BAFI1026 Risk Management Course Guide S2 2010

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Supplementary Course Guide

SCHOOL OF ECONOMICS, FINANCE & MARKETING BAFI 1026 Risk Management

Supplementary Course Guide Semester 2, 2010
STAFF:
Vineet Kapoor Course Coordinator & Lecturer TEL: +61 3 9925 5416 FAX: +61 3 9925 5986 EMAIL: [email protected]

Binesh Seetanah

Dealing Simulation Supervisor TEL : +61 3 9925 5641 (lab hours only) EMAIL : [email protected]

Guillaume Galanos

Dealing Simulation Instructor TEL : +61 3 9925 5641 (lab hours only) EMAIL : [email protected]

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

A. COURSE IDENTIFICATION Course Code and Title

BAFI1026 Risk Management
Pre-requisites

BAFI1002 Financial Markets, or deemed equivalent.
Co-requisites

None, but it is advantageous to students to have completed Business Finance or be doing Business Finance concurrently
Course coordinator

Vineet Kapoor
B. COURSE DESCRIPTION What is this course about?

This course aims to expand on the concepts that you have been introduced to in Financial Markets. It introduces you to the concepts of financial risk management and how to identify exposures and their associated risks. It will also introduce various hedging and derivative instruments that are used in financial markets. You will also be able to appreciate the role of the Treasury function within corporations and banks and differentiate between the two. Use will be made of the Financial Treasury Training facility and you will take part in trading simulations using live financial data.
C. OBJECTIVES / LEARNING OUTCOMES What can I expect to learn by studying this course?

At the conclusion of this course, you should be able to: Identify the risks involved in a financial markets transaction and analyse the problems involved with exposure to movements in rates and prices. Be familiar examine the major products used to manage financial risk. Be able to compare the benefits and disadvantages of each of these products. Develop an understanding of the use of financial information in decision-making. Understand treasury issues from a corporate as well as a banking perspective.

D. LEARNING ACTIVITIES What opportunities does the course provide for me to learn? What will I be expected to do?

To achieve the objectives listed above this course requires you to participate in various learning activities. These activities comprise, but are not limited to, the following:

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide Attendance at and note taking during scheduled lectures and demonstration lectures. Attendance at and participation during demonstration lectures. Reading of and note taking from prescribed text and distributed references. Completion of demonstration problems prior to each demonstration lecture. Participation in four dealing simulation workshops in the Treasury Training Facility (mandatory). Completion of two Dealing Simulation team (group) reports. Completion of four Perdisco e-workbook quizzes.
E. ASSESSMENT How will I demonstrate my learning in this course? Assessment Tasks and Value

The assessment tasks you are required to complete are: Perdisco Quizzes (4 x 5% each) Assignments (2 x 15% each) Final Examination (3 hours) 20% 30% 50% 100%

There is no hurdle requirement for this course – you must achieve an aggregate mark of 50% or better to pass the course. Perdisco Assessment Tasks: This semester there will be four small assessment tasks delivered via a Perdisco e-learning workbook, with each task contributing 5% to your final assessment. Important points to note: The assessment tasks will be primarily based on the lecture content for the relevant topic/s. The e-workbook assessment tasks will be interactive quizzes that can be submitted online from anywhere, are marked instantly and give you immediate feedback on your performance. You will be allowed two attempts at each quiz and the higher mark from your two attempts will count towards your final assessment. In the interest of student access and equity, a number of free ‘library copies’ will be provided in Electronic Special Reserve (ESR) for those of you who cannot afford to purchase the eworkbook to complete their online assessments. To access these, you must first create an account, add this unit’s e-workbook to it and click on ‘ESR login’. For more information, click ‘ESR info’ after registration.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide Perdisco Quiz Schedule: The Perdisco quizzes will be available as follows: Quiz Quiz 1 Quiz 2 Quiz 3 Quiz 4 Topics Covered Topics 1-2 Topic 3 Topics 4-5 Topics 6-7 Week Offered Weeks 3&4 Week 6 Weeks 10&11 Weeks 12&13 Availability
Start End

Monday 02/08/10 Monday 23/08/10 Monday 27/09/10 Monday 11/10/10

Friday 13/08/10 Friday 03/09/10 Friday 08/10/10 Friday 22/10/10

Assignments/Dealing Simulation Reports: The dealing simulation reports are compulsory group assignments based on your trading activities in the dealing room. The assignments contribute 30% to your final assessment: Assignment 1: Foreign exchange markets & trading (15%) – Due in Week 7 Assignment 2: Money market/fixed interest markets & trading (15%) – Due in Week 13 Both assignments are to be bound and submitted on the due dates shown in Section J. Assignment guides will be available on the learning hub before the respective dealing simulations start. Each group needs to hand in the soft copy either on a floppy disk or a CD along with the hard copy of your report. Any reports submitted via email will NOT be graded. Please also make sure that the report is in a format compatible with MSOffice/Word 2003. Final Exam: The Final Exam will be of Three Hours’ duration, and will be in two parts: Part A: (40 Marks) - 20 Multiple-choice questions, covering all topics Part B: (60 Marks) - short answer/calculation questions, covering all topics. The exam contributes 50% to your final assessment. Note: All aspects of the course are examinable, including lecture content, course notes, readings, Perdisco e-workbook content and all aspects of dealing practice experienced in the trading simulations.
Assessment Criteria What will you be looking for when you assess my work?

