BAFI1026 Derivatives and Risk Management

Assessment 3 – Individual Risk Management Report (50%)

Report and Excel

Due Date: Week 14, 23:59 Friday, 14 June 2024 (Melbourne time)

Ø Assessment Task

This is an individual task. In this assessment, students are required to form. one equity portfolio, evaluate their risks and provide solution to manage the risk. The goal of this individual assignment is to gain a better understanding of the portfolio investment (in the US stock market) and risk management process. Below are the tasks:

● to build one equity investment portfolio and justify the stock selection

● to hold the portfolio from Monday, 29 April 2024 to Friday, 17 May 2024 and observe its changes

● to identify the portfolio risk by reporting portfolio’s VaR

● to provide suggestions of managing the risk

● to communicate your investment and risk management process using a professional report

Ø Investment fundings

You have been offered a one-year loan of $1,000,000 or A$1,500,000 from Bank A (assume current exchange rate: 1 USD = 1.5 AUD). You will borrow this money in either currency to invest in US stock market.

Ø Portfolio Creation

Please follow the following steps to build one portfolio.

1. Create an account (with your real first & surname) on https://finance.yahoo.com/portfolios/

2. Create a watchlist of one Portfolio based on the close price as of Monday, 29 April 2024

Note: The specified date here is used to start the observing period of your portfolios, not the date on which you must perform. the task. For example, you can create portfolios on 17 May 2024, but you will still observe the price change between the sample period Monday, 29 April 2024 to Friday, 17 May 2024. As an illustration, this is the link to the historical daily prices of the BRK.B stock. Berkshire Hathaway Inc. (BRK-B) Stock Price, News, Quote & History - Yahoo Finance

3. This watchlist of Portfolio ($1 million) consists of Four stocks from the S&P500

4. Choose any Three stocks from Table 1 (that are in the top 100 largest companies in S&P500) plus Berkshire Hathaway Inc. (BRK.B).

a. Make the number of shares for BRK.B equal to “Last three digits of your student number” if they are larger than 200.

b. Make the number of shares for BRK.B equal to “First three digits of your student number” if your last three digits are smaller than or equal to 200.

Example: For student S350999, you need to hold 999 shares of BRK.B in your Portfolio. For student S350200, you need to hold 350 shares of BRK.B in your Portfolio.

c. Determine the weights and shares for the rest of the stocks you chose in step a.

d. You have USD 1 million for this Portfolio.

Note: Since the shares can’t be bought in fraction, a tiny variation from the specified budget is acceptable. You can choose to hold some Cash if you believe the investment opportunity is not good enough, but you will need to justify this decision in your report. The total $1 million investment you have is based on the share prices on Monday, 29 April 2024.

5. Take screenshots of your portfolio and the necessary information in all sections. Make sure you attach them in the Appendix of your submitted report.

6. Suppose this is a Buy-and-Hold strategy, therefore, do not change your portfolio setting during your holding period Monday, 29 April 2024 to Friday, 17 May 2024.

Ø Guideline for Investing and Calculations

Marking Guide Your report must include the following sections:

1. Trading philosophy: (2 marks)

Give an overview of your philosophy to form. the portfolio. You should identify yourself as a value or growth investor or a mixture of both. Provide brief definitions for value/growth investing.

2. Portfolio construction: (5 marks)

Present your initial portfolio, including information on why you have invested in the stocks in your initial portfolio (three stock selection for Portfolio).

a. The overall market and macroeconomic condition (2.5 marks)

b. Industry consideration and/or diversification, specific stock’s strengths/positive prospects (2.5 marks)

