Written Assignment & Oral Presentation Assignment for Advanced Financial

Risk Management (125781) Semester 2, 2024

Due: 5pm, 18 October, 2024

This material consists of two Assignments (Part 1 and Part 2) and contributes 40% toward your total mark in this course, 30% for Part 1 (Assessment 2) and 10% for Part  2 (Assessment 3). (Updated)

PART 1: Journal Article Reading Report (Length limit: less than 2000 words)

For this part, you are required to read a journal article on a specific topic related to financial risk management. You can start from reading one from the following two articles (available in the Stream) and write a report to show your understanding of a research report which is good preparation to develop your own research skills.

Phan, Nguyen and Faff (2014), “Uncovering the asymmetric linkage between financial derivatives and firm value – The case of oil and gas exploration and production companies”, Energy Economics”, 45, 340-352.

Chernenko and Faulkender (2011), “The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps”, Journal of Financial and Quantitative Analysis, Vol 46, No. 6 1727-1754.

These are the suggested sections in your report:

•   Introduction (of the topic),

•   Literature review (mainly using the contents in the article)

•   Tested relation (or hypothesis),

•   Testing summary on method, data description and test results,

•   Conclusion(s) and further discussion.

The last section (added to the above sections and not included in the sample report) is on recent trends (of the topic). To meet the requirement, you are required to do a literature search via Massey University library website via “Article databases”

(https://www.massey.ac.nz/study/library/). You can do the search using some keywords of the topic. You are expected to identify 3 to 5 journal articles to comment on the recent trends.

Among them, at least 2 of them (can either be published or working papers) are most recent (2020 onwards) works.

• Working papers can be found from Social Science Research Network:

http://papers.ssrn.com/sol3/DisplayAbstractSearch.cfm

• If you are not sure how to conduct a good literature review, here are some examples of excellent literature reviews:

o “Anomalies and Market Efficiency,” G. William Schwert, 2005, Handbook of the Economics and Finance, Elsevier Science.

o “A  Survey  of  Behavioral  Finance,”  Barberis,  N.,  and  Thaler,  R.,   2005, Handbook of the Economics and Finance, Elsevier Science.

Special notes (and part of the marking criteria):

1)   Please carefully read the University Policy on Academic Honesty and Plagiarism.

“Plagiarism means presenting someone else's work, words or ideas as your own. It's a type of cheating and doing it in an assignment at Massey can mean that you have to answer to an allegation of breaching academic integrity. A link to the Student Guide to Academic Integrity at Massey University is here (Academic integrity student guide - Massey University). Please also read the content in How we deal with academic integrity breaches.

These are the common points for your attention. It is NOT acceptable to:

Copy another student’s work, in part or in total, or an official answer from either the current class or from a previous class.

Allow other students to copy your work, in part or in total.

Copy your own work if it has already been submitted for assessment elsewhere.

Provide students in future years with copies of your assignments.

Copy and paste sections from internet sourced documents or pages.

Have another person prepare and/or write your assignment (or parts of your assignment) on your behalf.

2)   You are required to use a standard format of citations and provide a list of references at the

end of the report. The details of the requirement is available via the link:Find rules for creating a reference list on OWLL.

PART 2: Oral Presentation requirement:

You should prepare a presentation of 4 to 5 minutes to meet the requirement in the following case study.  The oral presentation task is an individual assignment. You are required to submit two (or three) files (in the Oral Presentation Drop-Box):

1)  A PowerPoint file of presentation covering your answers for the questions raised in the end of the Case Study description. (It is recommended to submit the Excel file to show your calculation details.)

2)  A video record (mp4 format is preferred) of your presentation following the contents in your presentation file of the above 1).

Grading Sheet for Oral presentation Part (Score out of 10)

▪ Structure of the presentation (easy to follow, well organized presentation file)    /4

▪ Effective communication of main points           /3

▪ Clarity of speaking (e.g., coherence)             /1.5

▪ Timekeeping and speed of speaking             /1.5

Case Study – financial risk analysis and hedging strategy

A pension fund manager expects to receive an inflow of funds in 90 days time and would like to invest some of the funds in a certain stock. The stock price today is $25. The fund manager would be very happy if in 90 days’ time the stock was selling for $25.  But he is worried about the possible stock price rising in the period, so he decided to hedge the risk with futures or option markets. He asks you as a financial consultant to help him to make the decision. The maximum price the manager would pay for the stock is $30.

You have estimated that the stock price will be distributed somewhere around current price in 90 days. The detail distribution is expressed in Table 1.

Table 1

The first hedging strategy is to use the stock’s futures contract. The current price for the futures contract with 90 days maturity is $25.20.

You can also hedge the risk with stock options. The current option quotes are listed in Table 2.

Table 2

You are also provided with a third opportunity. An innovative financial institution offers you the following type of contract. If the stock price is above $30, you can buy  the stock at $30. If the stock price is below the $X, you buy the stock at a price of $X. If the stock price is between X and 30, you will pay the spot price. The lower bound, X, is set by the financial institution such that the value of the contract is zero.

Current market information provides you with the following information:

Volatility of the stock (σ)          27.25 percent

Discount Rate (rc)                       6.00 percent (continuous interest rate)

* Assuming a 365-day year for both volatility and risk free rate.

Requirements:

a.       The following table shows the net effect of being unhedged for various price scenarios. Examine the table and discuss the pension fund manager’s risk exposure if he remainsunhedged.

Stock price          13    20    25    30    35    37

Net effect            12     5      0     -5   -10   -12

b.       Show how the futures contract can be used to hedge the risk, what payoffs will

there be for the hedged portfolio? (Follow the format of the table in (a) )

c.       If you use options to hedge the risk, which option would you choose and what will the payoffs for the hedged position be?

d.       For the contract provided by the financial institution, can you identify the two implicit options? (Hint: Buying Call and Writing Put). Explain why with their net values associated with different stock prices.

e.       Since the lower bound X, is such that the value of the overall contract is zero,

determine the lower bound X for the contract. (Hint: you need to pay a premium for buying a call option and you will receive a premium for writing a put option. The X value is determined by the condition that the call premium paid equalsthe put premium received. You need to us Black-Scholes model and the trial- and-error method to find the X value)

f.        Summarize the payoffs for the three hedging strategies: futures contract, option contract and financial institution’s contract in the table provided below.

←------Hedged Payoffs--------→

Financial

Stock price  average        Probability   Futures        Option          Institution

13 to 15         14            0.01             To be supplied by your analysis.

15 to 17         16            0.02

17 to 19         18            0.04

19 to 21         20            0.09

21 to 23         22            0.15

23 to 25         24            0.19

25 to 27         26            0.19

27 to 29         28            0.15

29 to 31         30            0.09

31 to 33         32            0.04

33 to 35         34            0.02

35 to 37         36            0.01

Expected Values:

g.       In the same table as (f) compute the expected value of each alternative.

h.       Which hedging strategy would you recommend to the fund manager? Discuss why. Have considered the risk difference in your assessment?