Question 1: Corporate Value at Risk (20 points)
Consider the FTZ Company as discussed in Lecture 6 on Value-at-Risk. Due to economic uncertainty for next year, the financial price uncertainty faced by FTZ has increased drastically for the next budget year. In particular, the annualized volatility of euro/dollar exchange rate has increased to 15%, the volatility of aluminum price to $300 and the volatility of interest rate is 3%.
- Determine the 95% Value at Risk for FTZ by doing 5,000 simulations on its pre-tax earnings. Explain the meaning of the 95% Value-at-Risk. (5 points)
- Suppose FTZ’s management has decided not to hedge any of the identified market risks. FTZ’s financial controller figures that next year’s cash flow will be strained and the cash reserve is estimated to be $12 million only. FTZ is applying for a line of credit from Nopay Bank that can cover the potential shortfall of the pre-tax earnings with 95% confidence level. Determine the size of the line of credit. (5 points)
- FTZ has a good project that can start next year. The cost of investment is $3 million. The cash reserve is estimated to be $12 million next year. FTZ’s management has engaged you as their consultant on risk management. The management’s risk appetite is that they do not prefer a perfect hedge against all market risks because they still want to keep some upside potential in the pre-tax earnings. They want to hedge the market risks such that (1) the line of credit will no longer be needed and (2) the cash reserve will be enough to cover the investment in the good project next year. What risk(s) would you advise to hedge? Explain. (10 points)
Note: Please use the excel template for Corporate Value-at-Risk provided for this question.
Question 2: Hedging at Porsche (20 points)
Read the case on Hedging at Porsche and answer the following 2 questions.
- How might Porsche’s ownership structure influence the hedging strategy pursued by management. (10 points)
- Do you think Porsche’s strategy of using options to acquire a stake in VW instead of buying stocks directly is a sensible one? Or do you agree with the critics who argued that Porsche was speculating with shareholders’ money and that it had become a “hedge fund” that neglected its core business? (10 points)
Question 3: Downside Risk Analysis (20 points)
The Excel file “Q3 Downside Risk” provides the monthly index levels for HANGSENG (HS), DAX, NIKKEI, DOWJONES and SHANGHAI COMPOSITE (SSE) for the 5-year period from September 2016 to August 2021.
Meanwhile, you’re considering investing USD10 million in ONE stock fund that mimics one of the market indices for 5 years. Your investment objective is to generate a 5-year holding period return of 50%. The current risk-free rate of interest is 3%. It is believed that the performance of the markets in the foreseeable future is similar to the previous five years.
- Using the stock market data provided, estimate the annualized mean return and the annualized standard deviation for each of the five markets. (5 points)
- How would you rank the five markets based on the traditional price of risk measure? (5 points)
- How would you rank the five portfolios with respect to your investment objective? (5 points)
- Suppose you prefer to invest the USD10 million in the Shanghai market with downside risk limited to no more than 20%. What should be the target wealth in your investment objective? (5 points)
Question 4: Credit Risk Analysis (20 points)
BBB Inc. is a CNY-based importer who imports agricultural products from Europe. Currently BBB Inc. has an account payable of 5 million euros that will come due in 3 months. The current exchange rate between CNY and euro is CNY7.6923 per euro. The exchange rate outlook between CNY and euro is highly uncertain and BBB’s treasurer has decided to hedge against the exchange rate risk by using forward contract with Nopay Bank. The 3-month forward rate today is CNY 7.7787 per euro.
- Use the PROFIT/LOSS graph below to describe the exchange rate exposure of Nopay Bank as a result of providing the forward hedge service to BBB assuming no counterparty default risk. Clearly indicate the exchange rate for each turning point, if any, in the net payoff. (5 points)
- Suppose Nopay Bank is concerned about the counterparty risk arising from the possibility that BBB would default on the forward delievery date. Draw a different PROFIT/LOSS graph to describe the corresponding exchange rate exposure of Nopay Bank with counterparty default risk. Clearly indicate the exchange rate for each turning point, if any, in the net payoff.
(5 points)
© Suppose Nopay Bank requires BBB Inc to buy credit insurance to protect Nopay Bank against BBB’s default. Draw another PROFIT/LOSS graph to describe the credit insurance in terms of call or put option. Clearly indicate the exchange rate for each turning point, if any, in the net payoff. (5 points)
Question 4: Credit Risk Analysis Continued
- Suppose the CNY interest rate is 5% p.a., the euro interest rate is 0.5% p.a. and the volatility of the CNY/euro exchange rate is 30%. The credit rating of BBB inc. indicates that the probability of default is 5%. Based on the given information and your analysis in parts (a), (b) and (c) above, determine the corresponding cost of credit insurance to BBB Inc. (5 points) Hint: you can use the Excel worksheet provided “Q4 Option Pricing” to do the calculation.
Question 5: Strategic Hedging (20 points)
You’re the risk manager of an airline operating in Hong Kong. The current jet fuel price is US$100 per ton and the annualized volatility of jet fuel price is standing at 80% due to economic uncertainty among other factors. The risk-free rate is 5%. You’ve decided to hedge the jet-fuel cost for 6 months, and you’re considering the various hedging strategies. The 6-month forward price on jet fuel is US$100. The up-front cost of forward is zero. Currently, the 6-month jet-fuel options available are as follows.
| Call Options | Strike Price | Put Options | Strike Price |
| Call L | 70 | Put L | 70 |
| Call S | 100 | Put S | 100 |
| Call H | 130 | Put H | 130 |
Relative to the NAKED position, evaluate the range of protection against loss, the upside potential, the downside, and the corresponding cost of hedging using the following combinations of forward and options.