Name: Zhang hanwen

HKU ID Number: 3036017176

Risk Management
HKU Master of Finance
Final Exam April 2023
k. s. maurice TSE
Due Date: by 23:59 on April 29 (Saturday)

Please submit a soft copy of your finished take home in WORD/PDF FORMAT to MOODLE by the
deadline.

1) Write down your NAME and HKU ID NUMBER at the upper left-hand corner of this page.
2) Submit your legible and professional answers in ONE single file.

Note that this take-home final is an EXAMINATION and so the universal rules and regulations
regarding examination conduct apply here as well.

Please read the following Statement on Academic Honesty before start working.

Note that you’re not allowed to work with or collaborate with anyone else in the Final Examination.
By taking this examination, you agree to the Academic Integrity Statement.

By working on this take-home exam, I agree and acknowledge that University “examinations” require
all students to respect the highest standards of academic integrity. For the “examination” I’m about to
take, I make the following pledge:

1. All the work will be my own.

2. I will not obtain or seek to obtain an unfair advantage by communicating or attempting to
communicate with any other person during the examination; neither will I give or attempt
to give assistance to another student in taking the examination;
3. I understand that students who are suspected of violating this pledge are liable to be
referred to the Disciplinary Committee, and may be subject to disciplinary action such as
suspension of studies or expulsion from the University.

ATTEMPT ALL FIVE QUESTIONS!

Ktse 1
Question 1: Strategic Risk Management (20 points)
Drywell Limited is a USD-based oil company producing one million barrels of oil in Tunisia
every year. The annual sales revenue depends on the world oil price.
Drywell’s cash-flow need for exploration and development (E&D) activities is determined by
the oil price level:
CF Need for E&D = $15,000,000 + 670,000 × $Oil Price
Drywell’s risk management objective is to generate enough cash needed for the exploration
and development (E&D) activities.
The current oil price is USD80 per barrel. It is expected to remain highly volatile with annual
standard deviation standing at 25%.
Drywell is considering using oil futures to achieve its risk management objective. The oil
futures price now is USD85 per barrel and fluctuates with annual standard deviation equal
to 23%. The correlation coefficient between the spot oil price and the futures price is equal
to 0.95.
As the risk analyst of Drywell Limited, you are to recommend an optimal hedging strategy
for achieving its risk management objective.

(a) How many barrels in oil futures should be used for the optimal hedge? (15 points)

Value Before Hedging:

𝑉 = 1,000,000 ∗ 𝑆 − (15,000,000 + 670,000 ∗ 𝑆) = 330,000𝑆 − 15,000,000

Value After Before Hedging:

𝑉′ = 330,000𝑆 − 15,000,000 + 𝑄𝑓 ∗ 𝐹

The Variance of Hedged Position:

𝑣𝑎𝑟(∆𝑉′) = 𝑣𝑎𝑟(330,000 ∗ ∆𝑆) + 𝑣𝑎𝑟(𝑄𝑓 ∗ ∆𝐹) + 2𝑐𝑜𝑣 (330,000 ∗ ∆𝑆, 𝑄𝑓 ∗ ∆𝐹)

= 330,0002 ∗ 𝑆 2 ∗ 𝜎𝑆2 + 𝐹 2 ∗ 𝑄𝑓2 ∗ 𝜎𝑓2 + 2 ∗ 330,000 ∗ 𝜌 ∗ 𝑆 ∗ 𝜎𝑆 ∗ 𝐹 ∗ 𝑄𝑓 ∗ 𝜎𝑓

Differentiating 𝑣𝑎𝑟(∆𝑃) with respect to 𝑄𝑓 :

2𝐹 2 𝑄𝑓 𝜎𝑓2 + 660,000𝜌𝑆𝐹𝜎𝑆 𝜎𝑓 = 0

330,000𝑆 𝜌𝜎𝑆 𝜎𝑓
𝑄𝑓 = − ∗
𝐹 𝜎𝑓2

Ktse 2
Hedge Ratio:

𝜌𝜎𝑠 𝜎𝑓 0.95 ∗ 0.25 ∗ 0.23

𝛽= = = 1.0326
𝜎𝑓2 0.232

The Size of Oil Futures:

330,000 ∗ 80
𝑄𝑓 = −1.0326 ∗ = −320,713.4118 𝑏𝑎𝑟𝑟𝑒𝑙𝑠
85

We need to short 320,713.4118 barrels in oil futures.

