Kyle Group Trading Game Final Report

LIANGDA WEN [42273251] ANH DUC TRAN [42576318] HAI YEN VU [42794037] YUZHEN YI [42773489]

Abstract: This report reviews Kyle teams performance in managing the portfolio and hedging exposures during last year. Although some mistakes were taken especially in quarter one, the portfolio cost of funds had outperformed the benchmark cost of funds by 1.6% at the end of quarter 4. Foreign exchange risk and commodity exposure had also been significantly reduced owing to our hedging strategies. Yield forecast accuracy and risk management efficiency would be crucial for our performance in next year.

Table of Contents 1. Introduction .................................................................................. 1 2. Portfolio performance .................................................................. 1 3. Foreign exchange risk .................................................................. 4 4. Commodity exposure ................................................................... 6 5. Conclusion ................................................................................... 7

1 Introduction This report is about the Kyle Groups performance in 4 quarters. The purpose of this report is to identify our inaccuracy estimation and inaccuracy hedges, and correct risk management activities under the specific economic overviews and exposures as well. It is also our better understanding about risk management. The main analysis is divided into three parts: first, we focus on our portfolio performance, which primarily contains interest rate estimation and cash flow management. Then, we analyze our hedging behaviors on foreign exchange risk. Last, we deal with the commodity exposure. The whole report is based on the theory and methodology from Risk Management Seminars.

2 Portfolio performance

5.8 5.75 5.7 5.65 5.6 5.55 5.5 5.45 5.4 5.35 5.57 5.53 5.53 5.52

5.78 5.7 5.63 5.63 5.6 5.57 expected yield(%) actual yield(%)

Figure 1: Expected and actual three commercial paper yield

6.3 6.2 6.1 6 5.9 5.87 5.8 5.7 5.6 15/3/2004 15/6/2004 15/9/2004 15/12/2004 15/3/2005 5.84 6.1 6.13 6.12 6.22

6 Expected rate(%) 5.9 Actual rate(%)

Figure 2: Expected and actual ten year A$ ten year bond rate

7 6 5 4 3 2 1 0 14/06/2004 14/09/2004 14/12/2004 14/03/2005 3.64 4.05 3.69 3.07 Portfolio cost of funds(%) Benchmark cost of funds(%) 5.72 4.78 4.67

3.4

Figure 3: Portfolio and benchmark cumulative cost of funds at the end of each quarter

Forming views on economy and interest rates is at the heart of portfolio construction. As shown in the figure 1 and figure 2, while our yield forecasts in quarter 1 moved inversely with the real yields, in the subsequent quarters, the expected yields were largely consistent with the real yields. As a consequence, the portfolio cost of funds had outperformed the benchmark cost of funds since quarter 2 (figure 3). A lesson we learned from the mistake we made in quarter 1 is to distinguish whether the economic data affect the short end or the long end of the yield curve. For instance, most impact of the cash rate is at short end, and one of the RBAs mean of altering cash rate is inflation rate targeting. Accordingly, the inflation outlook which suggesting it to be setting toward the lower end of the band would change markets mind about the increase in short-term yields. The US economy and the interest rate differentials with US, on the other hand, have an impact on the long-term economic growth outlook and thus affect the long-term bond yields. In contrary to the above analysis, the forecast we made in quarter 1 was while the international pressures would raise the short-term rates, the inflation rate targeting would decrease the long-term rates. Based on a wrong judgment, we decided to reduce duration, which consequently resulted in underperformance. Owing to the lesson we had learned from quarter 1 and a better understanding of hints, our forecasts had been significantly improved in subsequent quarters. Our strategies in remaining quarters were made in accordance with the changes of rates and swap spread. While the yields were about to rise and the swap spreads were going to widen in quarter 2 and quarter 4, using swaps had bigger payoff than issuing bonds. On the contrary, while the yields were about to fall and the swap spreads were going to widen in quarter 3,

buying back long bonds was a better strategy than using swaps. This train of thought had turned out to be right and had contributed to the increase in cumulative outperformance. A mistake we made in quarter 3 was violating the management range of benchmark duration, which was largely due to the error in operating the spreadsheet. As a liability manager, excess risk taking may have disastrous consequences for the clients. This mistake reminds us of the importance of determining the allowable level of risk and risk management.

