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Question 1: Corporate Value at Risk (20 points)
Consider the FTZ Company as discussed in Lecture 5 on Value-at-Risk. The financial price uncertainty faced by FTZ has increased drastically for the next budget year. In particular, theannualized standard deviation of euro/dollar exchange rate has increased to 10%, the standard deviation of aluminum price to$120 and the standard deviation of interest rate is 1%.FTZ’s annual budget is built by generating quarterly projections. FTZ believes that the value drivers for growth such as market share, product demand and competition will remain th...

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Question 1: Corporate Value at Risk (20 points)
Consider the FTZ Company as discussed in Lecture 5 on Value-at-Risk. The financial price uncertainty faced by FTZ has increased drastically for the next budget year. In particular, theannualized standard deviation of euro/dollar exchange rate has increased to 10%, the standard deviation of aluminum price to$120 and the standard deviation of interest rate is 1%.FTZ’s annual budget is built by generating quarterly projections. FTZ believes that the value drivers for growth such as market share, product demand and competition will remain the same as last year. Suppose FTZ must achieve a pre-tax earnings level of $165 million to cover the various R&D activities, capital expenditure as well as working capital needs.
Suppose FTZ doesn’t want to hedge the financial price risks. Determine the “risk capital” FTZ should prepare to set up that will ensure the availability of the $165 million with 95% confidence level. Develop your answer by doing 10,000 simulations on FTZ’s pre-tax earnings. (5 points)
(Note: Since the simulation is done on quarterly basis, you must convert the annual standard deviations above to quarterly standard deviations.)
Plot the probability distribution of FTZ’s pre-tax earnings and indicate the 95% Value-at-Risk on the graph. Explain the meaning of the 95% Value-at-Risk. (5 points)
FTZ’s financial controller figures that next year’s cash flow willbe very tight and is applying for a line of credit from Nopay Bank that can cover the potential shortfall of pre-tax earnings with 95% confidence level. FTZ’s cash reserve next year is estimated to be $3 million only. Determine the size of the line of credit. (5 points)
Suppose FTZ decides to hedge against ONLY ONE of the three price risks by using forward contract in order to achieve perfect hedge. Which price risk should FTZ hedge and what is the corresponding “risk capital” needed in order to provide the $165 million pre-tax earnings with 95% confidence level? (5 points)
Question 2: Structured Product (20 points)
Consider an “Airbag” security, an investment product, offered by SC Bank that is linked to the Hang Seng Index with the following terms:
Issuance date: 29 June 2017
Terminal date: 29 June 2022
Initial Hang Seng Index on 29 June 2017: 25,965
Payment at terminal date (per USD1,000):
= 1,000×1.25×((HSI on 29June2022)/(HSI on 29June2017))if HSI on 29June2022<20,772
= 1,000 if 20,772< HSI on 29June2022<25,965
= 1,000×((HSI on 29June2022)/(HSI on 29June2017)) if HSI on 29June2022>25,965
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%.
Draw a diagram to describe the payoffs of this Airbag product. (10 points)
Determine the fair market value of this Airbag product on June 29, 2017. (5 points)
If the minimum deposit required is $1,000, explain if this product is a good deal or not? (5 points)
Question 3: Pidilite Case(20 points)
Discuss the relevance and framework of credit quality analysis for a target company. (5 points)
What financial parameters would you use for evaluating a company’s credit quality and over all financial risk profile? (5 points)
Using a trend analysis of financial credit ratios, what’s your view on Pidilite’s financial health and overall credit quality? (10 points)
Question 4: Credit Risk Analysis (20 points)
AAA Inc. is a small HKD-baseddeveloper buying major home appliances from Italy for its new residential development. AAA’s hastotal account payableis8 million euros that will come due in 1 year. The current exchange rate between HKD and euro is HKD 9.1 per euro. The exchange rate outlook is highly uncertain and AAA’s treasurer has decided to hedge against the exchange rate risk by using forward contract with Nopay Bank. The one-year forward rate is 9.2767. Other market information is as follows:
HKD Risk-free rate = 5% per year
Euro Risk-free rate = 3% per year
Annual Standard deviation of HKD/Euro exchange rate = 30%
Using the graph below, describe by plotting the exchange rate exposure of Nopay Bank as a result of providing the forward hedge service to AAA 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 AAA would default on the forward delievery date. Use the graph below 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 AAA Inc to buy credit insurance to protect Nopay Bank against it’s default. Use the graph below to describe the credit insurance in terms of call or put option. No need to do calculation here. Clearly indicate the exchange rate for each turning point, if any, in the net payoff.(5 points)
Suppose AAA Inc is credit-rated by Nopay Bank with a B-rating which implies a default probability of 9%. Determine the cost of credit insurance for protecting Nopay Bank against the probable default by AAA Inc. (Hint: Use either the Black-Scholes formula or 10,000 simulation.)
Question 5: Downside Risk Analysis (20 points)
Suppose the mean return and the volatility of the Shanghai Stock Index are expected to be 6% and 25% respectively for next year. You are now considering investing RMB 1 million in a stock fund that mimics the performance of the Shanghai Stock Index for 2 years. The current risk-free rate of interest is 2%.
What is the target wealth level that you would be able to achieve with downside risk no more than 20%? (5 points)
Suppose the target wealth level is set at RMB 1.2 million. What is the downside risk of not doing the “portfolio switch” at the right time? (5 points)
Suppose the target wealth level is set at RMB 1.2 million. What is the downside risk of using the buy and hold strategy for one year? (5 points)
Everything else the same, what is the holding time period (in years) to achieve a target wealth of RMB 2 million from 1 million with downside risk less than 15%%, assuming portfolio switch is performed at the right moment? (5 points)

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