Question Paper

Financial Risk Management-II (232) : January 2005

Section D: Case Study (50 Marks)
• This section consists of questions with serial number 1 - 5.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Discuss the various steps involved in the risk management process of an organization.
(12 marks) < Answer >
2. Evaluate the various alternatives available for hedging the export proceeds of $ 50 million for various
exchange rate scenarios.
(16 marks) < Answer >
3. What strategy Mr. Yan should adopt to reduce the cost of capping the loan? Calculate the effective cost of
the capped loan if the 6-month LIBOR rates on reset dates are turned out as 4.80%, 5.00%, 5.10%, 4.60%,
4.55%, 4.40%, 4.30%, 4.25%, 4.65% and 4.90%. (Amortize the upfront-fee over the period of loan using
a discount rate of 4.50%).
(10 marks) < Answer >
4. Explain qualitatively the other alternatives DHP can adopt to hedge the cash flows.
(6 marks) < Answer >
5. What is basis? How is the basis is expected to change over the life of a futures contract? Explain why a
strengthening of basis benefits a short hedge and hurts a long hedge.
(6 marks) < Answer >
Danish Home Products (DHP) Inc., a company in Denmark manufactures sophisticated electronic gadgets for
the various house hold needs. The company’s products are famous for their usefulness and reasonable price.
Over a period of time, the company has developed a wide market throughout the world and supplies
customized gadgets for a specified need of a country. In January 2005, the company acquired a fresh order
worth $50 million from a US company. The order has to be delivered on the month of April and the payment
for the same will be realized sometime in the month of July.
During the past couple of months the DHP faced severe capacity constraints. It had to overload the process by
10% to meet the demand. So in anticipation of the US order it has invested DKr 150 million to expand its
production facilities in Denmark.
Mr. Yan Thomas, the Chief Financial Officer of DHP, is trying to estimate the amount of DKr the company will
be able to realize from the order. But it is not an easy task. Every moment his estimates are changing due to the
volatile market movement of dollar. The recent volatility in the foreign exchange market shows the weakening
of dollar against Danish Kroner. The analysts forecasted that dollar will depreciate against euro, if there is no
strong economic turnaround in the US. As DKr is closely related to Euro, it may also appreciate against dollar,
as a result the inflow to the company from the export bill may get reduced. So he is considering various
hedging alternatives to reduce the uncertainty of future cash inflows. The various alternatives Mr. Yan is
evaluating are hedging through call options, put options and futures market.
To finance the investment requirement in expanding the facilities the company has borrowed DKr 150 million
for five years from a local bank. The interest rate quoted is 6-month DKr LIBOR plus 25 basis points. The 6-
month DKr LIBOR at the time of entering into the contract was 4.50%. Interest is payable semi-annually and
first payment is due on April 01, 2005. The principal has to be repaid by bullet payment at the end of 5 th year.
Yan is concerned of rise in interest rate due to the economic recovery in US the interest rate may increase,
which is reflected by the recent hike of dollar interest rate by the Federal Reserve and in turn that will also raise
the Eurodollar interest rates. So Yan is planning to protect his company against the risk of rising interest rates.
He wanted to put a cap on his cost of borrowing. For the 5 year loan buying a 5-year cap close to the prevailing
interest rate is the most appropriate strategy. However, he finds out that such a cap is quite costly and the
benefit of cap may not be fully realized if the interest rate does not change significantly. So he is trying to find
out the ways to reduce the cost of capped loan. The following 5-year interest rate options on 6-month DKr
LIBOR is available at the market:

