### Task:

Assume that you are one of the highly skilled specialists in the CME Group Risk management team, which was formed to develop the right advice on risk management solutions and the implementation of derivative strategies for CME Group’s customers. The Director has asked you to prepare a report that addresses all the tasks required in the following four scenarios. Note that scenarios are independent of each other.

**Scenario 1: Hedging With Stock Index Futures**

March 2020 saw one of the most dramatic stock market crashes in history, which was caused by governments’ reactions to a COVID-19 outbreak (e.g. strict quarantines, lockdown of populations and the shut-down of the bulk of business activities). While there was rapid declines in stock prices for the great majority of industries, many sectors were in a position of strength, such as healthcare, consumer staples and information technology. The best industry performers yielded a positive monthly return of over 20% (Mazur et al., 2021).

One of your long-term clients, Mr Johnathan Dobek, constructed a stock portfolio on 30th January 2020 and intended to sell the portfolio on 18th June 2021. His portfolio consists of any four U.S. stocks (among nine stocks listed in Exhibit 1) plus Pfizer, Inc. (PFE) stock. Mr Johnathan was concerned about the spread of the new coronavirus outbreak and how badly coronavirus would hurt the U.S. stock market. However, he was confident that the stocks in his portfolio would outperform the market. Therefore, on 2nd July 2020, he asked you to set up a hedge against his portfolio’s market risk using CME E-Mini S&P500 index futures. He expected the hedge to be in effect at the close of trading on 2nd July 2020. The futures contract prices are presented in Exhibit 2, while the contract size of all futures is $USD50 per index point.

One of your long-term clients, Mr Johnathan Dobek, constructed a stock portfolio on 30th January 2020 and intended to sell the portfolio on 18th June 2021. His portfolio consists of any four U.S. stocks (among nine stocks listed in Exhibit 1) plus Pfizer, Inc. (PFE) stock. Mr Johnathan was concerned about the spread of the new coronavirus outbreak and how badly coronavirus would hurt the U.S. stock market. However, he was confident that the stocks in his portfolio would outperform the market. Therefore, on 2nd July 2020, he asked you to set up a hedge against his portfolio’s market risk using CME E-Mini S&P500 index futures. He expected the hedge to be in effect at the close of trading on 2nd July 2020. The futures contract prices are presented in Exhibit 2, while the contract size of all futures is $USD50 per index point.

**Task 1.1:**

This task aims to investigate how index futures can be used to reduce the market risk from holding the stock portfolio. In particular, you need to propose:

a)Which futures contract your client should use (i.e. June 2021 E-Mini S&P500 index futures or September 2021 E-Mini S&P500 index futures). Justify your choice.

a)Which futures contract your client should use (i.e. June 2021 E-Mini S&P500 index futures or September 2021 E-Mini S&P500 index futures). Justify your choice.

b)The number of futures contracts for the hedge and report the position in futures contracts to be taken, in order to reduce the beta of Mr Johnathan’s stock portfolio to 0.5.

**Task 1.2:**

Estimate the outcome of the hedge on 18th June 2021. Based on this outcome, appraise whether your client regretted having the stock portfolio hedged or not?

Hints:

Note that there are a total of five stocks in Mr Johnathan’s portfolio (Pfizer stock plus any four stocks in Exhibit 1). The selection of these four stocks included in Mr Johnathan’s portfolio is your own choice. Naturally, each student will end up with a different portfolio of five stocks. The number of shares for each of the four stocks chosen must be fixed over the holding period and follow Exhibit 1. For example, if Apple is selected, Mr Johnathan would hold 800 shares of Apple stock in his portfolio. For Pfizer stock, the number of Pfizer shares must equal “84063”. For example, Mr Johnathan would hold 84,063 shares of Pfizer in his portfolio.

Daily stock prices can be obtained from the Refinitiv Eikon website: https://eikon.thomsonreuters.com/index.html (Search the company name/symbol => Select “Price & Chart” – “Price history” Tab => Choose the relevant period then click “Update View” and “Download to Excel” (). Please use Close price.

To complete the tasks, you will need to self-calculate beta for each stock at the start of

the hedge (2nd July 2020). Beta is a measure of systematic risk of a security or portfolio compared to the market as a whole. Steps to compute beta for any stock using Excel is as follow:

(1)Download 2-year historical daily prices for a stock whose beta you want to measure.

