Hi Can someone help with the following: The Normal approximation for the VaR for Investor 2: The solution says the mean is 0.04*1000. Why is the mean not 0.96*1000? The probability of default is 0.04 and hence the probability of actually receiving 1 at the end of the year is 0.96? Tks
Yes, this is confusing. I think it depends on how you interpret the question. The way you have interpreted it, as I also did to start with, is by considering only the payoff X on the bonds at maturity: X is Bin(1000, 0.96). However, if you interpret the question as looking at the net return Y, taking into account the price paid for the bonds, then: Y is Bin(1000, 0.04) The examiners have gone for the second approach. Note that they did the same thing in April 2007 - ie there was a distinction between payoff and net return.
Even with the idea of 'looking at net returns' i still dont understand why bin(1000,0.4) is used as basis of calculating expected return for 2 can anyone clarify this??
Anna Bishop, I was wondering why working with net returns will make us look at the right tail of the probabilty distribution?Isn't it because we are looking at the distribution of losses. Plus I think what the examiner's have done in the April VaR is more of a technique of integration as they are still working with the left tail of the distribution of net net gains. Lewin, If you think about the whole thing as a sum of independent Bernolii trials you should arrive at a Bin(n,p). However the examiner's switched to Bin(n,q).