Term 5 years
Underlying interest rate 6-month DKr LIBOR
Reset dates April 1, October 1
Face value DKr 150 million
Cap strike rate 4.75%
Cap premium 1.50% of face value
Floor strike rate 4.50%
Floor premium 0.75% of face value
The following rates are quoted in the market:
Spot DKr/$ 6.0592/95
June DKr Futures $ 0.1652
September DKr Futures $ 0.1647 (Size of futures: DKr 125,000)
Options Strike price (DKr/$) Premium (DKr) Expiration
6.08 0.02 July
Call
6.02 0.06 July
6.08 0.05 July
Put
6.02 0.01 July
END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 6 - 13.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
6. What is delta hedging? Discuss the drawbacks associated with the delta hedging strategy?
(7 marks) < Answer >
7. Explain how you can make a portfolio gamma neutral. What is the use of making a portfolio gamma
neutral?
(8 marks) < Answer >
When we purchase an option, we can trade the cash instrument (called "trading spot" or "trading the cash"),
hoping to realize more profit from trading the cash than we pay initially in premium for the option. When we
sell an option, we hope that the premium that we are paid upfront dwarfs the losses we will sustain from
trading the cash.
When we buy options, we are said to be buying volatility. We make money if the spot rate is volatile enough
for us to pay for the option. When we sell options, we are selling volatility. We make money if spot is calm
enough that we don't have to hedge the exposure frequently.
However, delta hedging is not the only way for us to make money with options. The genius of derivatives is
that it allows us to take positions in (or to hedge against fluctuations in) other aspects of the cash instrument's
price evolution. Derivatives are dangerous if we do not understand or address each potential dimension of their
risk.
Here are several examples. With a simple plain vanilla option, we can make money if implied volatility moves
in our favor. With currency futures, currency forwards and currency options, we can speculate on the spread
between interest rates in two different countries for a maturity date. With some exotic options, we can buy an
option that appreciates in value with the passage of time (all other things being constant) and that also
appreciates in value with movement lower in implied volatility.
Options dealers and savvy options traders use time-proven techniques to break down the risks in an options
position or in a portfolio of options, futures, forwards and cash positions into information that is more readily
comprehensible and therefore more easily positioned or hedged. This method of analysis employs tools called
the "greeks,” as well as using simulation, scenario analysis, and value-at-risk analysis.
The delta of an option is the sensitivity of the option's price to very small changes in the price of the underlying
instrument. When we talked about trading spot around the options position in order to realize profit that would
pay for the option's premium, we were talking about trading the delta. By taking an opposite position equal in
size to the option's delta, we immunize the option against profit and loss variability due to small changes in the
spot rate.
The gamma effect means that position deltas move as the asset price moves and predictions of revaluation
profit and loss based on position deltas are therefore not accurate, except for small moves. Bought options have
positive gamma while sold options have negative gamma. A portfolio's gamma will be the weighted sum of its
option's gammas and the resulting gamma will be determined by the dominant options in the portfolio. In this
regard, options close to the money with short time to expiry have a dominant influence on the portfolio's
gamma. The Gamma of an option increases as the option matures and decreases with volatility.

