1 LTCM
Please read in details the paper “Risk Management Lessons from Long-Term Capital Mangement” by Philippe Jorion (on CCLE). Write short essays answering the following questions.
- What was the broad trading strategy of LTCM?
- Why did they need so much leverage?
- How did their demise happen?
- What were the most important issues with their risk management approach?
- How would you manage risk for a fund trying to trade similar strategies?
2 Merton model for credit risk
A company’s equity is $5 million and the volatility of equity is 60%. The face value of debt is $20 million and time to debt maturity is 1 year. The risk-free rate is 2%.
- What is the distance to default? 2. What is the default probability?
- What is the expected recovery rate on the debt?
Make sure to show and explain all steps!
3 Optional: Merton with an Arithmetic Brownian Motion
Solve Long Question 1 from last year’s final (on CCLE).
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