Note that there are a total of five stocks in Mr Johnathan’s portfolio (Pfizer stock plus any four stocks in Exhibit 1). The selection of these four stocks included in Mr Johnathan’s portfolio is your own choice. Naturally, each student will end up with a different portfolio of five stocks. The number of shares for each of the four stocks chosen must be fixed over the holding period and follow Exhibit 1. For example, if Apple is selected, Mr Johnathan would hold 800 shares of Apple stock in his portfolio. For Pfizer stock, the number of Pfizer shares must equal “84063”. For example, Mr Johnathan would hold 84,063 shares of Pfizer in his portfolio.

Daily stock prices can be obtained from the Refinitiv Eikon website: https://eikon.thomsonreuters.com/index.html (Search the company name/symbol => Select “Price & Chart” – “Price history” Tab => Choose the relevant period then click “Update View” and “Download to Excel” (). Please use Close price.

To complete the tasks, you will need to self-calculate beta for each stock at the start of

the hedge (2nd July 2020). Beta is a measure of systematic risk of a security or portfolio compared to the market as a whole. Steps to compute beta for any stock using Excel is as follow:

(1)Download 2-year historical daily prices for a stock whose beta you want to measure.

(2)Download 2-year historical daily prices for the underlying – market index S&P 500 (.SP500) from the Refinitiv Eikon website.

(3)Calculate the daily returns (i.e. % change) of (1) and (2).

(4)Find beta of the stock by using the Excel function = SLOPE (Y, X)

Y is the stock’s daily returns series, and X is the daily returns series of the S&P500 index, calculated in step (3).

Exhibit 1: List of stocks

(3)Calculate the daily returns (i.e. % change) of (1) and (2).

(4)Find beta of the stock by using the Excel function = SLOPE (Y, X)

Y is the stock’s daily returns series, and X is the daily returns series of the S&P500 index, calculated in step (3).

Exhibit 1: List of stocks

Stock name / Symbol Number of shares held

Apple Inc. (AAPL.O) 800

Microsoft Corporation (MSFT.O) 900

Facebook, Inc. (FB.O) 360

Intel Corporation (INTC.O) 974

PayPal Holdings, Inc. (PYPL.O) 257

International Business Machines Corporation (IBM) 678

Walmart Inc. (WMT) 1,200

General Mills, Inc. (GIS) 965

Costco Wholesale Corporation (COST.O) 900

Apple Inc. (AAPL.O) 800

Microsoft Corporation (MSFT.O) 900

Facebook, Inc. (FB.O) 360

Intel Corporation (INTC.O) 974

PayPal Holdings, Inc. (PYPL.O) 257

International Business Machines Corporation (IBM) 678

Walmart Inc. (WMT) 1,200

General Mills, Inc. (GIS) 965

Costco Wholesale Corporation (COST.O) 900

Exhibit 2: CME E-Mini S&P500 index futures price

Futures Contract Price on 02/07/2020 Price on 18/06/2021

CME E-MINI S&P 500 INDEX JUNE 2021 3,106.00 4,187.25

CME E-MINI S&P 500 INDEX SEP 2021 3,097.25 4,153.5

Data source: Datastream

CME E-MINI S&P 500 INDEX JUNE 2021 3,106.00 4,187.25

CME E-MINI S&P 500 INDEX SEP 2021 3,097.25 4,153.5

Data source: Datastream

**Scenario 2: Financial Risk Management**

Pfizer Inc. (PFE), established in 1849, is an American research-based multinational biopharmaceutical corporation. Pfizer has a long history of innovation in healthcare and research worldwide to advance wellness, prevention, treatments and cures. With a global portfolio including medicines, vaccines and many of the world’s best-known consumer health care products, Pfizer has become one of the world’s leading biopharmaceutical companies.

**Task 2.1**

Your task is to identify and discuss the primary financial risks that Pfizer Inc. is exposed to. Since Pfizer is a listed company, the company research can be accomplished through its financial reports and documents publicly available on the company’s website and Eikon.

**Task 2.2**

Determine and elaborate why Pfizer should hedge and why it shouldn’t hedge its foreign currency risk.

**Task 2.3**Explain to your non-technical client how the practice of financial risk management is similar to hedging and how it is different.

