SMM729: Derivatives and Risk Management Report - Oct 2017

This report analyzes a company's foreign exchange risk exposure and proposes a hedging strategy using currency futures contracts. It details the rationale for hedging an upcoming transaction, selects an appropriate futures contract, and calculates the required number of contracts. The report then evaluates the performance of the hedge, including margin account dynamics, and calculates losses incurred. Furthermore, the report addresses portfolio risk, including systematic and unsystematic risks, and performs a Value at Risk (VAR) analysis, exploring different VAR estimates and the potential use of derivatives to improve these estimates. The analysis considers the volatility of individual stocks and the portfolio, providing a comprehensive overview of risk management techniques.

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Contents
Question 2..................................................................................................................................1
Report on 20th October 2017...................................................................................................1
Introduction.........................................................................................................................1
Need For hedging the upcoming transaction and details of the appropriate hedging
strategy................................................................................................................................2
Conclusion..........................................................................................................................3
Report on 10th March 2018....................................................................................................3
Introduction.........................................................................................................................3
Performance of the foreign transaction hedge....................................................................4
Margin Account..................................................................................................................4
Conclusion..........................................................................................................................8
Question 3..................................................................................................................................9
Report to the advisory board................................................................................................10
Risks faced by the portfolio and VAR analysis................................................................10
Portfolio Risk:...................................................................................................................10
Portfolio VAR:..................................................................................................................11
Different VAR estimates..................................................................................................12
Back-testing......................................................................................................................14
Use of derivatives to improve the VAR estimates............................................................15
References................................................................................................................................16
Appendix..................................................................................................................................17
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Question 2
Report on 20th October 2017
Introduction
This report discusses the need for hedging the upcoming transaction where the company will
receive £ 9m on the 9th of March 2018. The report also explains the hedging strategy that
should be used to hedge this transaction using the currency futures contracts. After explaining
the need for hedging this transaction, the report chooses the appropriate futures contract on
CME and then it calculates the required number of futures contracts.
Need For hedging the upcoming transaction and details of the appropriate
hedging strategy
The company is expecting to receive a payment of £ 9m on the 9th of March 2018. The
company is based in US, so this transaction will introduce foreign exchange risk from the
depreciation of £. If £ depreciates in future in comparison to today then the company will
receive less dollar amount on 9th March 2018. Therefore, it is advised to hedge such risk from
foreign exchange fluctuation using derivatives (Golden, 2019). Futures and forward contracts
can be used for such type of hedging: Forward contracts are over the counter contract
between two parties that can be customised according to the need of the individual parties but
they involve credit risk; Futures contracts are exchange traded contracts and they have pre-
defined specification but they do not have any credit risk involved as exchange acts as a
counterparty (Hull, 2017). So, futures contracts can be used to reduce the volatility in the
cash-flows arising due to the fluctuations in the foreign exchange rate.
In this future transaction the company will receive £ 9m on the 9th of March 2018. It means
the company is long on £ 9m. In order to hedge this transaction risk the company needs to
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take short position in £ futures contract expiring near the transaction date. This will allow the
company to sell £ 9m for fixed dollars amount on contract expiry date.
Out of the available contracts, CME-STERLING COMP. MAR 2018 - IBC0318 is a suitable
contract. This futures contract has expiry near but later than the transaction date so it will
reduce the basis risk.
To calculate the required number of futures contracts, total transaction value is divided by the
value of single futures contract (Hull, 2017).
This contract is based on £ 62,500.00.
No. of £ futures contracts the company needs to short: 9000000/62500 = 144.
Conclusion
The report discussed the need for hedging the foreign transaction risk due to the fluctuations
in the foreign exchange. The company will receive £ 9m on the 9th of March 2018 so it faces
risk from the devaluation of £ as this will reduce the dollar amount it will receive after
conversion to the home currency. So, the company can short 144 CME-STERLING COMP.
MAR 2018 - IBC0318 contracts to receive a fixed amount on 9th March 2018 by selling £ 9m
at the contract rate.
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Report on 10th March 2018
Introduction
The report discusses the performance of the foreign transaction hedge that the company
entered on 20th October 2017. It also discusses about the margin account that is the initial
margin, maintenance margin and variance margin.
