2016-FRR Questions Bank

From the bank's point of view, repricing the retail debt portfolio introduces risks primarily related to fluctuations in interest rates and bank spreads. When interest rates change, the cost of funds for the bank can fluctuate, which affects the interest margins (bank spreads). Additionally, the repricing of existing debt to match current market rates introduces direct exposure to interest rate volatility. Therefore, the risks associated with fluctuations in these areas are III. Interest rates and IV. Bank spreads.

Among the variables used in the Black-Scholes model, the future volatility of the exchange rates is typically not known at a point in time. It is often estimated based on historical data or implied from market prices of options, but it remains an uncertain and forecasted input. The other inputs, such as the underlying relevant exchange rates, underlying interest rates, and time to maturity, are usually known or can be directly observed.

References:The inherent uncertainty in predicting future volatility is discussed in the context of option pricing in the "How Finance Works" document​​.

The risk manager has a long forward position of USD 1 million. The options portfolio decreases by JPY 0.50 for every JPY 1 increase in the forward position. This indicates that the options provide a hedge that is half the size of the forward position because a JPY 1 increase in the forward position is offset by only JPY 0.50 from the options. Thus, the options positions hedge the forward position by 50%.

Rho is a measure of the sensitivity of an option's price to changes in interest rates. If rho is positive, it means that the price of the option will increase when interest rates rise. This is because higher interest rates generally increase the cost of carry, which can make holding the underlying asset more expensive and thus increase the value of the option.