April 2010 Q 1 Part iv and ix

April 2010 q 1 Part iv

Estimate the expected risk adjusted performance measure for this transaction stating any assumptions for relevant market parameters that you require

Part of the response:
In the absence of any detailed analysis the customers
could roughly estimate that in extreme circumstances the markets might rise or fall by say 30% in the next 30 days. The customer could assume that a 30% market fall will impact the long shares but that the short shares do not fall in value. The corresponding assumption could be made if markets rise. Hence the customers could estimate that the capital required for the transaction is the order of 30%/2 or 15% of the total value of the shares traded. Hence the estimated RAPM is −1/15 = −6.667% over 30 days.

Shouldn't the denominator be 30% since the probability of a rise or fall is assumed to be the same?



I think this is an example of a question where the examiner put a rough solution with loads of assumptions, but was willing to award marks for any sensible attempt. If I had been doing it, and i had "estimated" that there was a 30% volatility of long shares and a 30% volatility of short shares, I might have assumed zero correlation between the two, and said that the volatility of the portfolio was ( (1/2)^2 * (30%)^2 + (1/2)^2 * (30%)^2 ) ^0.5 = 21%! I think what the examiner did was a scenario analysis. He assumed that there were two scenarios possible. One where the long share rises 30% and the short stays the same. Profit 30%. If the reverse happens the loss is 30%. If these are the only two points considered, and represents the whole of the sample, the standard dev of returns is ( (30%)^2 +(30%)^2) / 2 ) ^0.5 = 30% (!!!) No I cant get to the 15% either.



Part ix

Discuss the pricing considerations and methodology that the bank should use
when pricing this credit default swap

Part of the response:
The bank may reasonably allow for the following in the above CDS pricing
analysis.
(1) Its costs and the differences between retail and wholesale product
returns.
(2) Other non-credit factors included in the yield spread e.g. liquidity.


This just means that the credit default swap will have a certain marketability - perhaps more or less than the corporate bond that it refers to. this marketability can be an advantage (or disadvantage) and should be brought into the pricing formula.


(3) Product structuring advantages e.g. customers having different and
perhaps improved tax consequences under the bank products


If the product gives the customer a tax advantage (perhaps due to it being packaged in a tax efficient wrapper), then this advantage generates an additional profit which can be shared between the bank and the customer.



Couldn't quite understand the last 2 points and how they would impact CDS pricing.p