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MFIN6012 Risk Management

Final Exam June 2023

Due Date: by 23:59 on June 25 (Sunday)

Question 1: Credit Risk Analysis (10 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 6 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 entering into a forward contract with Nopay Bank.  The 6-month forward rate today is CNY7.9731 per euro.

Suppose Nopay Bank is concerned about the counterparty risk that BBB might default on the forward delievery date and hence requires BBB Inc to buy credit insurance to protect Nopay Bank against it’s default.  

Currently, the risk-free rate of interest is 7%.  The volatility of the CNY/euro exchange rate is 40%.  The credit rating of BBB inc. indicates that the probability of default is 5%.  

Determine the cost of credit insurance to BBB Inc.  

Question 2: Financial Risk Management (20 points)

Drywell Limited is a USD based oil company producing 1 million barrels of oil in Tunisia every year.  The annual cash flows from the sale of oil depend on the world oil price which is highly volatile with annual standard deviation equal to 42%.  The current oil price is USD 50 per barrel.  Drywell’s cash investment needed for exploration and development activities is proportional to the oil price and is equal to

$7 million + 800,000 x $Oil Price

Drywell’s risk management objective is to make sure that enough cash is generated to provide for the Exploration and Development activities.  Drywell is considering using oil futures to achieve its risk management objective.  The oil futures price now is USD 48 per barrel and fluctuates with annual standard deviation equal to 40%.  The correlation coefficient between the spot oil price and the futures price is equal to 0.82.  As risk analyst of Drywell Limited, you are to recommend an optimal hedging strategy to Drywell for achieving its risk management objective.  

(a) How many barrels in oil futures should be used for the optimal hedge?  

(b) What if the spot and the futures oil price today are respectively $25 and $26 respectively whereas other factors remain the same?

Question 3: Corporate Value at Risk (20 points)

Consider the FTZ Company as discussed in the lecture on Corporate Value-at-Risk and the corresponding information provided in the Excel File “Corporate VaR Stochastic Simulation” accompanying this Final Exam.  The financial price and marketing risks are delineated in Column R of Q3: Modelling Stochastic Prices and Sales.  

Suppose FTZ senior management believes that the financial price uncertainty will increase drastically for the next budget year.  In particular, the annualized standard deviation of the euro/dollar exchange rate, aluminium price and interest rate have all increased to 20%.  The entries for the standard deviations are located in the yellow Cells S8, S11 and S14 in the Excel Spreadsheet.    

(a) Determine the 95% Value-at-Risk for FTZ by doing 10,000 simulations on its pre-tax earnings.    Explain the meaning of the 95% Value-at-Risk.   (5 points)

(Enter the number of simulations in yellow cell AD6 and hit the “blue star” button.)

(b) How much of the 95% VaR in (a) is due to marketing risk domestically and overseas? (5 points)

(c) 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 very tight and the cash reserve is estimated to be $25 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)  

(d) Suppose the maximum line of credit from Nopay is $7 million.  As risk consultant to FTZ, what would you advise FTZ’s management to do?  If FTZ’s management is only comfortable with hedging one and only one financial risk, which one would you advise them to hedge perfectly so that the cash reserve and the line of credit will be adequate to cover the possible shortfall in earnings with 95% confidence.  (5 points)

You can use the excel file ”Corporate VaR Stochastic Simulation” provided for this question.

Question 4: KMV Analysis (20 points)

The key figures for the capital structure of China Evergrande Group (恒大集团) listed in the Hong Kong Stock Exchange is provided below for the financial years 2018, 2019 and 2020.  The capital structure supports Evergrande’s operations the following year; that is, the capital structure as of December 30, 2018 was relevant for the operations in 2019.

The monthly stock prices of Evergrande for the period from December 2018 to December 2021 are provided in the Excel File “KMV with Data”.  Evergrande was suspended from transaction by the HKEx in 2022.

Suppose the volatility of the stock price is constant at the long-term level which is equal to the standard deviation of the stock returns for the entire sample period.  Assume that the risk-free rate of interest is 2% p.a. for the sample period which is about the same as the yield on bonds issued by the HKSAR Government.

(a) Using the KMV model discussed in class, trace the monthly Expected Distance to Default (EDF) and the corresponding probability of distress for Evergrande from January 2019 to June 2021. (10 points)

(Hint: You can use the SOLVER template already included in the Excel File “KMV with Data”)

(b) Plot the monthly EDF and the Probability of Financial Distress. (3 points)

(c) Based on the credit rating given below, what is your opinion about the credit risk of Evergrande? (2 points)

(d) Do a test on the time dependence of the monthly volatility of Evergrande.  How would you test result affect your KMV analysis in part (a) above?  (5 points)

Question 5: Structured Product (30 points)

Consider a 5-year structured product of European type code-named “GOLDEN-GOAL” offered by a multinational investment bank to High-Net-Worth Individuals (HNWIs) that is linked to the Hang Seng Index with the following terms:

· Issue Price: USD 1 billion (USD 1,000 million)

· Issuance date: 26 June 2023

· Terminal date: 26 June 2028

· Initial Hang Seng Index on 26 June 2023: 19,800

· Payment at terminal date (per USD1,000) is as follows:

 and  are respectively the Hang Seng Index on 26^th June 2028 and 26^th June 2023.  It is believed that the Hang Seng Index will fluctuate with 15.75% volatility each year for the next 5 years.  The risk-free interest rate is 7%.  Assume that Hang Seng Index doesn’t pay dividend.  

(a) Determine the fair value of “GOLDEN-GOAL”.  (10 points)

(b) Determine the sensitivity of GOLDEN-GOAL price to the volatility of Heng Seng Index by plotting the price of GOLDEN-GOAL against the Hang Seng Index volatility.  (10 points)

(c) How sensitive is “golden-goal” price to stock market volatility; that is, how much the price will change if volatility varies between 10% and 20%?  (5 points)  

(d) Is GOLDEN-GOAL a very risky investment?  (5 points)