Performance of the foreign transaction hedge
The company entered into the foreign transaction hedge on 20th October 2017. The company
shorted 144 CME-STERLING COMP. MAR 2018 - IBC0318 futures contracts.
On 20th October 2017, the settlement price of this contract was F0 = $1.3253.
On 9th March 2018, the settlement price of this contract was F1 = $1.3852.
These prices tells for how much dollar amount a company will getting for every pound it will
sold. As F1 is greater than F0, that means the pound appreciated against dollar during this
period. That is a negative scenario for the company as it shorted 144 futures contract on 20th
October 2017. In other words the company entered into futures contracts to sell a £ for
$1.3253 but the settlement price has now increased to $1.3852 per £. According to this
futures contract the company will be selling pounds at lower dollar amount.
Loss per £ on one futures contract = (F1 - F0) = (1.3852 - 1.3253) = $0.0599.
Total dollar Loss on 144 futures contract = (Loss per £) * (£ per contract) * (No. of
Contracts) = 0.0599 * 62500 * 144 = $539100.
Spot Exchange Rate on 9th March 2018 (USD per £) = 1.3867
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If the company had not entered into these futures contract, the un-hedged outcome at the spot
exchange rate = £9000000 * 1.3867 =$12480300.
Therefore, Hedged outcome = Un-hedged outcome - Loss in futures contracts = $12480300 -
$539100 = $11941200.
The company faced loss of $539100 in futures contracts.
Margin Account
Initial Margin per contract = $2000.
Total Initial Margin = 2000 * 144 = $288000.
Maintenance Margin per contract = $1600.
Total Maintenance Margin = $230400.
Following table shows the daily changes in the margin account:
CME-STERLING
COMP. MAR
2018 - SETT.
PRICE (IBC0318)
USD per £ Opening
Margin
Account
Profit/Loss Ending Margin
Account
Variation
Margin
20-10-2017 $1.3253 $2,88,000.00 $0.00 $2,88,000.00 $0.00
23-10-2017 $1.3261 $2,88,000.00 -$7,200.00 $2,80,800.00 $0.00
24-10-2017 $1.3197 $2,80,800.00 $57,600.00 $3,38,400.00 $0.00
25-10-2017 $1.3314 $3,38,400.00 -$1,05,300.00 $2,33,100.00 $0.00
26-10-2017 $1.3215 $2,33,100.00 $89,100.00 $3,22,200.00 $0.00
27-10-2017 $1.3181 $3,22,200.00 $30,600.00 $3,52,800.00 $0.00
30-10-2017 $1.3258 $3,52,800.00 -$69,300.00 $2,83,500.00 $0.00
31-10-2017 $1.3340 $2,83,500.00 -$73,800.00 $2,09,700.00 $78,300.00
01-11-2017 $1.3305 $2,88,000.00 $31,500.00 $3,19,500.00 $0.00
02-11-2017 $1.3117 $3,19,500.00 $1,69,200.00 $4,88,700.00 $0.00
03-11-2017 $1.3123 $4,88,700.00 -$5,400.00 $4,83,300.00 $0.00
06-11-2017 $1.3227 $4,83,300.00 -$93,600.00 $3,89,700.00 $0.00
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07-11-2017 $1.3222 $3,89,700.00 $4,500.00 $3,94,200.00 $0.00
08-11-2017 $1.3167 $3,94,200.00 $49,500.00 $4,43,700.00 $0.00
