Risk Management – Practical Problem
1. In the 1980s, Bankers Trust developed index currency option notes (ICONs). These are bonds in which the amount received by the holder at maturity varies with a foreign exchange rate. One example was its trade at maturity varies with a foreign exchange rate. One example was its trade with the Long Term Credit Bank of Japan. The ICON specified that if the yen/US dollar exchange rate, ST , is greater than 169 yen per dollar at maturity (in 1995), the holder of the bond receives $1,000. If it is less than 169 yen per dollar, the amount received by the holder of the bond is
1,000- max[0, 1,000((169/(ST )- 1)
When the exchange rate is below 84.5, nothing is received by the holder at maturity. Show that this ICON is a combination of a regular bond and two options.
2. Suppose that the economic capital estimates for two business units are as follows:
Business units
Unit 1 Unit 2
Market Risk 10 50
Credit Risk 30 30
Operational Risk 50 10
The correlation between market risk and credit risk in the same business unit is 0.3. the correlation between credit risk in one business unit and credit risk in another is 0.7. the correlation between market risk in one business unit and market risk in the other is 0.2. All other correlations are zero. Calculate the total economic capital. How much should be allocated to each business unit?
1. In the 1980s, Bankers Trust developed index currency option notes (ICONs). These are bonds in which the amount received by the holder at maturity varies with a foreign exchange rate. One example was its trade at maturity varies with a foreign exchange rate. One example was its trade with the Long Term Credit Bank of Japan. The ICON specified that if the yen/US dollar exchange rate, ST , is greater than 169 yen per dollar at maturity (in 1995), the holder of the bond receives $1,000. If it is less than 169 yen per dollar, the amount received by the holder of the bond is
1,000- max[0, 1,000((169/(ST )- 1)
When the exchange rate is below 84.5, nothing is received by the holder at maturity. Show that this ICON is a combination of a regular bond and two options.
2. Suppose that the economic capital estimates for two business units are as follows:
Business units
Unit 1 Unit 2
Market Risk 10 50
Credit Risk 30 30
Operational Risk 50 10
The correlation between market risk and credit risk in the same business unit is 0.3. the correlation between credit risk in one business unit and credit risk in another is 0.7. the correlation between market risk in one business unit and market risk in the other is 0.2. All other correlations are zero. Calculate the total economic capital. How much should be allocated to each business unit?
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