Risk Management

Mid-term Assignment

Dear Student,
On the following three pages, you will find a total of 5 questions to be solved for the
mid-term assignment. The questions cover chapter 1 to 7 of the book Risk
Management and Derivatives by Rene M. Stulz.
The solutions to these questions have to be delivered in hard copy by Friday, 10 May,
4 pm to the letter box on the 9th floor of building K (the Finance Departments floor).
Only copies that are delivered in time will be considered!
The final score of this course is calculated as

where F is the score on the Final exam, A the score on this assignment, and C the
score the case study. Both the case study and this assignment are hence not
compulsory.
You can work in groups of maximum four persons on this assignment. All persons
within the group receive the same mark. There is no penalty (premium) whatsoever for
the number of students within a group.
Good luck,
Lieven Baele

1. You are the finance director of CR7, a US based manufacturer of luxury products.
The CEO has just signed a large contract with Hotel de Paris from Monaco for a
large delivery of accessories, worth 1 million. Both delivery and payment are due
in 7 months from now. At the current exchange rate of about 1.25 $ per , this
contract is worth about $ 1.25 million.
a. Represent graphically the cash flow (in $) of CR7 in six months on a figure
as a function of the $/ exchange rate, supposing that CR7 remains long in
, i.e. if it does not hedge.
b. The current US interest rate is 3%, the euro area interest rate is 1%.
Calculate the arbitrage-free 7-month forward price for the $/ exchange rate.
Show how this currency forward contract can be replicated by buying /
lending $ and/or s.
c. Describe the position in this forward contract if management of CR7 would
decide to fully eliminate exchange rate risk (long/short, hedge ratio).
Represent graphically the payoffs at maturity against the exchange rate for
the contract of your choice. Indicate at which ranges of the $/ exchange
rate CR7 makes a loss and at which it makes a profit on the forward contract.
d. Plot the hedged cash flow of CR7 if it adopts the position specified in (c) as
a function of the exchange rate. In this same picture, plot the unhedged cash
flow (part (a)).
e. Suppose that instead of hedging using a forward/futures contract, CR7
decides to hedge with options. Describe in detail the type of options you
would choose, and represent graphically the payoff at maturity of the
preferred option against the $/ exchange rate. Assume that the option
premium is 5% of the options strike price.
f. Represent graphically the unhedged cash flow, and the cash flows when
respectively forwards and options are used for hedging. What are the
arguments in favor or against the forward / options hedging strategy?
2. You manage a portfolio worth 1 Billion for a Dutch pension fund. The portfolio
invests solely in 10 large European industry indices. The euro denominated returns
(including dividends) are given in the attached excel file. You have currently
allocated 10 percent to each of the industries, i.e. each industry gets an equal
weight.
a. Calculate the average (annualized!) returns and volatilities for the 10
industries. What industries offer the most attractive risk-return trade-off?
b. Calculate the return correlation matrix, and discuss possibilities for
diversification.
c. Calculate the average annualized portfolio return and volatility. Use the excel
function mmult in your calculations of the portfolio volatility1, and report that
formula in your text.
1

After typing the formula, excel requires you to jointly press ctrl-alt-enter instead of just enter to calculate
the value.

d. Suppose that the global equity market portfolio is a good proxy for the market
portfolio in the CAPM (returns also attached in attached excel sheet).
Calculate the betas of the 10 industries with respect to the market portfolio.
Interpret the numbers you obtain.
e. Assume the expected return (on top of the riskfree rate) on the market
portfolio amounts to 6 percent. The riskfree interest rate equals 2.5%.
Calculate the expected return for each of the industries. Interpret the
numbers. Calculate the expected portfolio return, and use the obtained
number in your answer of the following questions.
f. Financial theory argues that optimal weights are the result of a maximization
of expected return and a minimization of risk. Suppose that the investor
maximizes the function Portfolio Expected Return 3 times the Portfolio
Variance. Use excel solver to obtain optimal weights (again, impose no
short sales allowed and 100 % sum of weights).
g. Assume that the portfolio returns are normally distributed. Calculate the
probability that the portfolio will incur a loss of more than 5 percent over the
next month. Similarly, what is the probability that the portfolio will realize a
loss of more than 10 percent over the next three months?
h. Calculate the probability that in one year the value of the portfolio will lie
between 900M and 1050M.
i. Calculate the 1-month Value-at-Risk at the 1%, 5%, 10% level. Interpret your
results.
j. You consider liquidating 5% (absolute value) of your position in Financials
to invest it fully in Utilities. Quantify the impact of this sale on the 3-month
Value at Risk (at a 5% level) without calculating the expected return and
volatility of the new portfolio. Explain what you find.
3. You have received an additional amount of 100 million to invest in the pension
fund of question 2. Instead of investing it in Europe, you consider purchasing US
equities, as you think that an economic rebound is likely to happen first in the US.
While you are positive about the US equity market, you are less optimistic about
the evolution of the $/ exchange rate.
a. Does this investor expect the euro to appreciate or depreciate with respect
to the US$?
b. Should the investor take a short or a long position in the $/ forward
contract?
c. Suppose that the current $/ exchange rate is $1.26/. Given that the $
interest rate is 1 percent, and the interest rate equals 2.5 percent, what is
the arbitrage-free forward price?
d. Determine the optimal hedge ratio using the euro-denominated prices on a
broad US equity market index, and the euro to the $US exchange rate (use

linest function in excel). Explain why or why not it is higher/lower/equal than

1. Evaluate the quality of the hedge.
4. On April 1st, the forward price on 3 month Treasury Bills of face value 1,
deliverable on July 1st and payable on September 30th is 0.98. On April 1st, the
spot price for bills of the same face value and maturing on June 30th and
September 30th is 0.97 and 0.945, respectively.
a. Calculate the arbitrage-free treasury-bill forward price.
b. Is there an arbitrage opportunity at these prices? If so, describe it and
compute the profits per unit (I am (also) looking for a concrete number here!)
c. You have a floating-rate loan maturing on September 30th. The interest rate
for the final quarter is set on July 1st. You are worried that interest rates will
increase in the near future, and you would want to hedge against this
increase. Describe the characteristics and position in the correctly-priced
Treasury Bill future. Show in a table that at maturity the hedge indeed works
well.
5. OKB bank, a Belgian provincial bank specializing in providing financial services to
small companies, has an investment portfolio worth 10 Million. Early March 2012,
management receives a letter from the supervisory authorities stressed after they
failed to foresee the recent subprime crisis that they want OKB bank to further
improve its risk management tools, including for relatively small positions like this
one. The returns and asset weights are given in the attached excel file, as well as
the global equity market index that serves as a market portfolio. The riskfree rate is
2 percent, and the market risk premium (in excess of riskfree rate) equals 6 percent.
a. Calculate the one-year Value-at-Risk at the 0.5 percent level (use the
normsinv function to get the 0.5 percent multiplication factor from the
standard normal distribution).
b. The risk manager has allocated 2.5 Million of capital as a buffer specifically
for potential losses on their investment portfolio. Do you consider this
sufficient?
c. Use Excel solver to find the weights that yield a Value-at-Risk at the half-apercent level of exactly 2.5 Million while still keeping the expected return
as high as possible. Do this by maximizing the function Expected Return
2 times the VaR(0.5%). Impose a short-sales constraints (all weights at least
0) and a sum of weights equal to a 100 percent.