09-11-2017 $1.3212 $4,43,700.00 -$40,500.00 $4,03,200.00 $0.00
10-11-2017 $1.3251 $4,03,200.00 -$35,100.00 $3,68,100.00 $0.00
13-11-2017 $1.3169 $3,68,100.00 $73,800.00 $4,41,900.00 $0.00
14-11-2017 $1.3218 $4,41,900.00 -$44,100.00 $3,97,800.00 $0.00
15-11-2017 $1.3218 $3,97,800.00 $0.00 $3,97,800.00 $0.00
16-11-2017 $1.3237 $3,97,800.00 -$17,100.00 $3,80,700.00 $0.00
17-11-2017 $1.3271 $3,80,700.00 -$30,600.00 $3,50,100.00 $0.00
20-11-2017 $1.3290 $3,50,100.00 -$17,100.00 $3,33,000.00 $0.00
21-11-2017 $1.3289 $3,33,000.00 $900.00 $3,33,900.00 $0.00
22-11-2017 $1.3373 $3,33,900.00 -$75,600.00 $2,58,300.00 $0.00
23-11-2017 $1.3373 $2,58,300.00 $0.00 $2,58,300.00 $0.00
24-11-2017 $1.3382 $2,58,300.00 -$8,100.00 $2,50,200.00 $0.00
27-11-2017 $1.3369 $2,50,200.00 $11,700.00 $2,61,900.00 $0.00
28-11-2017 $1.3423 $2,61,900.00 -$48,600.00 $2,13,300.00 $74,700.00
29-11-2017 $1.3474 $2,88,000.00 -$45,900.00 $2,42,100.00 $0.00
30-11-2017 $1.3573 $2,42,100.00 -$89,100.00 $1,53,000.00 $1,35,000.0
0
01-12-2017 $1.3516 $2,88,000.00 $51,300.00 $3,39,300.00 $0.00
04-12-2017 $1.3519 $3,39,300.00 -$2,700.00 $3,36,600.00 $0.00
05-12-2017 $1.3491 $3,36,600.00 $25,200.00 $3,61,800.00 $0.00
06-12-2017 $1.3424 $3,61,800.00 $60,300.00 $4,22,100.00 $0.00
07-12-2017 $1.3518 $4,22,100.00 -$84,600.00 $3,37,500.00 $0.00
08-12-2017 $1.3448 $3,37,500.00 $63,000.00 $4,00,500.00 $0.00
11-12-2017 $1.3389 $4,00,500.00 $53,100.00 $4,53,600.00 $0.00
12-12-2017 $1.3367 $4,53,600.00 $19,800.00 $4,73,400.00 $0.00
13-12-2017 $1.3471 $4,73,400.00 -$93,600.00 $3,79,800.00 $0.00
14-12-2017 $1.3501 $3,79,800.00 -$27,000.00 $3,52,800.00 $0.00
15-12-2017 $1.3383 $3,52,800.00 $1,06,200.00 $4,59,000.00 $0.00
18-12-2017 $1.3441 $4,59,000.00 -$52,200.00 $4,06,800.00 $0.00
19-12-2017 $1.3435 $4,06,800.00 $5,400.00 $4,12,200.00 $0.00
20-12-2017 $1.3441 $4,12,200.00 -$5,400.00 $4,06,800.00 $0.00
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21-12-2017 $1.3435 $4,06,800.00 $5,400.00 $4,12,200.00 $0.00
22-12-2017 $1.3432 $4,12,200.00 $2,700.00 $4,14,900.00 $0.00
25-12-2017 $1.3432 $4,14,900.00 $0.00 $4,14,900.00 $0.00
26-12-2017 $1.3431 $4,14,900.00 $900.00 $4,15,800.00 $0.00
27-12-2017 $1.3440 $4,15,800.00 -$8,100.00 $4,07,700.00 $0.00
28-12-2017 $1.3479 $4,07,700.00 -$35,100.00 $3,72,600.00 $0.00
29-12-2017 $1.3557 $3,72,600.00 -$70,200.00 $3,02,400.00 $0.00
01-01-2018 $1.3557 $3,02,400.00 $0.00 $3,02,400.00 $0.00
02-01-2018 $1.3628 $3,02,400.00 -$63,900.00 $2,38,500.00 $0.00
03-01-2018 $1.3547 $2,38,500.00 $72,900.00 $3,11,400.00 $0.00
04-01-2018 $1.3586 $3,11,400.00 -$35,100.00 $2,76,300.00 $0.00
05-01-2018 $1.3597 $2,76,300.00 -$9,900.00 $2,66,400.00 $0.00
08-01-2018 $1.3595 $2,66,400.00 $1,800.00 $2,68,200.00 $0.00
09-01-2018 $1.3562 $2,68,200.00 $29,700.00 $2,97,900.00 $0.00
