Derivative & Risk Analytics Project — Fall 2020

Due Date and Time: December 2", 2020 by 8pm

General Introduction: As part of the course work you are going to complete four
assignments. Three are modeling exercises and will involve work in Excel and the fourth is a case
study of a high profile derivatives mistake.

Quick overview of Assignments with more specifics on following pages:

Each of the three modeling assignments are:
e To be professionally modelled and completed in Excel
e Accompanied by a two page executive summary in Word highlighting the steps in the
modeling and the results. Word formatting guidelines are outlined on Page 5

The fourth assignment is a case study. Choose one of the following events, research
it and summarize your findings in a two page executive summary:
e Metallgesellschaft in 1993 lost $1.3B with speculated on oil prices
e Robert Citron of Orange County, California lost $1.7B in 1994 on floating rate notes and
repurchase agreements
e Sumitomo Corp in 1996 lost $2.6B in an attempt to corner the copper market
e Amaranth Advisers in 2006 lost $6.6B on natural gas futures
e Morgan Stanley in 2007 lost $9B on subprime mortgage bets
e Jerome Kerviel of Societe Generale in 2008 lost $7.2B on equity derivatives
e Aracruz, a Brazilian pulp producer, in 2008 lost $2.5B on currency positions
e JP Morgan’s London Whale lost $2B in 2012
Assignment 1: Futures Pricing
You manage the following S&P 500 portfolio:
Market Value: 20 Million, Beta: 1.0, Dividends: 0%, Risk Free Rate: 5%.

Futures available on the S&P 500 Index are:

Current Index Level: 1,000, Beta: 1.0, Dividends: 0%, Maturity: 1 Year, Multiplier 250
Assume that the performance of the portfolio follows the capital asset pricing model (CAPM)

a) You want to fully hedge the portfolio for the coming year. Recommend the hedge and show
the performance of the hedge if the Index finishes the year at 800 or 1,350.
b) Show the difference in the performance of the hedge between using the Spot Price and the
Forward Price in computing the number of contracts used in hedging. For the 800 or 1,350
index scenarios reconcile the performance difference between both hedging outcomes.
Assume that instead of a 1 year Futures contact the only contract you can sell is a 3 year
contract. However you can buy a Futures contract for any maturity. You also want to target
a portfolio Beta of 0.25 for the upcoming year. Show the performance of the
hedged/adjusted portfolio if the Index finishes the year at 500 or 2,000.
d) Assume that instead of a 1 year Futures contact the only contract you can sell or buy are 3
month contracts. You want to target a Beta of -2 for your portfolio for the upcoming year
and will therefore need to replace with a new 3 month contract as the existing one expires.
Show the performance of the hedged/adjusted portfolio if the Index finishes the first quarter
at 800, the second quarter at 900, the third quarter at 950 and finished the year at 850.
e) Outlined two unique benefits of Futures over Forwards, and two unique benefits of
Forward over Futures.
Assignment 2: Swap Pricing
Assume that the alternating Swap Bond and Forward rates observed for the next 10 years are:

Swap Forward Swap Forward

Year Rates Rates Year Rates Rates
1 1.5000% 6 3.5810%
Z 2.5126% 7 3.5000%
3 2.5000% 8 5.8518%
4 4.6200% 9 4,0000%
3 3.2500% 10 9.8996%

Compute the fixed rate on a 10 year $100 million vanilla Swap, where the cash flows are
bond like, using the forward rate methodology and the spot rate approach. Assume annual
compounding.
After the swap is incepted, if the floating rates realized in the future are exactly the initially
estimated forward rates, what are the annual cash flows for the fixed and floating side of
the swap? What is the present value of each side of the swap and the net present value of
the overall swap?
If up until the end of year 5, floating rates were exactly equal to forward rates but in years
6-10 forward rates move up by 100 basis points (that is 1.00%) more than estimated at
inception. What is the value of the swap at the beginning of year 6? If you are the fixed
payer on the swap are you exposed to the risk of your counterparty defaulting or are they
exposed to you defaulting?
d) Compute the fixed rate on a $100 million two year forward starting swap that matures in
10 years?
Assignment 3: Self Designed Case Study
Select one of the option pricing models (Binomial, Monte Carlo or Black Scholes).
In your modelling and write up, please cover the following:
a) Describe the fundamental drivers behind the model.
b) Outline a key application where this model is used for hedging and an example of how it
could be used for speculation.
c) Use some simple quantitative example to highlight the points in b).
d) Describe a situation from practice when the model was (or could be) an outstanding success
and another situation where it led to (or could lead to) poor results from faulty execution
or naive application.

Assignment 4: Case Study on Derivatives Event

Having chosen one of the derivatives disasters outlined on page one, complete a 1
page executive summary that outlines:
a) What was the expected outcome?
b) What was the actual outcome?
c) What was the dollar impact and how did it affect the value and reputation of the
organization?
d) What went wrong in the analysis, modelling or execution?
e) How could this be avoided in the future?
f) What changes did the organization make to improve its ongoing oversight?
General approach to the write ups and
formatting your output:
General Tone and Structure: Your summaries should be clearly written and be intelligible to a
business audience, not necessarily a derivatives audience. For example when you cover a model
you should, in a few short sentences, give the intuition behind it. Any critical numbers should be
quoted in your summaries while the backup should reside in the exhibits and models. The write
ups should flow in the manner of a case study. The best reports will be clearly written and flow
easily. They will also stretch as much as possible for insight and succinct conclusions.

Editing is Essential: A tightly edited document is essential in business and in this class. A
reasonable rule of thumb is that you should spend twice as much time editing as writing. Clear
business writing is a major professional asset and many times the difference between a
recommendation being adopted or ignored. Therefore don’t demand that the reader strain to
understand your critical arguments. Be as clear as possible.

Format of Write Ups: Paper formatting guidelines below. If Exhibits need to be formatted
differently, that’s fine.

Page Layout: Portrait

Font: Times New Roman Size 12
Spacing: Single spaced
Page Layout: Margin top and Bottom are 1”, Left and Right margins are 1.25”
Text should be justified (that it not aligned to left or right)

In addition to you write ups you can include as many exhibits as you feel are necessary.