Financial Risk and Investment Analysis

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Market and Credit Risk Analysis 764N1
MSc Financial Risk and Investment Analysis
Summer Term Project
Pick one of the below projects and write a detailed report presenting the results and
analysis of your work. You will then make an individual presentation of the results,
as if to the Head of Risk Management and the Risk Management & Control team
in a financial institution.
1. Your first job as a newly hired risk manager for XYZ Corp is to write a market risk report on
an equally weighted portfolio consisting of at least 25 international stocks denoted in at least
three different currencies. You should do the analysis in USD. Choose your stocks from the
international stocks whose details are provided below. Your report should analyse the risk of
the portfolio on 31 March 2016 and should be purely forward-looking; no comparison with
realized returns after the 31 March 2016 are required.
First, attribute the portfolio return to a range of risk-factors. Naturally equity indices might
be considered, but it would also help to use VIX, term spreads or other interest-rate sensitive
factors. Multi-factor models can be employed for this, however other approaches are also
possible. For example, the MATLAB statement
[b,bint,r,rint,stats] = regress(y,X)
or an equivalent Excel/VBA command may be used.
Secondly, build a multi-factor VaR model. There are no specific requirements for the VaR
model but it is important to demonstrate that you have considered different methodologies
and have based your final decision on comprehensive back-testing. The report should include:
(i) the estimate of a 1-day, 10-day and 1-month VaR (as a percentage of the amount
invested) at a 1% level and an analysis of the portfolio under extreme market conditions;
(ii) appropriate attribution of VaR to the various risk factors in your portfolio;
(iii) disaggregation of risks so that traders can implement appropriate risk mitigating strategies;
(iv) a scenario analysis that shows the portfolio risk under different economic conditions;
and
(v) a brief discussion of the quality of your factor model to explain the portfolio returns.
Further considerations:
• Study data processing/validation: there might be some issues involving structural
change and outliers. You could also carry out an Internet search for relevant publications.
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Market and Credit Risk Analysis 764N1
• Please use at least three years of daily historical data.
Since you are new to the company you would like to build a strong case for a sizeable bonus
and you believe that adding further insights by using other risk measures could be important.
Portfolio Construction:
In order to construct the equally weighted portfolio, you may pick any 25 stocks from the
list below. Please note that the stock prices may be denominated in the currencies of the
respective countries. You may convert the prices into US Dollars using the relevant spot
exchange rates. If a stock has been de-listed, choose another stock for your analysis.
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Market and Credit Risk Analysis 764N1
Reuters RIC Company Name Country
PSMGn.DE PROSIEBENSAT 1 MEDIA AG ORD GERMANY
LRE.L LANCASHIRE HOLDINGS LTD ORD UNITED KINGDOM
BCOM.BR BELGACOM SA ORD BELGIUM
TEL.NZ TELECOM CORPORATION OF NEW ZEALAND LTD ORD NEW ZEALAND
GSZ.PA GDF SUEZ SA ORD FRANCE
SDFGn.DE K&S AG ORD GERMANY
NPOS.PA NEOPOST SA ORD FRANCE
MTS.AX METCASH LTD ORD AUSTRALIA
ORAN.PA ORANGE SA ORD FRANCE
EDP.LS EDP ENERGIAS DE PORTUGAL SA ORD PORTUGAL
PDLI.OQ PDL BIOPHARMA INC ORD UNITED STATES
ZURN.VX ZURICH INSURANCE GROUP AG ORD SWITZERLAND
DJS.AX DAVID JONES LTD ORD AUSTRALIA
CLLN.L CARILLION PLC ORD UNITED KINGDOM
COS.TO CANADIAN OIL SANDS LTD ORD CANADA
FOE.OL FRED OLSEN ENERGY ASA ORD NORWAY
CNPP.PA CNP ASSURANCES SA ORD FRANCE
BA.TO BELL ALIANT INC ORD CANADA
HFC.N HOLLYFRONTIER CORP ORD UNITED STATES
RWEG.DE RWE AG ORD GERMANY
CTL.N CENTURYLINK INC ORD UNITED STATES
AZN.L ASTRAZENECA PLC ORD UNITED KINGDOM
0008.HK PCCW LTD ORD HONG KONG
CPG.TO CRESCENT POINT ENERGY CORP ORD CANADA
BOUY.PA BOUYGUES SA ORD FRANCE
CWC.L CABLE & WIRELESS COMMUNICATIONS PLC ORD UNITED KINGDOM
FUM1V.HE FORTUM OYJ ORD FINLAND
ORI.AX ORICA LTD ORD AUSTRALIA
ENI.MI ENI SPA ORD ITALY
N/A STOCKLAND CORPORATION LTD AUSTRALIA