3 Foreign exchange risk The Central Treasury is required to appropriately manage foreign exchange risk for clients, based primarily on economic overviews released each quarter. According to client profiles, the QEPA will need to purchase 5000 tonnes of copper in USD on 15 December 2004 and APA also has to pay European supplier EUR 5,000,000 at the same date. Moreover, the clients have conducted some transactions with regard to foreign exchange risk, such as a purchase of roadwork equipment in USD. For quarter 1, the economic overview in June 2004 illustrated that the Australian dollar has been a major beneficiary of the downward trend in the $US over the past 18 months or so. Additionally, the burden falls to domestic policy makers in Europe to keep interest rates lower. Hence, AUD will have appreciated significantly against EUR and USD, so we decided to not hedge AUD against EUR and USD. With respect to the purchase of 5,000 tonnes of copper in USD, a total cost incurred is less than benchmark hedging cost; consequently, savings can be computed as shown in Table 1.
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Table 1: Foreign exchange hedging in each quarter

Similarly, for quarter 2, our estimation is that there is an appreciation of AUD against EUR and USD, which is explained by the Australian dollar is high and still moving higher, particularly against the Euro. Therefore, we did not hedge foreign currency risk with AUD. Nonetheless, it was a wrong decision since we made a loss in USD related transactions. For quarter 3, It is not clear whether the downward trend in the $US is over, showing that AUD would appreciate against USD, hence no need to hedge AUD against USD. Furthermore, APA has to pay the European supplier EUR 5,000,000 on 15 September 2004, thereby buying EUR 5,000,000 at spot exchange rate to honour the obligation.

For the last quarter, the Central Treasury has no exposure with EUR and we have not hedged any USD. Therefore, we just buy USD at spot price for copper and roadwork equipment.

4 Commodity exposure One of our clients QEAP has contracted to purchase 5,000 tonnes of copper in nine months (15/12/2004) and our task was to fulfil their needs.

3,000 2,500 2,000 1,500 1,000 500 0 Q1/2004 Q2/2004 Q3/2004 Q4/2004 Q1/2005 Forecast Actual

Figure 4: Actual and Forecast of copper price (US$/tonne)

For quarter 1, from the economic overview, it was predicted that the copper price may increase since the ongoing improved the US economy. The current copper price (15/03/2004) was US$2,345/tonne and it would increase to US$2,385 as our prediction. Therefore, we decided to hedge the potential increase in price by purchasing 9 months copper forward at US$2,427.
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In the quarter 2, the copper price moved to US$2,365 as our forecast despite of smaller proportion. We however expected that copper price will not increase further and it maybe go down to at least US$2,360 in the next time. Hence, our strategy was to sell forward 5,000 tonnes of copper in 6 months at US$2,379 to offset the previous forward. The overview for quarter 3 indicated that copper price was decreasing during the quarter due to the implication of rising US interest and the lower demand from Japan and Euro. We had predicted that the commodity price would go down to US$2,360 this quarter, but the actual price was much lower 2,200. Along with above analysis, we supposed that the price reached the lowest point at this period, so we purchased copper forward at US$2,220. For the next quarter, we estimated that the price may increase slightly to US$2,280. With respect to quarter 4, due to the increase in the supply and the uncertainty about the world growth momentum as well as base metal, the demand continued falling during this quarter to US$2,095. We had hedged the copper price in quarter 3, therefore, we completed our task for client. Generally, although we could not purchase the copper for client at the lowest price, we made a good deal for them with relative low cost.

5 Conclusion To summarize, $17,767,665.62 had been saved owing to our portfolio strategies. Our foreign exchange hedging and commodity hedging had also resulted in big savings.

Given the mistakes we had made during last year, improving yield forecast accuracy and risk management efficiency would be our priorities in next year.