10-01-2018 $1.3539 $2,97,900.00 $20,700.00 $3,18,600.00 $0.00
11-01-2018 $1.3566 $3,18,600.00 -$24,300.00 $2,94,300.00 $0.00
12-01-2018 $1.3764 $2,94,300.00 -$1,78,200.00 $1,16,100.00 $1,71,900.0
0
15-01-2018 $1.3764 $2,88,000.00 $0.00 $2,88,000.00 $0.00
16-01-2018 $1.3821 $2,88,000.00 -$51,300.00 $2,36,700.00 $0.00
17-01-2018 $1.3907 $2,36,700.00 -$77,400.00 $1,59,300.00 $1,28,700.0
0
18-01-2018 $1.3920 $2,88,000.00 -$11,700.00 $2,76,300.00 $0.00
19-01-2018 $1.3900 $2,76,300.00 $18,000.00 $2,94,300.00 $0.00
22-01-2018 $1.4007 $2,94,300.00 -$96,300.00 $1,98,000.00 $90,000.00
23-01-2018 $1.4026 $2,88,000.00 -$17,100.00 $2,70,900.00 $0.00
24-01-2018 $1.4242 $2,70,900.00 -$1,94,400.00 $76,500.00 $2,11,500.0
0
25-01-2018 $1.4145 $2,88,000.00 $87,300.00 $3,75,300.00 $0.00
26-01-2018 $1.4184 $3,75,300.00 -$35,100.00 $3,40,200.00 $0.00
29-01-2018 $1.4104 $3,40,200.00 $72,000.00 $4,12,200.00 $0.00
30-01-2018 $1.4177 $4,12,200.00 -$65,700.00 $3,46,500.00 $0.00
31-01-2018 $1.4200 $3,46,500.00 -$20,700.00 $3,25,800.00 $0.00
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01-02-2018 $1.4287 $3,25,800.00 -$78,300.00 $2,47,500.00 $0.00
02-02-2018 $1.4152 $2,47,500.00 $1,21,500.00 $3,69,000.00 $0.00
05-02-2018 $1.4023 $3,69,000.00 $1,16,100.00 $4,85,100.00 $0.00
06-02-2018 $1.3979 $4,85,100.00 $39,600.00 $5,24,700.00 $0.00
07-02-2018 $1.3899 $5,24,700.00 $72,000.00 $5,96,700.00 $0.00
08-02-2018 $1.3940 $5,96,700.00 -$36,900.00 $5,59,800.00 $0.00
09-02-2018 $1.3825 $5,59,800.00 $1,03,500.00 $6,63,300.00 $0.00
12-02-2018 $1.3843 $6,63,300.00 -$16,200.00 $6,47,100.00 $0.00
13-02-2018 $1.3893 $6,47,100.00 -$45,000.00 $6,02,100.00 $0.00
14-02-2018 $1.4003 $6,02,100.00 -$99,000.00 $5,03,100.00 $0.00
15-02-2018 $1.4106 $5,03,100.00 -$92,700.00 $4,10,400.00 $0.00
16-02-2018 $1.4037 $4,10,400.00 $62,100.00 $4,72,500.00 $0.00
19-02-2018 $1.4037 $4,72,500.00 $0.00 $4,72,500.00 $0.00
20-02-2018 $1.4000 $4,72,500.00 $33,300.00 $5,05,800.00 $0.00
21-02-2018 $1.3948 $5,05,800.00 $46,800.00 $5,52,600.00 $0.00
22-02-2018 $1.3969 $5,52,600.00 -$18,900.00 $5,33,700.00 $0.00
23-02-2018 $1.3982 $5,33,700.00 -$11,700.00 $5,22,000.00 $0.00
26-02-2018 $1.3974 $5,22,000.00 $7,200.00 $5,29,200.00 $0.00
27-02-2018 $1.3926 $5,29,200.00 $43,200.00 $5,72,400.00 $0.00
28-02-2018 $1.3778 $5,72,400.00 $1,33,200.00 $7,05,600.00 $0.00
01-03-2018 $1.3776 $7,05,600.00 $1,800.00 $7,07,400.00 $0.00
02-03-2018 $1.3795 $7,07,400.00 -$17,100.00 $6,90,300.00 $0.00
05-03-2018 $1.3836 $6,90,300.00 -$36,900.00 $6,53,400.00 $0.00
06-03-2018 $1.3893 $6,53,400.00 -$51,300.00 $6,02,100.00 $0.00
07-03-2018 $1.3902 $6,02,100.00 -$8,100.00 $5,94,000.00 $0.00
08-03-2018 $1.3801 $5,94,000.00 $90,900.00 $6,84,900.00 $0.00
09-03-2018 $1.3852 $6,84,900.00 -$45,900.00 $6,39,000.00 $0.00
Initial Margin = $288000.
