Overview

The task you are given is to estimate the market risk for a 5 year Commonwealth government bond, held on September 2 , 2019 (you are working out the risk position assuming that you own the bond at the close of trading the previous day).  You will do this by estimating the Value-at-Risk for the bond.  This will require you to choose the best VaR model by back testing several methods to determine the most reliable for the task at hand.

Description

You will be asked to calculate the following;

• 10 day VaR for the bond at a confidence level of 99%.

Note: This risk estimate applies to the next 10 trading days from September 2, 2019 until September 13, 2019 (i.e. – it should be a forecast of risk).

Based on what you have learnt from EFB344, you are considering several options for how to compute this risk measure,  a) the normal distribution using the EWMA for volatility, or b) a normal distribution  based on a rolling window for volatility.  Both methods require choosing parameters to assign weight to past data,  for the EWMA and the window length for the rolling window.  You will consider the following;

Normal Distribution (EWMA)
Normal Distribution (RW)	Rolling window with 252 trading days.

 

This leaves you with two possible models that could be used to provide the VaR measure asked for above.  You must choose the most appropriate model and report the associated 10 day VaR.  To inform your decision of which to use, you are going to consider the recent historical performance of both models in calculating 1 day VaR at the confidence level of 99%.  You will do so by first examining the frequency of instances when the VaR was exceeded by the observed loss over the period for which you are provided with historical data (approximately five years).

You will then evaluate the appropriateness of these frequencies over time relative to the Basel traffic light levels discussed in lectures. Based on this performance, select the best model and report the required VaR(10, 99%) for September 2, 2019.

Bond Pricing details and Risk management assumptions

The bond you are dealing with has five years to maturity, with semi-annual coupons at a rate of 4% per annum.  The face value of the bond is $1,000,000.  When pricing the bond you are to assume that you use a single discount rate for all cash flows (you are provided with data for this rate).  This is equivalent to assuming a flat yield curve that always moves in parallel shifts.

Presenting your results

• You are to conduct your analysis in a copy of the Excel file “Assignment_Part_A – Data and Results.xlsx” provided on Blackboard. This file contains a tab with the raw data for the discount rate as well as a front page for you to summarize your results.  All working is to be contained in the subsequent tabs.
• The front tab asks you to provide the following
  • Your name and Student number
  • The exceed probabilities for the two models above.
  • A graph summarizing the Basel Traffic Light results (such as the one shown in lecture 3).
  • Which of the models above is your preferred model based on the back testing results.
  • The final VaR(10,99%) for the portfolio based on your preferred model.
  • An evaluation of the relative performance of the two models and a clear justification of which model is superior based on your back testing. This is essentially a discussion of how you should interpret the back testing results in order to select the most appropriate model.  This should be no more than 300 words.
• Your excel file should be formatted in a reasonably clear way, so that someone who was given the same job after you would be able to understand your working and replicate what you have done.

Details of Submission

• Also note QUT’s late assignment policy:

Late Assignment + No Extension = 0%

Additional Notes and Instructions.

• Your excel spreadsheet must contain the formulas that you have used for all calculations (e. – don’t paste the values for the calculations).
• There is an Excel file available on blackboard (called “Excel guide.xlsx”) that includes instructions for how to do several useful things in excel. It also includes some informative examples which might be of interest.  Please look at this file.
• A few hints that will help stop people going down the wrong path;
  • Remember that we are assuming that daily changes in the discount rate are normally distributed.
  • You can assume that the mean change in discount rates is zero.
  • You should initialize your EWMA using the variance of the first 252 changes in the discount rate. This will enable you to produce the same number of potential exceedances for both models.

Criteria and Standards Sheet for Assignment Part A (30 marks)

Marking Criteria	High Distinction	Distinction	Credit	Pass	Fail	Mark
KS (1.1): Demonstrate and apply integrated discipline (including technical) knowledge
Subject Knowledge	Demonstrates comprehensive understanding of relevant finance and risk management concepts and techniques.	Demonstrates a developed understanding of relevant finance and risk management concepts and techniques.	Demonstrates a developed understanding of relevant finance and risk management concepts and techniques but with a few errors.	Demonstrates an adequate understanding of relevant finance and risk management concepts and techniques.	Insufficient or inaccurate understanding of relevant finance and risk management concepts and techniques.	/18
KS (1.2): Apply technical and technological skills appropriate and effective for real world business contexts
Excel Use and Formatting	Document prepared and formatted according to standards required by the subject.	Document generally prepared and formatted according to standards required by the subject, but with a small number of minor errors	Document generally prepared and formatted according to standards required by the subject, but contains some errors	Frequent errors, but displays an ability to prepare and format the document according to standards required by the subject.	Fails to format the document to an appropriate standard required by the subject	/ 5
HO (2.2): Exercise independent judgement and initiative in adapting and applying knowledge and skills for effective problem solving
Critical Analysis	Provides a clear and well-reasoned justification for the choice of superior risk management model that fully considers the empirical findings.	Provides a strong justification for the choice of superior risk management model that is supported by the empirical findings.	Provides a solid justification for the choice of superior risk management model which is generally consistent with the empirical findings.	Provides only weak justification for the choice of superior risk management model which barely takes account of the empirical findings.	Fails to provide a justification for the choice of superior risk management model and/or the arguments are at odds with the empirical findings.	/7