How do I approach the following question?
A portfolio has 100 million invested in equities. It has also transacted an interest rate derivative issued by counterparty X, which the value is 0 if the reference interest rates are equal to or below 2% p.a., 5 million if the reference interest rate is between 2% p.a. and 3% p.a., and $15 million if the reference interest rate is higher than or equal to 3% p.a. The current reference interest rate is 2.5% p.a.
(i) What is the current value of the portfolio?
(ii) What is the current value of the portfolio if we subject the portfolio to three stress tests below:
Test 1: +1% p.a. reference interest rate and -25% market value of equities
Test 2: -1% p.a. reference interest rate and +25% market value of equities
Test 3: +2% p.a. reference interest rate, -50% market value of equities, counterparty X default with 50% recovery of the market value of the interest rate derivative.
(iii) Suggest the reasons for Tests 1 and 2 to be calibrated this way i.e positive direction for interest rate and negative direction for the market value of equities and vice versa.