Question One:

Using relevant examples, explain the meaning of the following types of risks with respect to financial institutions.

1. Market Risk (3 Marks)
2. County or Sovereign Risk (3 Marks)
3. Off-Balance-Sheet Risk (3 Marks)
4. Interest Rate Risk (3 Marks)

Question Two:

An investor has an investment capital of KES 8,000,000. He wishes to invest in two securities, A and B in the following proportion; KES 4,200,000 in security A and KES 3,800,000 in security B.

The returns on these two securities depend on the state of the economy as shown below:

State of Economy

Probability

Return on Security A

Return on Security B

Expansion

0.4

25%

5%

Boom

0.3

20%

10%

Recession

0.2

12%

20%

Depression

0.1

-20%

35%

Required:

1. Compute the expected portfolio return (2 Marks)
2. Determine the correlation coefficient between security A and Security B and interpret it. (4 Marks)
3. Calculate the portfolio risk as measured by standard deviation and interpret it. (2 Marks)

Bonus Question:

Prove that;

1. The covariance of the risk-free asset with any risky asset or portfolio of assets will always equal zero.
2. The correlation between any risky asset i, and the risk-free asset,