(b) What if the spot and the futures oil price today are respectively $30 and $31
respectively and are expected to stay at the same level for the foreseeable future
with all other factors remaining the same? (5 points)

$𝑂𝑖𝑙 𝑃𝑟𝑖𝑐𝑒 × 1,000,000 𝑏𝑎𝑟𝑟𝑒𝑙 ≥ $15,000,000 + 670,000 × $𝑂𝑖𝑙 𝑃𝑟𝑖𝑐𝑒

$𝑂𝑖𝑙 𝑃𝑟𝑖𝑐𝑒 ≥ $45.45
When the spot and futures price is far below $45.45, such as $30 and $ 31, there is no need
to hedge and the E&D activities should be suspended
What is more, as it is expected to stay at the same level for the foreseeable future, zero
volatility in the market indicates that the standard deviation is zero. Hence, the
optimal hedge ratio is zero. So, we do not need to hedge and Optimal barrels in oil
futures = 0.

Ktse 3
T

Question 2: Structured Product (20 points)

BOWEN Limited is a real estate developer has a real estate development project valued at
$9 billion. Today, BOWEN borrows from NOPAY BANK a 30-year, $6.5 billion fixed-rate
mortgage at 9%p.a. requiring monthly mortgage payments.

Since the mortgage interest rate of 9% is set below market, Nopay Bank requires profit
sharing of one-third of the property value appreciation at the end of year 10. BOWEN will
pay Nopay Bank one-third of the value appreciation of the project either at the end of year
10 or when the property sells, whichever occurs first.

For example, suppose the property value increases by $6 billion over the next 10 years. At
the end of year 10, BOWEN will pay the bank 1/3 of the $6 billion appreciation ($2 billion).
On the other hand, there is no profit sharing if the real estate value drops below $9 billion at
the end of year 10.

Suppose the annualized risk-free rate of interest is 5% and the volatility of the real estate
price is 40%.

(a) Determine the fair market value of the mortgage today. (10 points)
Stock price (S) 9.0
Strike price (K) 9.0
Maturity (T) 10.000
Riskfree Rate (r) 5%
Dividend yield (q) 0.00%
Volatilty (v) 40.00%

VBA function "BS"

Euro Call Price 5.414
mortgage = Cash Inflow from fixed rate bond + Value of American Call Option because the value
added part will be given to NOPAY BANK.
So the total value is 6.5+1/3*5.414=8.305

(b) Determine the one-year 95% Delta-Gamma VaR for this mortgage. (5 points)

Because the volatility only comes from the call part, we have:

Ktse 4
 BSM for option pricing
Inputs
S 9
K 9
σ 0.4
r 0.05
T 10.0000
δ 0
European call option price (HK$) 5.4140
European call delta (Δ) 0.8480
European call gamma (Γ) 0.0207
European call theta ( ) -0.0007
European call vega ( ) 0.0670
1 1
𝑉𝑎𝑅(𝑑𝐶) = (1.65 ∗ √Δ2 𝑆 2 𝜎 2 + 0.5(Γ𝑆 2 𝜎 2 )2 )
3 3
1
= (1.65 ∗ √0.8482 ∗ 92 ∗ 0.42 + 0.5(0.0207 ∗ 92 ∗ 0.42 )2 )
3
= 1.682𝑏𝑖𝑙𝑙𝑖𝑜𝑛

(c) Is the one-third profit sharing charged by NOPAY BANK a fair deal to BOWEN Ltd?

Briefly explain. (5 points)

The one-year 95% Delta-Gamma VaR implies that the NOPAY BANK will not lose
more than 1.682billion in a year under 95% confidence interval.

However, the mortgage can be considered as the BOWEN Ltd sold 1/3 of a call
option to the NOPAY BANK with a value equal to 1.805billion, which is more than the
loss of the bank more than with 5% chances.

So it is not a fair deal to BOWEN Ltd.

Ktse 5
Question 3: VaR Modelling (20 points)
Consider a portfolio consisting of 100,000 shares of TENCENT and 100,000 short calls with
strike price equal to $500 and 6 months to expiration. One call contract represents one
share of the underlying stock. The current stock price of TENCENT is $500 per share. Based
on historical price data, the stock price volatility is estimated to be 30% p.a.; the risk-free
interest rate is 3% p.a. The annual dividend yield of TENCENT is 0.24%.