Caselet 2
Read the caselet carefully and answer the following questions:
8. Discuss the limitations of discounted cash flow (DCF) method for valuing investment opportunities.
(8 marks) < Answer >
9. Explain the various ways we can leverage the flexibilities underlying the real options.
(8 marks) < Answer >
Most of the large companies in the world have changed their business-priorities in some way. Some of them
had to slow or freeze long-term projects; others have prioritized those expected to demonstrate a faster payoff.
The typical techniques used to evaluate different types of projects don’t leave scope for gauging various
flexibilities underlying the projects. This has prevented some potentially profitable projects from take-off.
Companies use primarily four techniques for valuing investment opportunities: accounting rate of return,
payback period, discounted cash flow method (DCF) and real options. Accounting rate of return is the ratio of
the average forecast profits over the projects lifetime to the average book value of the investment. Again a
comparison with a benchmark rate is done before accepting the investment. Payback period states, how many
periods company must wait before cumulative cash flows from the project exceed the cost of the investment
project. If this number of periods is less than or equal to the firms benchmark, the project is accepted.
Subsequent cash flows beyond this payback period have no significance in the calculation. In DCF technique,
we require estimates of expected future cash flows and an appropriate discount rate. Here the problem arises.
NPV is calculated based on the information that is available at the time of appraisal. DCF technique loses its
significance when there is uncertainty. DCF technique was first developed to value bonds. There is little bonds
investor can do to alter the coupons they receive or the amount realized at redemption or the yield on the bond.
Companies, however, are not passive investors; they have different types of flexibility like option to sell the
asset, invest further, wait and see or abandon the project entirely. One alternative that ensures that companies
acknowledge such flexibilities is to value these projects in a similar fashion of valuing financial options.
The real option analysis helps management to identify various flexibilities. These can be classified into growth
options (scaling up, switching up or scoping up a project), deferral/learning options and abandonment options
(scaling down, switching down or scoping down a project).
Adopting a real option decision can have a variety of outcomes on the financial impact of the project. For
example, if the project is deferred, the company must wait to determine whether a good state of nature will
return. The deferral option is one that’s generally exhibited and is treated analogous to a call option.
If the scenario is such that a capital expenditure decision is going to be abandoned, management still obtains
salvage value or opportunity cost of the asset. In a scale down and restart scenario, the company waits for a
good state of nature to return before restarting the project. In scale down scenario, the company reduces
operations if the state of nature is worse than expected. In a switch up scenario, the company considers
alternative technologies, depending on input price. In a temporary expansion period, company puts more
money into the project if state of nature is better than expected. And in a full-fledged growth scenario, company
takes advantage of future interrelated opportunities through collaborative, inter-departmental efforts.
Some kinds of flexibility are common to financial and real options. In each case, an option holder can decide
whether to make the investment and realize the pay off. If we look at the Black-Scholes option valuation
formula, we can interpret how a change in one of the input factors affects the price of the real option. The
management of a company can exploit the flexibility of the real options approach by proactively influencing
one or several input values. There are various ways to leverage the value of real option before exercising it.
Caselet 3
Read the caselet carefully and answer the following questions:
10. Discuss the significance of various parameters underlying the VaR calculation.
(10 marks) < Answer >
11. Which VaR approach mentioned in the caselet is the best according to you? Discuss.
(9 marks) < Answer >
The modern age of risk measurement began in 1973. The year saw the collapse of Bretton Woods system of
fixed exchange rates and the publications of the Black-Scholes option pricing formula. The collapse of Bretton
Woods system and the rapid transition to a system of floating exchange rates among many of the major trading
countries provided the right push for the measurement and management of foreign exchange risk, while the
Black-Scholes formula provided the conceptual framework and basic tools for risk measurement.
Value-at-risk can be defined as the maximum loss a portfolio of securities can face over a specified time period,
with a specified level of probability. For example, a VaR of $1 million for one day at a probability of 5% means
that the portfolio of traded securities would expect to lose at least $1 million in one day with a probability of
5%. Alternatively, there is 95% probability that loss from the portfolio in one day should not exceed $1 million.
From the probability statement we can interpret that 5% indicates that it is expected to occur once in every 20
trading days.
The basic idea behind VaR is to determine the probability distribution of the underlying source of risk and to
identify the worst given percentage of outcomes. The normal probability distribution is widely used for
computing VaR, though not necessarily appropriate in all the cases. The biggest attraction of normality is that if
the portfolio return is normal, the VaR is the multiple of portfolio standard deviation and the normal value of
the confidence level.
The user of VaR have to make decisions about the following important parameters for calculation of VaR: (i)
time horizon, (ii) confidence interval, (iii) data series, and (iv) mapping / selecting relevant risk factors. Utmost
care is taken in considering each, as choices made can change not only the actual number, but also the uses and
meaning of the VaR number itself.
At present various approaches exist for computing VaR, the most important of which are considered to be: the
variance-covariance approach, the historical simulation approach and the Monte Carlo simulation approach.
Variance-covariance approach allows an estimate to be made of the potential future losses of a portfolio
through using statistics on volatility of risk factors in the past and correlations between changes in their values.
Volatilities and correlation of risk factors are calculated for a selected period of holding the portfolio using
historical data. VaR is computed as multiplying expected volatility of the portfolio by a factor that is selected
based on the desired confidence level.
Historical Simulation approach does not depend on calculation of correlations and volatilities. Instead it uses
historical data of actual price movements to determine the actual portfolio distribution. In this way the
correlations and volatilities are implicitly handled. In fact the most important advantage of this approach is that
the ‘fat-tailed’ nature of security’s distribution is preserved since there is no abstraction to a correlation and
volatility matrix.
To apply Monte Carlo Simulation approach, first we have to calculate the correlation and volatility matrix for
the risk factors. Then these correlations and volatilities are used to drive a random number generator to
compute changes in the underlying risk factors. The resulting values are used to re-price each portfolio position
and determine trial gain or loss. This process is repeated for each random number generation and re-priced for
each trail. The results are then ordered such that the loss corresponding to the desired confidence level can be
determined.

