Summer Assessment 2020
Assessment paper and instructions to candidates:
FM402 – Financial Risk Analysis
Suitable for all candidates
Instructions to candidates
There are two sections: Section A and Section B. There are two questions in each
section. Answer a total of three questions. All questions have equal weight.
Questions with parts have marks allocated as shown.
If at any point in this examination you feel that anything is unclear, please make any
additional assumptions that you feel are necessary and state them clearly.
Precision, clarity, and legibility will all be valued and rewarded in grading.
Specify the question numbers that you answered in the box provided on the
coversheet for submission.
Instructions on how to scan and upload your answers can be found on the course
Moodle page. It is your responsibility to ensure that your answers are legible,
including the scanned versions of your answers.
Time Allowed: You have a 24-hour window to complete and submit your assignment.
The exam was written with the intention that it should take 2 hours 30 minutes for
students to complete. We recommend that you spend 15 minutes reading the exam
paper before you begin writing your answers.
Permitted materials: This is an open-book, open-notes exam.
Calculators: Calculators are permitted in this assessment.
LSE ST2020/FM402 Page 1 of 4
SECTION A
Question 1. [33 marks] Please aim to answer this question in no more than three pages. Discuss the effects
of noise traders on asset prices in equilibrium in the model of De Long, Shleifer, Summers and Waldmann
(1990). How does the setup of the model of Shleifer and Vishny (1997) differ from the one in De Long, Shleifer,
Summers and Waldmann (1990)? Discuss to what extent these models may provide an explanation of
empirical patterns in asset prices.
Question 2. [33 marks] Please aim to answer this question in no more than three pages. In the Black-Scholes-
Merton framework, explain how a put option can be replicated dynamically by trading in the underlying asset
and the riskless asset. Discuss the assumptions underlying this dynamic replication. What implications do
jumps in asset prices have for the ability to replicate a put option as suggested by the Black-Scholes-Merton
framework? Discuss the role of so-called portfolio insurance schemes in the 1987 stockmarket crash.
Ó LSE ST 2020/FM402 Page 2 of 4
SECTION B
Question 3
Assume that the spot curve is flat at 0.5% and that there is no default risk.
i) [5 marks] Consider a 30-year zero-coupon bond with face value of £100. Calculate the price, Macaulay
duration, modified duration and convexity of this bond. Show and explain all the steps in your calculations.
ii) [10 marks] Now consider a perpetuity which pays an annual coupon of £1 forever. It never repays any
principal. Calculate the price, Macaulay duration, modified duration and convexity of this perpetuity. Show and
explain all the steps in your calculations.
iii) [5 marks] How would you hedge the interest rate exposure on a short position with a market value of £500
million in this perpetuity using the 30-year zero-coupon bond described in part i)? Give a quantitative answer
and explain all the steps in your calculations.
iv) [13 marks] Now suppose that the spot curve shifts down so that it is flat at 0.1%. Calculate the prices of
the 30-year bond and the perpetuity with this new spot curve. Explain the performance of the hedge calculated
in part ii) following this shift in the spot curve.
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Question 4
i) [6 marks] Please aim to answer this question in no more than half a page. Consider a credit default swap
(CDS) contract on company A. Explain how you would estimate the risk neutral default intensity and the risk
neutral loss given default for company A.
ii) [10 marks] Suppose that the riskless spot curve is flat at 0%. Assume a constant risk neutral default intensity
of 5% and a risk neutral loss given default of 30% for company A. Calculate the “at-market” annual spreads
for 1-year and 5-year credit default swap (CDS) contracts on company A. Show and explain all the steps in
your calculations.
iii) [6 marks] Please aim to answer this question in no more than half a page. Consider a portfolio which
consists of buying a 5-year bond on a company and buying credit protection through a 5-year CDS on the
same company. Is this portfolio riskless? Discuss why or why not.
iv) [11 marks] Please aim to answer this question in no more than one page. Suppose you have a large pool
of subprime mortgages which individually have a high probability of default. Is it possible to create a mortgage-
backed security (MBS) tranche with a low probability of default based on this pool? Discuss why or why not.
Ó LSE ST 2020/FM402 Page 4 of 4