(a) Using the delta-VaR approach, what is the one-day 95% VaR of this portfolio?
(5 points)

𝑑𝑃 = 100,000 ∗ (1 − ∆) ∗ 𝑑𝑆
(𝑆𝜎)2
𝑉𝑎𝑟(𝑑𝑃) = 𝑉𝑎𝑟(43270 ∗ 𝑑𝑆) = 432702 ∗ 𝑉𝑎𝑟(𝑑𝑆) = 432702 ∗
252
𝑂𝑛𝑒𝐷𝑎𝑦 95%𝑉𝑎𝑟 = 1.645 ∗ √𝑉𝑎𝑟(𝑑𝑃) = 672,579.75

(b) Using the delta-gamma VaR approach, compute the one-day 95% VaR for the
portfolio. (5 points)
2
1 2  1 
Var (dV ) = 1.645  (100000 − 100000  ) 2  ( S ) + 2  (50000) 2   S 2 2 
252  252 
= 673677.77
Now suppose you plan to hold the TENCENT stock for five days only due to a drastic shift in
government policy on internet business. Your analysis of the DAILY volatility of TENCENT
shows that it’s generated by the GARCH(1,1) process as given below.
Let 𝑟𝑡 = 𝑙𝑛(𝑆𝑡 /𝑆𝑡−1 ).
1
• 2
𝑟𝑡 = 0.00036 − 2 × 𝜎𝑡|𝑡−1 + 𝜎𝑡|𝑡−1 𝑍𝑡 ; 𝑤ℎ𝑒𝑟𝑒 𝑍𝑡 ~𝑁(0,1)
• 2
𝜎𝑡|𝑡−1 2
= 0.000001287 + 0.07293𝜀𝑡−1 2
+ 0.91893𝜎𝑡−1|𝑡−2
• 𝜀12 = 0.001521
• For t = 1, 𝜎1|0 = 0.025

(c) Determine the volatility expected for each of the next five days. (5 points)

Ktse 6
 As note tells us,
2
(1 − (𝛼 + 𝛽)ℎ−1 ) 2
𝜎𝑡+ℎ|𝑡 =𝑤∗ + (𝛼 + 𝛽)ℎ−1 𝜎𝑡+1|𝑡
1 − (𝛼 + 𝛽)
W=0.000001287, α=0.07293，β=0.91893

For t=1,
𝜎1|0 = 0.025
For t=2,
2
(1 − (𝛼 + 𝛽)2−1 ) 2
𝜎2|0 = 0.000001287 ∗ + (𝛼 + 𝛽)2−1 𝜎1|0
(𝛼
1 − + 𝛽)
2
𝜎2|0 = 0.000621
For t=3,
2
(1 − (𝛼 + 𝛽)3−1 ) 2
𝜎3|0 = 0.000001287 ∗ + (𝛼 + 𝛽)3−1 𝜎1|0
1 − (𝛼 + 𝛽)
2
𝜎3|0 = 0.000617
For t=4,
2
(1 − (𝛼 + 𝛽)4−1 ) 2
𝜎4|0 = 0.000001287 ∗ + (𝛼 + 𝛽)4−1 𝜎1|0
1 − (𝛼 + 𝛽)
2
𝜎4|0 = 0.000614
For t=5,
2
(1 − (𝛼 + 𝛽)5−1 ) 2
𝜎5|0 = 0.000001287 ∗ + (𝛼 + 𝛽)5−1 𝜎1|0
1 − (𝛼 + 𝛽)
2
𝜎5|0 = 0.000610

(d) Determine the 5-day holding-period return volatility. (5 points)

Ktse 7
 𝑟1,5 = 𝑟1 + 𝑟2 + 𝑟3 + 𝑟4 + 𝑟5
5
2 2
𝐸𝑡 (𝑟𝑡,𝑇 ) = ∑ 𝜎ℎ|1 = 0.003087
ℎ=1

Question 4: Risk Exposure and Credit Insurance (20 points)

BBB Inc. is a CNY-based importer who imports agricultural products from Europe. Currently
BBB Inc. has an account payable of 5 million euros that will come due in 6 months.

The current exchange rate between CNY and euro is CNY7.6923 per euro. The exchange
rate outlook between CNY and euro is highly uncertain and BBB’s treasurer has decided to
hedge against the exchange rate risk by entering into a forward contract with Nopay Bank.
The 6-month forward rate today is CNY7.9731 per euro.

Suppose Nopay Bank is concerned about the counterparty risk that BBB might default on
the forward delievery date and hence requires BBB Inc to buy credit insurance to protect
Nopay Bank against it’s default.

Currently, the risk-free rate of interest is 5%. The volatility of the CNY/euro exchange rate is
30%. The credit rating of BBB inc. indicates that the probability of default is 5%.

Determine the cost of credit insurance to BBB Inc.

the cost of credit insurance =0.6961*5million*5%=174025CNY

Ktse 8
Question 5: KMV Analysis (20 points)
The key figures for the capital structure of Kaisa Group Holdings (佳兆业集团) listed in the
Hong Kong Stock Exchange is provided below for the financial years 2020, 2021 and 2022.

