7244AFE / 7810AFE Derivatives & Risk Management Individual Assignment

Trimester 1 2022 / Teaching Period 3 2022

DUE DATE:

Full Written Assignment:    Due on Monday, 20 June 2022, 9:00 am

WEIGHTING:       30% [80 marks in total]

There are two parts in this assignment: Part A (45 marks in total) and Part B (35 marks in total). Both parts (A and B) need to be answered. Part A requires students to provide a risk management consulting report to a client. In the report, students need to address the issues faced by the client as mentioned in the case. 39 marks are allocated to the addressing of the questions indicated in the case. In addition, another 6 marks are allocated to the conclusion and other aspects of the report (including the format of the report, writing clarity, grammatical accuracy, relevance of justification, etc.).

Part B is comprised of 4 short-answer questions related to various topics in the course. Show step-by-step procedures on how to reach the final answer. If a formula is used, write down the formula before plugging in numbers; also provide a brief justification for the choice of the formula.

SUBMISSION:

  1. Go to the course site on Learning@Griffith. Find the Assessment folder. You can submit your draft version first and SafeAssign will return the text matchings of your assignment with the databases. You are then given a chance to revise your assignment before submitting the final version.
  2. The assignment must be Word-processed, using Times New Roman, 12 Font, 1.5 spaced for the main text, and single spaced for tables, figures & appendixes. Handwriting is not allowed.
  3. Please also complete the assignment coversheet form by answering two questions.
  4. Marks MAY be deducted if the requirements and submission instructions are not completed.

Additional requirements for Part A: Consulting Report

  1. Answer all the questions raised in the case. Follow the general format of a consulting report, which could be, but not limited to, the sample posted on Learning@Griffith.

2.       Source Material: You may need to use some source materials to support your arguments.

Newspaper articles can be retrieved from library databases such as Factiva: http://librarycatalogue.griffith.edu.au/record=b1460526

Proquest: http://librarycatalogue.griffith.edu.au/record=b1494610 Academic articles can be retrieved from databases such as

Proquest: http://librarycatalogue.griffith.edu.au/record=b1494610 Ebscohost: http://librarycatalogue.griffith.edu.au/record=b1550066 Google Scholar: http://scholar.google.com.au/

  • Reference Style: Follow AGPS Harvard Style https://web.library.uq.edu.au/files/26535/harvard-2002-style-guide.pdf
  • All answers must use proper English expression and grammar.
  • Word Limit (applies to Part A only): 12 pages maximum excluding references & appendixes.

Part A (45 marks)

In Part A, you need to provide a risk management consulting report to a client. In your report, please address the issues faced by the client as mentioned in the case:

Suppose you are a risk management specialist employed by WeManageYourRisk, a company which is located in Redland Bay, Australia. WeManageYourRisk is specialised in providing energy and mining companies with expert advice regarding their various risk management needs.

Assume it is May 2022. Mr Gustavo Fring who is treasurer of WeExtractOil contacts you to discuss the company’s financial risk management. WeExtractOil is an Australian oil and gas company specialised in offshore oil and gas extraction. The company has ambitious goals to expand and increase its market value in the next few years by reaching an output of 3,000,000 barrels of oil per year.

WeExtractOil’s profit and loss is subject to the price change of crude oil. It is assumed that WeExtractOil will lose $5,000 for each cent decrease in the price of a barrel of crude oil in late August 2022. The price of crude oil is known to be quite volatile. Gustavo has a basic understanding of how derivatives like forwards, futures and options work but would like to receive detailed advice about derivatives positions and potential outcomes of various strategies. More specifically, Gustavo is considering following strategies:

  • Using futures contract traded in the COMEX division of the Chicago Mercantile Exchange (CME) Group, or
  • Using OTC option contracts with the WeTradeDerivatives bank, a financial institution Gustavo has worked with in the past, or
    • Doing nothing.

Furthermore, Gustavo has heard that derivatives can be very dangerous and might lead a company to a financial ruin. Gustavo shares that he had recently listened to a podcast mentioning the derivatives disaster suffered by the Metallgesellschaft and is concerned about potential risks arising from derivatives instruments.

In your report, please discuss following aspects concerning WeExtractOil:

  1. Which futures contract should WeExtractOil use and what position should it take if it wants to use futures to hedge the exposure? Why? [3 marks]
  2. What is the optimal hedge ratio? What does it mean? [5 marks]
  3. What is the company’s exposure measured in barrels of oil? [2 mark]
  4. Use the COMEX contract specifications for oil futures to advise how many crude oil futures contracts should be traded. What are the margin requirements related to such a futures position? [4 marks]
  5. Provide an explanation (without calculations) what option contracts (puts or calls) and what positions (long or short) are suitable for the needs of the company, should the company decide to go with strategy b). [3 marks]
  6. Provide a thorough and clearly arranged comparison of the three strategies (a), b) and c) as listed above) and discuss advantages and disadvantages of each strategy. [5 marks]
  • What are other major risks faced by WeExtractOil apart from the risk arising from oil price changes? Provide a brief explanation of these risks. [4 marks]
  • Based on your independent research regarding the Metallgesellschaft case, please explain in your own words what was the strategy chosen by Metallgesellschaft, what went wrong and what in your view could have been done better? [6 marks]
  • Discuss whether WeExtractOil should use derivatives and if WeExtractOil uses derivatives, what areas should WeExtractOil be aware when using the derivatives. [4 marks]

Follow the general format of a consulting report, please use some source materials (such as academic journal articles and newspaper articles) to support your arguments in your report. Follow a proper referencing and citation style. [3 marks]

Note: Monthly data for spot and futures prices (both in US$, WTI Crude Oil) for the past five years have been obtained for you. See Appendix A.

