QUESTION 3.

a) Discuss the potential channels through which the relationship between banks and governments can create systemic risk.

[10 marks]

b) Suppose that a one-year project that requires an initial investment of $5 million has a 65% chance of generating $12 million income, a 5% chance of generating $7 million income, a 10% chance of generating $3 million income and a 20% chance of generating nothing.

i) Illustrate the cumulative probability distribution for this projects gains and losses [Feel free to draw the distribution by hand and paste a picture of it].

[4 marks]

ii) What is the projects 90% one-year VaR? What is the meaning of it?

[4 marks]

iii) What is the expected shortfall when the confidence level is 75%?

[4 marks]

iv) In what way the VaR is inferior to the Expected Shortfall as a risk measure?

[3 marks]