Company: China Evergrande 12/30/2020 12/30/2021 12/30/2022

Current Liabilities (CNY 000s) 127,781,185 200,834,338 201,719,459
Long Term Liabilities (CNY 000s) 103,398,130 30,213,669 27,279,431
No. of Shares Outstanding (000s) 7,015,468 7,015,468 7,015,468

The monthly stock prices of Kaisa for the period from January 2020 to April 2023 are
provided in the Excel File “KMV with Data”.
Suppose the volatility of the stock price is constant at the long-term level which is equal to
the standard deviation of the stock returns for the entire sample period from January 2020
to April 2023. Assume that the risk-free rate of interest in China is 2.8% p.a. for the sample
period. Also assume that the amount of debt due within a year is equal to current liabilities
plus one-half of long-term liabilities.
(a) Using the KMV model discussed in class, trace the monthly Expected Distance to
Default (EDF) and the corresponding probability of distress for Kaisa from January
2020 to April 2023. (10 points)

(Hint: You can use the SOLVER template already included in the Excel File “KMV with
Kaisa Group Data”)

Date Price/Share Monthly Return EDF Prob. of Financial Distress

Jan-20 3.27 0.0581 0.8529 9.84%
Feb-20 3.46 -0.1705 0.8696 9.61%
Mar-20 2.87 0.0314 0.8117 10.42%
Apr-20 2.96 -0.0716 0.8218 10.28%
May-20 2.75 0.0318 0.7971 10.63%
Jun-20 2.84 0.1781 0.8077 10.48%
Jul-20 3.34 0.1337 0.8592 9.76%
Aug-20 3.79 0.0128 0.8951 9.27%
Sep-20 3.84 -0.0886 0.8986 9.22%
Oct-20 3.50 0.1333 0.8726 9.57%
Nov-20 3.96 -0.0637 0.9073 9.11%
Dec-20 3.71 -0.0602 0.8894 9.34%
Jan-21 3.49 0.1198 0.8148 10.38%
Feb-21 3.90 -0.0448 0.8505 9.88%
Mar-21 3.73 -0.0935 0.8364 10.07%
Apr-21 3.38 0.0562 0.8046 10.53%
May-21 3.57 -0.1765 0.8226 10.27%
Jun-21 2.94 -0.2823 0.7553 11.25%
Jul-21 2.11 0.2275 0.6140 13.48%
Aug-21 2.59 -0.1815 0.7057 12.01%
Sep-21 2.12 -0.4340 0.6163 13.44%
Oct-21 1.20 -0.1167 0.2573 19.92%
Nov-21 1.06 -0.2642 0.1508 22.00%
Dec-21 0.78 0.1282 -0.1739 28.45%
Jan-22 0.88 -0.1932 -0.0317 25.63%
Feb-22 0.71 0.1831 -0.2908 30.72%
Mar-22 0.84 0.0000 -0.0834 26.66%
Apr-22 0.84 0.0000 -0.0834 26.66%
May-22 0.84 0.0000 -0.0834 26.66%
Jun-22 0.84 0.0000 -0.0834 26.66%
Jul-22 0.84 0.0000 -0.0834 26.66%
Aug-22 0.84 0.0000 -0.0834 26.66%
Sep-22 0.84 0.0000 -0.0834 26.66%
Oct-22 0.84 0.0000 -0.0834 26.66%
Nov-22 0.84 0.0000 -0.0834 26.66%
Dec-22 0.84 0.0000 -0.0834 26.66%
Jan-23 0.84 0.0000 -0.0834 26.66%
Feb-23 0.84 -0.6071 -0.0834 26.66%
Mar-23 0.33 -0.0152 -1.8204 48.28%
Apr-23 0.33 -1.0000 -1.8642 48.44%

Ktse 9
 (b) Plot the monthly EDF and the Probability of Financial Distress. (3 points)

(c) Based on the credit rating given below, what is your opinion about the credit risk of
Kaisa in terms of credit rating? (2 points)

EDF 0.02% 0.04% 0.08% 0.18% 0.70% 1.95% 11% 15% 20%
Rating AAA AA A BBB BB B CCC CC D

The Probability of Financial Distress showed a fluctuating upward trend until April 23, when
it reached nearly 50% and was given a D rating, demonstrating a high credit risk.
(d) Do a test on the time dependence of the monthly volatility of Kaisa. How would
your test result affect your KMV analysis in part (a) above? (5 points)
If we use daily log return:

We can find that there is only White Noise under this circumstance and no time dependence.
If we use log return square:

Ktse 10
Both plots indicates a time dependence of the monthly volatility of Kaisa. When the
volatility is high, the KMV model would underestimate the probability of distress if it
assumes a constant volatility.
End of Take-home Final Exam

Ktse 11