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Semester One Sample Examinations, 2019

FINM7405 Financial Risk Management

Question 1         ( 10 Marks)

The following table is relevant to answer parts (a) to (c) of this question.

Assume you manage the following portfolio of liabilities.

Instrument

Coupon

Maturity date

Face Value ($m)

Market

Value ($)

Market

Interest rate

Macaulay Duration

DB02

5.20%

15-03-02

100

100,077,029.60

5.08/5. 12

?

DB11

5.65%

15-03- 11

100

100,607,102.57

5.53/5.57

7.77

Note: Today is the 15th  March 2001 and there are 92 days between today and 15th  June 2001. The DB02 market value is based on 5. 12% yield and DB11 market value is based on 5.57% yield.

(a) Assume that the  $100m  of  DB02  in the table  above was  issued today to  an  institutional investor called BondBuy Ltd. If BondBuy holds the DB02 until maturity, what percentage return will BondBuy have earned on its investment for the one year holding period?

[1 mark]

If BondBuy holds the DB02 to maturity, they must earn the market yield prevailing on the bond at the time of purchase ie. 5.12% compounded semi-annually. In this case, as in the game, we assume that we issue the bond at the worst rate to us 5.12%. Thus, the buyer receives 5.12%.

(b) Calculate DV01 for the DB02 bond.

[2 marks]

t

cash flow

PV

weight

t x weight

0.5

2600000

2535101.4

0.025332

0.012666

1

102600000

97541928

0.974668

0.974668

100077030

0.987334

PV for first row = 260000 (1+0.0512/2)-0.5*2

Weight for the first row = 2535101/100077030

Macaulay duration = 0.9873

Modified duration = 0.9873/(1+0.0512/2) = 0.9627

DV01 = 0.9627 * market value * 0.0001 = 0.9627 * 100077030* 0.0001 = 9634

(c) Today (15th  March 2001) you receive a highly regarded economic forecast of interest rates in three months. The rate forecast for DB02 is 4.88/4.92 and the rate forecast for DB11 is 5.48/5.52.

(i)          Use the duration to estimate the expected change in the dollar value of the DB02 and DB11 liabilities that you manage.

[2 marks]

DB02:

We forecast a change from 5.12% to 4.92%; this is a drop of 20 basis points Thus, a 20bps drop will produce 20 * DV01 = 20*9634=$192686 increase in DB02

DB11:

We forecast a change from 5.57% to 5.52%; this is a drop of 5 basis points Thus, a 5bps drop will produce 5 * DV01 = 5*76061=$380,305 increase in DB11

Where modified duration for DB11 = Macaulay duration/(1+yield/2) = 7.77/(1+0.0557/2) = 7.56 and DV01 for DB11 = 7.56*100607103*0.0001 = 76061

(ii)          Calculate the cost of funds for DB02 over the period 16th  March 2001 to 15th June 2001

(assume DB02 yield in June is equal to the forecast of 4.88/4.92) .

[2 marks]

The cost of funds is equal to the return achieved by an investor who held the bond over that 3 month period.

t

cash flow

PV

0.25

2600000

2568598.2

0.75

102600000

98927226

101495825

In the first row, the time interval between 15 June 2001 and 15 Sept 2001 (which is the coupon date of DB02) is 0.25. Hence, the PV = 260000 (1+0.0492/2)-0.25*2

In the second row, the time interval between 15 June 2001 and 15 Mar 2002 (which is the maturity of DB02) is 0.75. Hence, the PV = 10260000 (1+0.0492/2)-0.75*2

Thus, the price in June is $101,495,825

The price in March is $100,077,030 and in June is $101,495,825.

The annualized cost of funds is therefore: ($101,495,825/$100,077,030-1) X 365/92 = 5.63%

Note: The question assumes 92 days between March 2001 and June 2001.

(iii)        Assume that you are required to raise $150mil today for a client. Which bond (DB02 or

DB11)  should  you  issue  to  raise  the  required  funds?  (Note:  you  can  ignore  any management ranges that would normally apply in the trading game)

[ 1 mark]

The answers from c(i) and c(ii) suggests that the highest cost of funds will reside in the DB11 bond, given that the dollar value increase (i.e., liability value increases) is around double that of DB02.

Therefore, we should use DB02 to raise the funds (because the increase in the liability value of DB02 is relatively smaller).

(iv)         Draw a deal slip similar to the one given below on the answer booklet. Then, in respect

of the bond issued in part (c. iii), complete the deal slip. Ensure that you raise exactly the $150mil as required.

[2 marks]

BOND

TRANSACTION ADVICE

Transaction Date

15      /   3      / 01

dd/mm/yy

Security Code

DB02

X

Issue

X

Buy

DB04

Currency of Issue

AUD

DB06

Face Value

$149,884,544.53

DB11

Coupon

5.20%

US04

Yield %

5. 12%

US11

Spot Rate

EUR06

AUD Proceeds

$150,000,000.00

Signature xxxxxxxxxxxxxxx

Note: face value to raise $150M is:

100,000,000/100,077,029.6*150,000,000=$149,884,544.53

Question 2         (8 Marks)

Today is the 14th September 2001 (the last day of Quarter 2) and, as the manager of a large      portfolio of liabilities, you need to determine the funds to be raised or invested on the first day of Quarter 3 (tomorrow).  Other information that may be relevant to this calculation includes:

•    Two of your clients (QEPA, APA) will each make a one-off repayment of $10m tomorrow.

•     Another client (LG) requires an advance of $15m tomorrow and this follows an advance of the same amount on the 15th June (at 5.60% for three years).

•     Tomorrow, LG will also pay an overseas supplier US$5M (AUD10M) for the supply of raw materials for a new infrastructure project .

•     At the start of the year (15th  March) your clients made the following debt service payments:

o  QEPA:    $1.45m

o  LG:          $2.05m

o  APA:        $4.63m

Note: these quarterly debt service payments are scheduled to continue for at least the next two years.

•     No futures contracts were bought or sold in June. However, you plan to buy 200 ten year futures contracts tomorrow. The deposit margin is $2,000 per contract  and brokerage is $5 per contract payable in arrears.

•    At the start of the current quarter, you issued commercial paper with face value of $170m . The face value and coupon of bonds currently on issue is: DB02               ($150m/5.2%); DB04 ($100m/5. 1%); DB06 ($300. 1m/5.3%); DB11                         ($245m/5.65%). There are two pay fixed, receive floating domestic interest rate    swaps on issue with face value and coupon: IRSDB04 ($50m/5. 1%); IRSDB11     ($125m/5.65%). Also, on issue is one $US denominated eurobond (US11) with    face value and coupon of $US55m/6% and one $Euro denominated eurobond      (EUR06) with face value and coupon of $EUR58.75m/5%. Both eurobonds have  been swapped back into domestic CP3M with a face value of AUD200m .

•     Coupons are paid in March and September

•     The market value of the portfolio on the 15th June was $1,107,534,373 and the administration charge is 0.50% per annum .

•    Assume that there are no debt service payments other than those mentioned or implied above.

(a) Calculate the net client cashflow that will occur on the first day of the new quarter (tomorrow). Clearly show all calculations and cashflows.

[3 marks]

Write your answer here:

Client Cashflows

Advance (LG)                            -

Repayment (QEPA)

Repayment (APA)

DSP (QEPA)

DSP (LG)

DSP (APA)

DSP (Qtr 2 advance to LG)

15,000,000

10,000,000

10,000,000

1,450,000

2,050,000

4,630,000

1,366,648

14,496,648

15,000,000

= 1 (1 + 5.6%4) 12

5.60%

PV = A 1 (1 + r) n

r