Black Rock Investors is managing the pension fund of Virgin Atlantic. Sir Richard Branson wants to assess the risk of the portfolio following the Euro crisis. During a discussion with the team of Black Rock, Richard raised the following queries.
Statement 1
"Financial institutions use Value at Risk (VAR) as a measure of market risk. How appropriate is VAR for the trust's portfolio."
Statement 2
"My portfolio of investment consists of derivatives products and alternative investments, I think Monte-Carlo VAR method is the most suitable method to estimate VAR portfolio as they follow a normal distribution"
Statement 3
"The expected 1-day return for the $10,000,000 portfolio is 0.705 and the historical standard deviation of daily returns is 0.13. The daily value at risk at 5% significance is the same for an monthly value at risk at 5% significance."
Statement 4
"The daily value at risk will decrease with an increase in the expected 1-day return and daily VAR will increase with a decrease in the historical standard deviation."
Statement 5
"A portfolio's VAR will be conservative when it is measured at a 5 percent probability than when it is measured at a 1 percent probability."
Richard is about to enter a forward rate agreement for the financing of the business expansion.
The details of the Forward rate agreement are as follows:
Virgin Atlantic will borrow $ 50,000,000 in six months at LIBOR for 1 year and LIBOR is currently 10%. The trust enters an FRA with a reference rate of 5% and a notional principal of $ 50,000,000. Assuming in three months into the contract, however, LIBOR has climbed to 12%. Assuming the risk-free rate is 8%.
REQUIRED:
(i) Define Value at Risk as a measure of market risk and the key elements involved when interpreting VAR.
(ii) Outline the three methods used to calculate VAR and the if Richard is correct with the statement relating to the use of analytical method for derivative products,
(iii) Using the data in statement 3, calculate the daily VAR and monthly Value at Risk.
(iv) Critique the validity of statement 4 in relation to the effect on VAR for an increase in expected return and secondly an increase in historical standard deviation.
(v) Identify at which level of significance, VAR is less conservative.
(vi) Using the details of the FRA with supporting workings, estimate the value of the credit risk and which party bears the credit risk.
(vii) Briefly outline four techniques of the managing credit risk.