**Task 2.4**Assume that Mr Johnathan Dobek (in scenario 1) decided not to sell the portfolio. He keeps holding the portfolio until today, which is 7th September 2021. Assume that there is no change in the number of shares in the portfolio.

a)On 7th September 2021, calculate 5% and 1% 10-day VaR of Mr Johnathan’s portfolio (which was constructed in Scenario 1) using the historical method. Interpret the value at risk results calculated so that your client would easily understand them.

b)Follow up your VaR estimates in part a with an ex-post evaluation, i.e. discuss how your VaR results compare to the actual 10-day portfolio returns from 8th September 2021 to 21st September 2021.

a)On 7th September 2021, calculate 5% and 1% 10-day VaR of Mr Johnathan’s portfolio (which was constructed in Scenario 1) using the historical method. Interpret the value at risk results calculated so that your client would easily understand them.

b)Follow up your VaR estimates in part a with an ex-post evaluation, i.e. discuss how your VaR results compare to the actual 10-day portfolio returns from 8th September 2021 to 21st September 2021.

**Task 2.5**Mrs Susan Moore’s portfolio consists of 800 shares of Apple stock and 555 shares of Pfizer

stock.

stock.

a)Calculate Analytical VaR at 99% confidence level over one month and 10-day horizon on Mrs Susan’s portfolio, as of 7th September 2021.

b)Follow up your VaR estimates in part a with an ex-post evaluation, i.e. discuss how your VaR results compare to the actual 10-day portfolio returns from 8th September 2021 to 21st September 2021.

Hints:

b)Follow up your VaR estimates in part a with an ex-post evaluation, i.e. discuss how your VaR results compare to the actual 10-day portfolio returns from 8th September 2021 to 21st September 2021.

Hints:

Find the standard deviation of each stock’s returns by using the Excel function=STDEVP (a stock’s daily returns series)

Find expected return of each stock by using the Excel function = AVERAGE (a stock’s daily returns series)

Find the correlation between the returns on two stocks by using the Excel function=CORREL (stock 1’s daily returns series, stock 2’s daily returns series)

Find expected return of each stock by using the Excel function = AVERAGE (a stock’s daily returns series)

Find the correlation between the returns on two stocks by using the Excel function=CORREL (stock 1’s daily returns series, stock 2’s daily returns series)

**Scenario 3: Design An Interest Rate Swap**

SCG and RMD both wish to invest $55 million in 5 years and have been offered the rates shown in Exhibit 3. SCG wishes to invest at a floating rate of interest, while RMD requires a fixed-rate investment.

Fixed Rate Floating Rate

SCG 2.8% LIBOR – 1.5%

RMD 3.6% LIBOR + 0.9%

SCG 2.8% LIBOR – 1.5%

RMD 3.6% LIBOR + 0.9%

**Exhibit 3: Interest rates****Task 3.1:**

This task requires you to design a vanilla swap that allocates 70% advantage (i.e. gain) to RMD and 30% advantage (i.e. gain) to SCG. Assume that a financial institution, acting as an intermediary, is planning to charge a 0.4% premium.

**Task 3.2:**Assume that today is 15th June 2021, the two companies enter the $55 million 5-year swap you have designed in Task 3.1. The payments of the swap are made semi-annually, on 15th December and June each year. Note that LIBOR is determined on the previous settlement date. The accrual period is the actual number of days divided by 360. Your task is to complete the Template (Exhibit 4) below, which demonstrates the cash flows on the swap from the perspective of RMD.

Exhibit 4: Template of CFs on the swap

Exhibit 4: Template of CFs on the swap

**Scenario 4: Value a Currency Swap**

90 days ago, the mutual fund entered into a one-year currency swap by agreeing to swap US dollars for euros at the fixed rates. The annualised fixed rate in dollars and euros are 7.77% and 6.94%, respectively. The exchange rate at the start of the swap was $0.68. The new exchange rate today is $0.65. Assume that the notional dollar amount is $65,000,000. The payments are made semi-annually based on the assumption of 30 days per month and 360 days in a year. The adjustment Current LIBOR and Euribor rates are shown in Exhibit 5.

Term LIBOR (%) Euribor (%)

90 days 7.1 5.5

270 days 7.4 6.0

Exhibit 5: Current LIBOR and Euribor rates

90 days 7.1 5.5

270 days 7.4 6.0

Exhibit 5: Current LIBOR and Euribor rates

**Task 4:**Your task is to determine the market value of the swap today from the mutual fund’s perspective, which pays dollars and receives euros.

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