Consider a FI with a bond portfolio comprised of sovereign country debt that has

Question

Consider a FI with a bond portfolio comprised of sovereign country debt that has both interest rate and exchange rate risk exposure. The duration of assets is 3.4 years and the duration of liabilities is 5.2 years.   The portfolio has assets of US$18 billion (including 2.5 billion euro) and liabilities of US$16 billion (including 4.15 billion euro) with no other currencies bought or sold forward.  

If there is only a 1% chance that US dollar/euro exchange rates will increase by at least US$0.25 per euro tomorrow, what is the daily earnings at risk (DEAR) on the 1% Value at Risk (VaR)?

A. A loss of US$25 million or less.

B. A loss of US$412.5 million or more.

C. A loss of US$1.65 million or more.

D. A loss of US$4.15 million or more.

E. A loss of 2.5 billion euro.

the right answer is B but i have no idea how to do it.

Explanation / Answer

Asset Denominated in Euros = 2.5 billion and Liabilities Denominated in Euros = 4.15 billion

If the Euro/Dollar exchange rate increases by $0.25 per euro, then Increase in dollar value of

The Euro Denominated Asset = 0.25 x 2.5 = $0.625 and The Ueor Denominated Liabilities = 0.25 x 4.15 = $1.0375

Therefore, Increase in Net Liability (in $) = Assets - Liability = 0.625 - 1.0375 = $ - 0.4125 billion OR $ 412.5 million

The negative sign indicates a loss and hence the daily earnings at risk on the 1% Value at Risk (amount of investment under threat) is a loss of $ 412.5 million. Hence asnwer is Option (B).

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