c. Investors required to decrease leverage Investors buy more assets Asset
prices increase Leverage of investors decreases
d. Investors required to decrease leverage Investors buy more assets Asset
prices increase Leverage of investors increases
40. Which of the following are the results of the dominance of negative feedback traders over
the market?
(I)
Markets become illiquid.
(II)
The prices of assets with unreasonably low prices tend to move back to
reasonable levels.
(III) The prices of assets with unreasonably high prices tend to move back to
reasonable levels.
a. (I) and (II)
b. (I) and (III)
c. (I), (II), and (III)
d. (II) and (III)

PART B: Problems and short-answer questions (40 marks)

Question 1 (8 marks)
Consider that you hold a portfolio that is summarized in the table below:

Stock X
Stock Y
Stock Z

Value
100,000
300,000
400,000

Expected Expected
Annual
Annual
Return

9.50%
6.70%
5.50%

17.50%
15.40%
13.30%

The correlation coefficients between the stocks of the portfolio are summarized as follows:

X
Y
Z

Correlation Coefficients ()
X
Y
1.0
0.5
1.0
0.1
0.3

a. What is the annual expected return of the portfolio? (1 mark)

b. What is the annual standard deviation of the portfolio? (2 marks)
Hint: The standard deviation of a three-asset portfolio is given by = (2 2 +
2 2 + 2 2 + 2 + 2 + 2 )

Your financial advisor recommends that you sell all your holdings of stock Z and replace
them with a new stock W. He bases his argument on the fact that stock Ws expected
return is exactly the same as that of stock Z (5.50% annually), yet its standard deviation is
10.00%, which is significantly smaller than that of stock Z. If you accept the advisors
recommendation, your new portfolio and correlation coefficients would be as follows:

Stock X
Stock Y
Stock W

Value
100,000
300,000
400,000

Expected Expected
Annual
Annual
Return

9.50%
6.70%
5.50%

17.50%
15.40%
10.00%

X
Y
W

Correlation Coefficients ()
X
Y
1
0.5
1
0.2
0.1

c. What is the new annual expected return of the portfolio? (1 mark)

d. What is the new annual standard deviation? (2 marks)
e. What can you say about the financial advisors recommendation? What did he miss in his
analysis? (2 marks)
Question 2 (6 marks)
The probabilities that a man survives to 30, 31, and 32 are respectively 0.97146, 0.97015, and
0.96882.
a. What is the probability of the man dying between his 30th and 31st birthday? (Include 5
decimal points.) (1 mark)
b. What is the probability of the man dying between his 31st and 32nd birthday? (Include 5
decimal points.) (1 mark)
c. What is the probability of the man dying between his 30th and 31st birthday, conditional
on reaching the age of 30? (Include 5 decimal points.) (1 mark)
d. What is the probability of the man dying between his 31st and 32nd birthday, conditional
on reaching the age of 30? (Include 5 decimal points.) (1 mark)
e. What is the minimum premium that an insurance company should charge to a man aged
30 for a $350,000 two-year term life insurance contract? Neglect interest-rate effects.
(Hint: Calculate the charges for the first and the second year and then sum the two
figures.) (2 marks)

Question 3 (7 marks)
Suppose that you work as treasurer at a U.S. corporation and you know that in three months your
company will be paying 15,000,000 for the purchase of machinery. The spot rate and forward
rates of USD/EUR (that is, number of USD per EUR) are given below. (Assume that there is no
bid-ask spread for simplification.)
Spot
1.32
1-month forward
1.35
3-month forward
1.32
6-month forward
1.31
a. What type of risk should you be worried about the most? Give a brief explanation about
this risk. (2 marks)
b. What forward contract should you buy to ensure that you would be able to make the
above-mentioned transaction in three months (that is, buying the machinery) while
hedging against the risk discussed in part a? (Specify the amount and the currency.) (2
marks)
c. Suppose that after three months (that is, on the day the transaction is executed) the spot
rate of the USD/EUR was 1.33. What is the net cost (or net saving) resulting from the
hedging transaction described in part b? (3 marks)
Question 4 (9 marks)
Suppose that you are managing a portfolio of highly liquid and frequently traded stocks. The
one-day changes in the value of a portfolio are normally distributed with a mean of 0 and a
standard deviation of $10 million. The first-order autocorrelation of the daily changes is 0.35.
a. Calculate the standard deviations of the 3-day and 20-day changes in the portfolio value.
(3 marks)
b. What is the 3-day VaR and the 20-day VaR of the portfolio for a confidence interval of
95%? (The inverse cumulative standard normal distribution of 95% is 1.645.) (3 marks)
c. Which of the two VaRs (3-day or 20-day VaR) is most suitable for your portfolio? Why?
(3 marks)

Question 5 (10 marks)

Suppose that the CDS spreads for 3-year, 5-year, and 10-year instruments are 40, 50, and 110
basis points, respectively, with an expected recovery rate of 55%.
a. What is the average default intensity over 3 years? (2 marks)
b. What is the average default intensity over 5 years? (2 marks)
c. What is the average default intensity over 10 years? (2 marks)
d. What is the average default intensity between years 3 and 5? (2 marks)
e. What is the average default intensity between years 5 and 10? (2 marks)