3. Risk identification: (20 marks)

In this part, you should discuss the risk profile of your portfolio. Use daily historical stock price between 1 May 2019 and 29 April 2024 to calculate the VaR of your Portfolio (VaR template can be found in Week 11’s material on Canvas). The discussion should include the following points:

a. Calculation and discussion of the one-day 95%-Value at Risk of each stock in your portfolio using historical simulation approach. That means, if you have four stocks in total, you need VaR for each. (8 marks)

b. Calculation and discussion of the 10-day 99%-Value at Risk of your portfolio using model- building approach. Show key steps of workings. (3 marks)

c. Calculation and discussion of the 10-day 99%-Value at Risk of your portfolio using a historical simulation approach. (3 marks)

d. Discuss the performance of VaR in (b) and (c), by comparing your calculated VaR results and the portfolios’ actual 10-day returns (Monday, 29 April 2024 to Friday, 10 May 2024). (3 marks)

e. Calculation and discussion of the 95%-Expected Shortfall (CVaR) of your portfolio using a historical simulation approach. (3 marks)

4. Hedging using Options: (10 marks)

Suppose you hold the portfolio for another two weeks, on any day between Monday, 20 May 2024 and Friday, 31 May 2024, how will you use the option contract to hedge one of your three selected stocks in your Portfolio. (Please take the screenshot of option quote and spot price as of the same day and attach them in the Appendix of your submitted report).

a. You need to determine and explain which option you want to use (i.e., specify whether it is a call or put, when the expiration date is, appropriate strike price, whether you should go long or short, number of contracts, etc.). Provide justification for your decision. (6 marks)

Note: Option price per share is limited to within 1.5% of the stock’s market price and not included in the initial $1 million budget.

b. Discuss when you will exercise your option and its potential payoff. (4 marks)

5. Hedging using Swap: (5 marks)

You want to borrow in U.S. dollars at a fixed rate of interest to match with your investment cash flows. Bank A offers you to borrow in US dollars at 7% or in Australian dollars at LIBOR + 0.5% per annum (adjusted for the differential impact of taxes). You found that Bank A also offer another customer who requires a floating-rate loan to borrow in US dollars at 7.5% or in Australian dollars at LIBOR + 2.0% per annum. Bank A can arrange a swap between you and the other customer with a net 20-basis-point spread. Design a swap that minimizes your borrowing costs and appears equally attractive to you and the other customer. What rates of interest will you and that customer end up paying? (Provide explanation, list your calculation process and use figure to illustrate the swap structure). (5 marks)

6. Hedging using CDS: (5 marks)

You would like to include corporate bonds in your existing portfolio. To hedge the potential default risk, you decide to purchase CDS (credit default swap) from Bank A.

Suppose that the risk-free zero curve is flat at 6.5% per annum with continuous compounding and that defaults can occur halfway through each year in a new five-year credit default swap. Suppose that the recovery rate is 35% and the default probabilities each year conditional on no earlier default is 3.5%. Assuming payments are made annually. Estimate the credit default swap spread? ((Provide explanation, list your calculation process in tables). (5 marks)

7. The professionalism of the report. (e.g., Usage of professional Figures and Tables, with numbering and captions.) (3 marks)

Total=50 marks

Ø Submission

All submissions must be made electronically on Canvas, accompanied by a cover sheet. The submission must be using 1 or 1.5 spacing and 12-point Times New Roman font. Work that fails to meet these specifications will not be accepted. Students should ensure that the report is free from problems like copying and plagiarism.

The report and excel spreadsheet will be submitted through “Canvas-Assignments-Assessment 3”. You can submit multiple times before the due date. The report should be no longer than 2500 words (-/+ 15%), excluding references and appendix. The student can have up to 2-page appendix. Citation and reference should be provided where necessary. The Excel file contains your workings to support the reported analysis.

Students are required to keep back-ups of all submitted work just in case any are lost.

The tutor of your enrolled session will mark your assessment.

Note:

● The report will include VaR calculations which will require you to use Excel. Therefore, though the result of calculations should be discussed in the report, you should submit a separate Excel file to Canvas to show your detailed calculations. Meanwhile, you also need to include one or two tables to summarize the key results of your calculations in the report.

● This instruction includes suggestions on items to include in the report, more information for parts you think are important may be included as you feel necessary, keeping in mind the word limit.

● The teaching team is not supposed to comment on your calculation workings or identify your calculation mistakes. The teaching team will provide guidance to make sure that you are on the right track. However, it is still your responsibility to investigate your work and identify the errors.

Ø Table 1 Stock List