MN-3503: Financial Innovation and Risk Management MAY/JUNE 2023

Java Python SCHOOL OF MANAGEMENT

MN-3503: Financial Innovation and Risk Management

DEGREE EXAMINATIONS: MAY/JUNE 2023

Answer ALL Questions

Question 1

(a)      Describe how underinvestment and asset substitution can destroy firm value and how risk management can mitigate these problems. [15 marks]

(b)      Provide an example of Decentralised Finance (Defi) and critically examine the effect of Defi on traditional banks and the future of financial services. [18 marks]

[Total: 33 marks]

Question 2

(a)      Mr Adani invests in two risky securities with the following details:  Security 1: r1 =0.16; σ1 =0.30;        Security 2: r2 =0.08; σ2 =0.25

Where r1  is the expected return of security 1 and σ1  is the standard deviation of returns of security 1;

r2  is the expected return of security 2 and  σ2 is the standard deviation of returns of security 2

The correlation coefficient (p12 ) between the returns of the two securities is -0.5

(i) Calculate the expected rate of return(r) and risk(σ) for the following portfolios:

I.40% security 1 and 60% security 2 II.80% security 1 and 20% security 2 [12 marks]

(ii) Given a risk-free rate of 4%, describe how Mr. Adani can use a combination of a risk- free instrument and a risky portfolio with an expected return of 15% to achieve an expected return of 26%. [9 marks]

(b)      Fedelity PLC has a £1000 million investment opportunity that generates £425

million in cash flows per year for three consecutive years. Cash flows are realised at the end of each year. The firm could decide to close down the project immediately after inception and would recover £900 million. The firm could also choose to abandon the project and sell off assets at the beginning of year 2 and recover £800 million or £450 with equal chance. The firm also could sell off assets  at the beginning of year 3 and realise £375 million with 40% chance or £150 million with 60% chance. Assume the discount rate is 6%. Advise the firm whether and when it should exercise the option (i.e. abandon the project) and calculate the value of the option. [12 marks]

[Total: 33 marks]

Question 3

(a)      Consider a bank with available capital of £100 million. The gain from an investment portfolio of this bank during 6-month period is normally distributed with a mean of £12 million and a standard deviation of £35 million.

(i) Calculate 1-day value at risk at the confidence level of 99% (α=2.33) and explain the meaning of the  VaR that you calculate. [9 marks]

(ii)The bank uses a 99% 6-month Value at Risk (α=2.33) to determine its economic capital. The 1% tail loss distribution has a 0.7% chance of resulting in a £600 million loss and a 0.3% chance of resulting in a £15 million loss. Calculate the annual Risk-Adjusted Return on Capital (RAROC) of the investment portfolio,  considering the expected tail loss. [10 marks]

(b)      Explain the process of “Insuratisation” and discuss advantages and disadvantages of catastrophe bonds from issuers’ and holders’ point of view respectively