King’s Business School, King’s College London

This paper is part of an examination and counts towards the award of a

degree. Examinations are governed by the College Regulations under the
authority of the Academic Board. Students must not share or distribute this
examination paper.

Examination 2022/23
Module Code and Title: 7SSMM707 Risk Management
Examination Period: Period 2, May 2023
Time allowed: The paper will be available for 3 hours from 10:00 on
Wednesday, 10th of May 2023. Students are given an additional 30 minutes
to submit their answers and therefore must submit their answers to the
submission portal by 13:30 on 10th May 2023.
Word count: The answer to each essay-type question should not be more
than 300 words (i.e., approximately 2/3 of a typed page single-spaced).

INSTRUCTIONS TO CANDIDATES:
1. Answer TWO questions from the FOUR questions from Section A.
Answer ALL questions from Section B.
2. A template cover sheet has been provided on the KEATS page, you
should complete and type your answers below, or attach to the front
of your submission. Make sure you clearly indicate the questions you
are answering (e.g. Section A, Question 1).
3. Paste any required diagrams & graphs for your answers directly onto
the answer sheet using software or uploaded photos.
4. Save your work regularly, at least every 15 minutes.
5. If you have a PAA cover sheet, you should include this in addition to
your submission.
6. If you answer more questions than specified, only the first answers
(up to the specified number) will be marked.

ONLINE SUBMISSION INSTRUCTIONS:

1. You should submit your work via the Turnitin submission link on the
module KEATS page.
2. Ensure your document is submitted through Turnitin with the title
CANDIDATE ID – MODULE CODE- e.g. AD12345-7SSMM707.
3. Once submitted please check you are satisfied with the uploaded
document via the submission link.
4. If you experience technical difficulties and are unable to upload your
assessment by the deadline, please collate evidence of the technical
issue and submit a mitigating circumstances form (MCF). Remember
that the evidence must clearly show timestamps and proof that you
attempted to upload your assessment before the deadline.

2023 © King’s College London

 7SSMM707

SECTION A – ANSWER ONLY TWO QUESTIONS

Question 1

For each of the statements below, determine if they are TRUE/FALSE and
briefly explain why.

a) Delta hedging is most difficult for at-the-money options just before their

expiration.

b) A protective put with a higher strike price provides greater downside

protection but lower upside gains.

c) A covered call with a lower strike price provides greater downside

protection but a lower maximum gain on the upside.

d) It is possible to change the Gamma of a portfolio of options by adding the

underlying assets to your position.

e) You have delta hedged a long call position on a stock. The stock price

drops. To maintain your hedge, you need to buy back some shares.

[15 marks]

Question 2

Explain how you would calculate the 5-day 95% Value at Risk for a portfolio
of 𝑁 stocks using the model building approach. Discuss the limitations of your
approach.
[15 marks]

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Question 3

A callable bond is a fixed coupon bond whose issuer has the right to buy it
back for its face value (i.e., the call price) any time before its maturity.
Callable bonds exhibit negative convexity.

Explain what negative convexity means and why callable bonds have negative
convexity. Construct a strategy using interest rate swaps that can help you
hedge against the risk that a callable bond is bought back by its issuer.

[15 marks]

Question 4

Consider a firm that expects to borrow $100 million in June for a three-month
period thereafter. Explain how the firm can lock in the borrowing rate today
using Eurodollar (ED) futures.

Suppose that the June ED futures price today is $92.8 and illustrate how
hedging will work if the 3-month spot rate in June is (i) 6% per annum and (ii)
8% per annum. Can the firm perfectly hedge its interest rate risk? Explain why
or why not.

[15 marks]

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SECTION B – ANSWER ALL QUESTIONS

Question 1

Consider two 1-year loans with a principal of $1 million and a default

probability of 2% each. Assume that if one loan defaults, the other does not.
Assume that in the event of default, the loan leads to a loss that can take any
value between $0 and $1 million with equal probability, i.e., the probability
that the loss is higher than $ 𝑥 million is 1 − 𝑥. If a loan does not default, it
yields a profit equal to $0.02 million.

a) Compute the 1-year 99% Value at Risk (VaR) and Expected Shortfall (ES) of

a single loan.

b) Compute the 1-year 99% VaR and ES for the portfolio of both loans.

c) Does the VaR and the ES satisfy the subadditivity property in this case?

[25 marks]

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Question 2

A farmer is currently growing wheat and plans to sell it in September next

year. He needs to plan his budget now, because of upcoming expenses.
Suppose that the futures price of wheat for September delivery is £100 per
ton. There is 50% probability that the spot price of wheat in September will
be £90 per ton or £110 per ton.

a) Suppose that the farmer is certain that he will need to sell 2 tons of wheat
in September. Explain how the farmer could lock in today his future
revenue.

b) Suppose that the farmer is not certain about the quantity of wheat he will
sell in September. For each possible price of wheat, there are two equally
likely quantities, i.e., there are four equally likely price-quantity pairs,
which are shown in the Table below.
Price (£) Production (tons)

110 2.5
110 1.8
90 2
90 1.5

i. Suppose the farmer takes a futures position on his expected

production of wheat in September. Will this strategy help him reduce
his risk? Explain why.

ii. Design a hedging strategy that minimizes the variance of the

farmer’s revenue in September.
[25 marks]

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Question 3

Explain how you would hedge a short position in a 5-year zero-coupon bond
using a portfolio of 1-year zeros and 10-year zeros if the yield curve is normal
as shown below. Would you experience gains or losses from this hedging
strategy if the yield curve twists as shown below?

Maturity (years) 1 5 10
Spot rates (Normal yield curve) 4% 5% 6%
Spot rates (Twisted yield curve) 6% 5% 4%

[20 marks]

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