Corporate Value at Risk (20 points) Consider the FTZ Company as discussed in Lecture 6 on Value-at-Risk.
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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%.
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.
Question 5: Strategic Hedging (20 points) Continued
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- 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 FTZs management has decided not to hedge any of the identified market risks. FTZs financial controller figures that next years 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. FTZs management has engaged you as their consultant on risk management. The managements 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)
- How might Porsches ownership structure influence the hedging strategy pursued by management. (10 points)
- Do you think Porsches 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)
- Using the stock market data provided, estimate the annualized mean return and the annualized standard deviation for each of the five markets. (5 points)
Portfolio | Shanghai | Hang Seng | Dow Jones | DAX | NIKKEI225 |
Annualized Mean Return | |||||
Annualized Standard Deviation |
- How would you rank the five markets based on the traditional price of risk measure? (5 points)
Portfolio | Shanghai | Hang Seng | Dow Jones | DAX | NIKKEI225 |
Rank | |||||
1 = most preferred; 2 = least preferred |
- How would you rank the five portfolios with respect to your investment objective? (5 points)
Portfolio | Shanghai | Hang Seng | Dow Jones | DAX | NIKKEI225 |
Rank | |||||
1 = most preferred; 2 = least preferred |
- 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)
- 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.
- Suppose Nopay Bank requires BBB Inc to buy credit insurance to protect Nopay Bank against BBBs 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)
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 |
| Explanation |
Range of Protection | |
Upside ($) | |
Downside ($) | |
Cost ($) |
| Explanation |
Range of Protection | |
Upside ($) | |
Downside ($) | |
Cost ($) |
| Explanation |
Range of Protection | |
Upside ($) | |
Downside ($) | |
Cost ($) |
| Explanation |
Range of Protection | |
Upside ($) | |
Downside ($) | |
Cost ($) |
| Explanation |
Range of Protection | |
Upside ($) | |
Downside ($) | |
Cost ($) |
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