Total Variation Margin Posted = $890100.
Total loss = $539100
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Ending Margin Balance = Initial Margin - loss + Variation Margin = $639000.
Conclusion
By entering into the futures contracts the company received $11941200, which is $539100
less than the amount it would have received in no-hedge scenario. This is because the pound
appreciated against dollar during this hedging period and the company was long pounds in
this foreign transaction but to hedge it the company shorted futures contracts. The main aim
of this hedging strategy using futures was to reduce the volatility of the company’s cash-
flows by fixing the future dollar amounts it will receive. So, the hedging has achieved this
purpose although company received less net dollar amount as compared to un-hedged
scenario due to the loss in futures contract. In these futures contracts the company posted
initial Margin of $288000 and it had posted the total variation margin of $890100 due to the
losses on futures contracts that reduced the balance in its margin account below the
maintenance margin of $230400.
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Question 3
(For this analysis it is considered that today’s date is 25th Jan 2018.)
Report to the advisory board
Risks faced by the portfolio and VAR analysis
Portfolio Risk:
The company is holding an equity portfolio that consists of:
UK Equity Portfolio Company Number of Shares
Tesco 1,200,000
Rolls Royce 750,500
BP 835,575
Centrica 1,825,500
Easy Jet 915,385
HSBC 250,785
The following table tells the weight of the each of the six companies according to the current
share price as on 25th Jan 2018.
Portfolio No. of shares Share price on 25th
Jan 2018
In money terms Weight
TSCO 1200000 209.7 251640000 7.71%
RR. 750500 836.89 628085945 19.26%
BP. 835575 516.7 431741603 13.24%
CNA 1825500 134.9 246259950 7.55%
EZJ 915385 1651 1511300635 46.33%
HSBA 250785 768.4 192703194 5.91%
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Total 3261731327 100.00
%
This equity portfolio faces two types of risks systematic risk and unsystematic risk. The
unsystematic risk is due to the company specific factors and it can be eliminated by the
process of diversification. As this is a diversified portfolio consisting of the stocks from
different industries so the idiosyncratic risk is low for this portfolio. The systematic risk tells
about the riskiness of company relative to the broad market. It is the risk related to the
general equity market. So, the portfolio faces risk from the decline in the value of these
stocks.
The following table represents the return and volatility (standard deviation) of these
individual stocks and the whole portfolio:
TESC
O
ROLLS-
ROYCE
HOLDING
S
BP CENTRIC
A
EASYJE
T
HSBC
HOLDING
S
Daily Std. dev. 1.61% 1.76% 1.55
%
1.38% 2.09% 1.34%
Daily Std. dev. Of the
portfolio
1.28%
The volatility of this portfolio given by the daily standard deviation of 1.28% tells how
spreads out the daily returns are around the mean value. So, the value of the portfolio is
volatile and it can result in the decreased value of the portfolio due to the negative market
movement. Such kind of risk is known as the market risk (Science Direct, n.d.).
Portfolio VAR:
Value at Risk (VAR) is a statistical measure of the risk of an investment. It gives the
probability of the portfolio loss being less than a particular value in a particular time-period
(Hull, 2012). For example, a daily 95% portfolio VAR of £ 2 million means that there is 95%
chance that daily loss on the portfolio will be less than £ 2 million. In other words, there is
5% chance that the loss in the portfolio value will be more than £ 2 million.
Such kind of VAR calculations assume that portfolio returns are normally distributed. The
VAR gives the probability in lower tail. So, a 5% significance level i.e 5% probability in
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