6 marks are allocated aspects of the report such as the format of the report, writing clarity, grammatical accuracy, relevance of justification, etc.

Part B (35 marks)

Please provide detailed solutions to all of the following questions.

Problem B1: Forward Pricing and Valuation of Forward Contracts [6 marks]

A stock is expected to pay a dividend of $2.0 per share in 3 months and a dividend of $2.5 per share in 6 months. The current stock price is $115, and the risk-free rate of interest is 8% per annum with continuous compounding for all maturities. An investor has just taken a short position in a 9-month forward contact on the stock.

  1. What are the forward price and the initial value of the forward contract? [2 marks]
  2. Four months later, the price of the stock is $125 and the risk-free rate of interest drops to 6% per annum. What are the forward price and the value of the short position in the forward contract?  [4 marks]

Problem B2: Properties of options [9 marks]

The price of a European call that expires in six months and has a strike price of $72 is $3.73. The underlying stock price is $75, and a dividend of $2 is expected in four months. The term structure is flat, with all risk-free interest rates being 5%.

  1. What is the price of a European put option that expires in six months and has a strike price of $72?    [1 mark]
  2. Explain in detail the arbitrage opportunities if the European put price is $0.5.  [4 marks]
  3. Explain in detail the arbitrage opportunities if the European put price is $1.5. [4 marks]

Problem B3: Valuation of plain-vanilla options [15 marks]

In this question, you need to price options with different valuation approaches. You will consider puts and calls on a share with spot price of $215. Strike price is $210. The risk-free interest rate is 5% per annum with continuous compounding.

Binomial trees:

Furthermore, assume that over each of the next two one-month periods, the share price is expected to go up by 6% or down by 6%.

  1. Use a two step-binomial tree to calculate the value of a two-month European call option using risk-neutral valuation. [2 marks]
  2. Use a two step-binomial tree to calculate the value of a two-month European put option using risk-neutral valuation. [2 marks]
  3. Use a two-step binomial tree to calculate the value of a two-month American put option. [2 marks]
  4. Show whether the put-call-parity holds for the European call and the European put prices you just calculated in a. and b. [1 mark]

Black-Scholes-Merton model:

Furthermore, assume that the volatility of the underlying asset is 20%.

  • What is the Black-Scholes-Merton price of a two-month European call option? [2 marks]
  • What is the Black-Scholes-Merton price of a two-month European put option? [2 marks]
  • What is the Black-Scholes-Merton price of a two-month American call option? [1 mark]
  • Show whether the put-call-parity holds for the European call and the European put prices you just calculated in e. and f. [1 mark]

Note: Give d1 and d2 with four decimal places and interpolate using the tables for N(x).

Comparison across models:

  • Compare the call option prices you calculated in a. and e. Compare also the put option prices you calculated in b. and f. Do expect these prices to be the same? Why/Why not? [2 marks]

Problem B4: Value of a swaption [5 marks]

Suppose that the LIBOR yield curve is flat at 7% with annual compounding. A swaption gives the holder the right to receive 6% (with annual compounding) in a four-year swap starting in four years. Payments are made annually. The volatility of the forward swap rate is 12% per annum and the principal is $15 million. Use Black’s model to price the swaption. Give d1 and d2 with four decimal places and interpolate using the tables for N(x).

Appendix A: Historical Crude Oil Prices (Spot and Futures)

MonthSpot PriceFutures Price
May-1748.6348.32
Jun-1746.3446.04
Jul-1750.1950.17
Aug-1747.0847.23
Sep-1751.3451.67
Oct-1754.4354.38
Nov-1757.2457.4
Dec-1760.2360.42
Jan-1864.9364.73
Feb-1861.5261.64
Mar-1864.8664.94
Apr-1868.5368.57
May-1867.0267.04
Jun-1874.3974.15
Jul-1869.2868.76
Aug-1870.4969.8
Sep-1873.7573.25
Oct-1864.9565.31
Nov-1850.650.93
Dec-184545.41
Jan-1953.7153.79
Feb-1956.9457.22
Mar-1960.1760.14
Apr-1963.4863.91
May-1953.2553.5
Jun-1959.3858.47
Jul-1957.5458.58
Aug-1955.1755.1
Sep-1954.2654.07
Oct-1953.9754.18
Nov-1955.3655.17
Dec-1961.2261.06
Jan-2051.5751.56
Feb-2045.1344.76
Mar-2020.0520.48
Apr-208.6218.84
May-2012.7735.49
Jun-2016.7339.27
Jul-2020.940.27
Aug-2026.5742.61
Sep-2040.1740.22
Oct-2035.9235.79
Nov-2045.2945.34
Dec-2048.2848.52
Jan-2152.1852.2
Feb-2163.5361.5
Mar-2159.1659.16
Apr-2163.5863.58
May-2166.3266.32
Jun-2173.6273.47
Jul-2173.9373.95
Aug-2168.6168.5
Sep-2175.1875.03
Oct-2183.5783.57
Nov-2166.1866.18
Dec-2175.2175.21
Jan-2288.1588.15
Feb-2295.7295.72
Mar-22100.28100.28
Apr-22104.69104.69
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