VIV.PA VIVENDI SA ORD FRANCE
POM.N PEPCO HOLDINGS INC ORD UNITED STATES
BALF.L BALFOUR BEATTY PLC ORD UNITED KINGDOM
UU.L UNITED UTILITIES GROUP PLC ORD UNITED KINGDOM
PFG.L PROVIDENT FINANCIAL PLC ORD UNITED KINGDOM
TOTF.PA TOTAL SA ORD FRANCE
CGL.L CATLIN GROUP LTD ORD BERMUDA
RDSa.AS ROYAL DUTCH SHELL PLC ORD NETHERLANDS
LAGA.PA LAGARDERE SCA ORD FRANCE
MBT.TO MANITOBA TELECOM SERVICES INC ORD CANADA
0511.HK TELEVISION BROADCASTS LTD ORD HONG KONG
RRD.OQ RR DONNELLEY & SONS CO ORD UNITED STATES
NCCb.ST NCC AB ORD SWEDEN
NAB.AX NATIONAL AUSTRALIA BANK LTD ORD AUSTRALIA
TRYG.CO TRYG A/S ORD DENMARK
DTEGn.DE DEUTSCHE TELEKOM AG ORD GERMANY
FE.N FIRSTENERGY CORP ORD UNITED STATES
SKAb.ST SKANSKA AB ORD SWEDEN
SCMN.VX SWISSCOM AG ORD SWITZERLAND
BCE.TO BCE INC ORD CANADA
UGL.AX UGL LTD ORD AUSTRALIA
WBC.AX WESTPAC BANKING CORP ORD AUSTRALIA
MEO1V.HE METSO OYJ ORD FINLAND
ATL.MI ATLANTIA SPA ORD ITALY
TLS.AX TELSTRA CORPORATION LTD ORD AUSTRALIA
SYD.AX SYDNEY AIRPORT UNT AUSTRALIA
TLSN.ST TELIASONERA AB ORD SWEDEN
SDRL.N SEADRILL LTD ORD BERMUDA
RSA.L RSA INSURANCE GROUP PLC ORD UNITED KINGDOM
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Market and Credit Risk Analysis 764N1
2. As a credit risk manager, you have been closely working with the CVA desk of your bank
with particular focus on interest rate products. The interest rate desk is about to enter into
the following trades with Morgan Stanley as the counterparty, and your boss asks you to
compute the expected exposures and the CVA charges associated with each trade:
(i) 7 year receiver swap (reset on a semi-annual basis)
(ii) 5 year payer swap (reset on an annual basis)
(iii) long position on a 6 year forward rate agreement with a tenor of 2 years
Suppose the recovery rate of Morgan Stanley is 62%, and you observe the CDS spread curve
of Morgan Stanley and the US Treasuries yield curve to be as follows (data from 22/02/16;
you may update if you wish):
Tenor Morgan Stanley US Yield Curve
(in bps) (in %)
6M 43.70 0.407
1Y 58.93 0.875
2Y 82.67 0.969
3Y 102.85 1.082
4Y 117.68 1.210
5Y 136.55 1.338
7Y 164.26 1.570
10Y 181.63 1.846
20Y 202.26 2.268
30Y 208.00 2.372
Since there is sufficient scope for the interest rate curve to change significantly during the
life of these trades, your chief risk officer asks you to simulate the future evolution of interest
rates using the Cox-Ingersoll-Ross (CIR) model (described below), with parameters calibrated
to the current yield curve.
Finally, in light of increasing worries about the banking sector in recent months, your boss
suggests a CVA comparison of these trades today with the same trades if made during the
credit crisis of 2008. (Note: data available from Reuters)
Your report should include:
(i) estimation of the parameters of the CIR process (including r0) to best fit today’s yield
curve (note: an exact calibration to match all maturities is not possible).
(ii) analysis of the expected exposures of each of the above instruments using quarterly
time steps, based on the simulated interest rates & zero coupon bond prices.
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Market and Credit Risk Analysis 764N1
(iii) calculation of the cumulative and individual CVA charges associated with each of the
above trades. Assume a netting agreement applies. Your boss advises you to compute
the default probabilities using a piece-wise constant default intensity function that can
be backed out from the CDS spreads.
(iv) comparison of model results with those from the crisis period
(v) a brief discussion of the dominant features of the results, and of themodel risk associated
with the analysis
Further considerations:
Since you are new to the company you would like to build a strong case for a sizeable bonus
(bigger than your market risk colleagues) and you believe that adding further insights could
be important, for example by comparing the impact of different types of trades and different
trade maturities, or perhaps discussing possible improvements to the modeling.
CIR Model:
Recall (from 762N1) that under the CIR model, the short rate is described by the stochastic
differential equation:
dr(t) = k(✓ − r(t))dt + ”
p
r(t)dW(t)
where k, ✓, ” > 0 with 2k✓ > “2 and W is a Brownian motion under the risk-neutral measure.
Then, the zero coupon bond price with maturity T at time t 2 [0, T] is given by:
P(t, T) = A(t, T)e

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