END OF SECTION E

END OF QUESTION PAPER

 Suggested Answers
Financial Risk Management-II (232) : January 2005
Section D : Case Study
1. The risk management function involves a logical sequence of steps. These steps are:
a. Determining Objectives: Determination of objectives is the first step in the risk management function.
The objective may be to protect profits, or to develop competitive advantage. The objective of risk
management needs to be decided upon by the management, so that the risk manager may fulfill his
responsibilities in accordance with the set objectives.
b. Identifying Risks: Every organization faces different risks, based on its business, the economic, social
and political factors, the features of the industry it operates in – like the degree of competition, the
strengths and weaknesses of its competitors, availability of raw material, factors internal to the
company like the competence and outlook of the management, state of industry relations, dependence
on foreign markets for inputs, sales, or finances, capabilities of its staff and other innumerable factors.
Each corporate needs to identify the possible sources of risks and the kinds of risks faced by it. For
this, the risk manager needs to develop a fundamental understanding of all the firm’s activities and the
external factors that contribute to risk.
c. Risk evaluation: Once the risks are identified, they need to be evaluated for ascertaining their
significance. The significance of a particular risk depends upon the size of the loss that it may result
in, and the probability of the occurrence of such loss. On the basis of these factors, the various risks
faced by the corporate need to be classified as critical risks, important risks and not-so-important
risks. Critical risks are those that may result in bankruptcy of the firm. Important risks are those that
may not result in bankruptcy, but may cause severe financial distress. The not-so-important risks are
those that may result in losses which the firm may easily bear in the normal course of business.
d. Development of policy: Based on the risk tolerance level of the firm, the risk management policy
needs to be developed. The time-frame of the policy should be comparatively long, so that the policy
is relatively stable. A policy generally takes the form of a declaration as to how much risk should be
covered, or in other words, how much risk the firm is ready to bear.
e. Development of strategy: based on the policy, the firm then needs to develop the strategy to be
followed for managing risk. The tenure of a strategy is shorter than a policy, as it needs to factor-in
various variables that keep changing. A strategy is essentially an action plan, which specifies the
nature of risk to be managed and the timing. It also specifies the tools, techniques and instruments that
can be used to manage these risks. A strategy also deals with tax and legal problems.
f. Implementation: Once the policy and strategy are in place, they are to be implemented for actually
managing the risks. This is the operational part of risk management. It includes finding the best deal in
case of risk transfer, providing for contingencies in case of risk retention, designing and implementing
risk control programs, etc. It also includes taking care of the details in the operational part, like the
back office work, ensuring that the controls are complied with, etc.
g. Review: The function of risk management needs to be reviewed periodically, depending on the costs
involved. The factors that affect the risk management decisions keep changing, thus necessitating the
need to monitor the effectiveness of the decisions taken previously.
The process of risk management has to be flexible because a company’s risk profile keeps changing. Hence,
it needs to be remembered that the emphasis of the risk management process is not an identification of any
specific risk, but on developing a method of assessment of risk and of arriving at the best possible way of
dealing with them, as and when they arise.
< TOP >
2. As DHP is long on dollar in July, so it can either write July dollar call options or buy July dollar put
options.
 Writing call at DKr 6.08/$
DKr realized per Total inflow
Spot Call exercised Premium inflow
dollar (DKr million)
6.04 No 0.02 6.04 303.0
6.05 No 0.02 6.05 303.5
6.06 No 0.02 6.06 304.0
6.07 No 0.02 6.07 304.5
6.08 No 0.02 6.08 305.0
6.09 Yes 0.02 6.08 305.0
6.10 Yes 0.02 6.08 305.0
So maximum inflow is capped at DKr 305 million, however there is a unlimited downside risk if DKr
appreciates.
Writing call at DKr 6.02/$
DKr realized per Total inflow
Spot Call exercised Premium inflow
dollar (DKr million)
6.00 No 0.06 6.00 303.0
6.01 No 0.06 6.01 303.5
6.02 No 0.06 6.02 304.0
6.03 Yes 0.06 6.02 304.0
6.04 Yes 0.06 6.02 304.0
6.05 Yes 0.06 6.02 304.0
So maximum inflow is capped at DKr 304 million, and there is a unlimited downside risk if DKr
appreciates against dollar.
Buy put at DKr 6.08/$
DKr realized per Total inflow
Spot Put exercised Premium outflow
dollar (DKr million)
6.04 Yes 0.05 6.08 301.5
6.05 Yes 0.05 6.08 301.5
6.06 Yes 0.05 6.08 301.5
6.07 Yes 0.05 6.08 301.5
6.08 No 0.05 6.08 301.5
6.09 No 0.05 6.09 302.0
6.10 No 0.05 6.10 302.5
Here minimum inflow is DKr 301.5million, and there is upside potential if DKr depreciates beyond
6.08/$
Buy put at DKr 6.02/$
DKr realized per Total inflow
Spot Put exercised Premium outflow
dollar (DKr million)
5.99 Yes 0.01 6.02 300.5
6.00 Yes 0.01 6.02 300.5
6.01 Yes 0.01 6.02 300.5
6.02 No 0.01 6.02 300.5
6.03 No 0.01 6.03 301.0
6.04 No 0.01 6.04 301.5
6.05 No 0.01 6.05 302.0
Here minimum inflow is DKr 300.5 million, and there is upside potential if DKr depreciates beyond
6.02/$.
Hedging through futures
As the company is long on dollar in July, So it will go short on September dollar futures. As the DKr
futures are available, so it will go long on DKr futures.
$50, 000, 000
125, 000 × 0.1647
Number of DKr contracts it should buy =