Assignment Guides will be available on the learning hub in due course and comprehensive briefings on what is required to complete the assignments successfully will be provided in class in weeks 2, 5 and 8.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

Submission of Assessment Tasks

Please refer to section J for assignment submission dates. Late assignment submissions will be accepted up to one week after the due date, however late submissions will incur a penalty of 10% of the available marks for each day late. Work submitted more than one week after the due date will not be accepted. Resubmission of assignments due to poor quality of the original submission will not normally be granted.
Return of Assessment Tasks

Every effort will be made to ensure that tests are graded assignments are marked and returned in a timely way, lecturer workload permitting.
Course Grades available

The standard RMIT Business grading scheme applies: HD D C P N High Distinction Distinction Credit Pass Fail 80% - 100% 70% - 79% 60% - 69% 50% - 59% < 50%

You must achieve an aggregate score of 50% or better to pass the course.
F. ACADEMIC ADMINISTRATION PROCEDURES What do I do if I need help with deadlines or have become ill?

Lectures and demonstration lectures are not compulsory, attendance at and participation in the Money Market and Foreign Exchange Dealing Simulations is compulsory. For each dealing session that you do not attend, you will lose 50% of the available marks for that assignment. Extensions are not normally granted. In cases of exceptional and genuine hardship (not including inconvenience, poor planning or pressures of work), limited extensions may be given. Applications should be made in writing to the course coordinator, unless RMIT special consideration regulations and processes require something different.
G. COURSE EVALUATION AND FEEDBACK How can I let you know about my experience of this course?

A formal course evaluation survey by questionnaire may be conducted in week 11 or 12 of the semester. Constructive informal feedback is accepted at any time.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

H. ACADEMIC MISCONDUCT University Plagiarism Statement Plagiarism: the presentation of the work, idea or creation of another person as though it is your

own. It is a form of cheating and is a very serious academic offence that may lead to expulsion from the University. Plagiarised material can be drawn from, and presented in, written, graphic and visual form, including electronic data, and oral presentations. Plagiarism occurs when the origin of the material used is not appropriately cited. Examples of plagiarism include: • Copying sentences or paragraphs word-for-word from one or more sources, whether published or unpublished, which could include but is not limited to books, journals, reports, theses, websites, conference papers, course notes, etc. without proper citation; • Closely paraphrasing sentences, paragraphs, ideas or themes without proper citation; • Piecing together text from one or more sources and adding only linking sentences; • Copying or submitting whole or parts of computer files without acknowledging their source; • Copying designs or works of art and submitting them as your original work; • Copying a whole or any part of another student's work; and • Submitting work as your own that someone else has done for you.
Enabling Plagiarism: the act of assisting or allowing another person to plagiarise or to copy

your own work.
I. LEARNING RESOURCES What will I need to access and read for this course? myRMIT

A comprehensive set of course notes and PowerPoint slides for each topic is available from the myRMIT under timed release. Other materials will be distributed in class from time to time. You are also encouraged to read widely from many financial publications, and are expected to read the financial press and journals. Recommended reading includes The Australian Financial Review, BRW, Risk, The Economist, Student Economic Briefs, bank publications and business journals.
In recent semesters the RMIT Student Union Copy Shop has engaged in the practice of selling prepackaged course materials. The copy shop is not authorised to reproduce and sell these materials, and as the course is under regular revision these materials have often been out of date. Be advised that you SHOULD NOT buy notes from the copy shop. If you choose to buy notes despite this warning, you do so at your own risk!!!

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide
Prescribed Text

This semester there will not be a prescribed textbook for this course. Instead, an online study resource has been developed for this unit to help you learn the content that will be covered this semester. Using hundreds of interactive practice questions and problem solving exercises, the e-workbook helps you make the most of your study time by offering: The chance to practice and revise each topic until you completely understand it Step-by-step feedback explaining why each answer you have given was correct or incorrect Help that’s available when you need it (even outside of normal class hours) The e-workbook costs $35.81 for unlimited access throughout the semester and can be purchased online by credit card, money order, cheque or BPAY. Payment instructions are provided after registration. Students who have regularly engaged with the e-workbook content in previous semesters have performed well and have found that the benefits outweigh the cost. Indeed, students who use the e-workbook and do not pass the unit are guaranteed an e-workbook refund under Perdisco’s ‘Guaranteed Pass Program’. To start using the e-workbook, visit http://www.perdisco.com.au/students/ and click on ‘Create a new account’.
Useful References:

The following references may be helpful in your study for this course: 1. Chance D.M. & Brooks R., An Introduction to Derivatives and Risk Management, 8th Edition, South-Western Cengage Learning 2. Daugaard D. & Valentine T., Financial Risk Management, a Practical Approach to Derivatives, Addison Wesley Longman. First Published by Harper Educational, 1995, reprinted 1997, 1998. 3. Viney C., McGrath’s Financial Institutions, Instruments and Markets, 5th Edition, McGraw Hill Book Co. Sydney. Some chapters provide very valuable background reading. If you have forgotten FX and MM concepts you should read all relevant chapters. A fairly basic text, easy to read with good self-tests. 4. Hunt B. & Terry C., 2nd Edition. Financial Institutions and Markets. Like McGrath, it provides excellent coverage of FX and Money Market concepts, though many students find it a more complex read. 5. Holliwell J., The Financial Risk Manual, Financial Times/Prentice Hall 1998. Very good overview discussion Risk Management issues. 6. Winstone D., Financial Derivatives, Chapman and Hall, 1995. Easy to read. 7. Chorafas D.N. Managing Derivatives Risk, IRWIN, 1996. Some very interesting chapters

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide 8. Klein R.A. and Lederman J. Derivatives Risk and Responsibility, IRWIN, 1996. Many short easy to read chapters about a range of management issues. 9. Reynolds B. Understanding Derivatives, FT Pitman Publishing, 1995. Easy to read chapters on general risk issues. 10.Marthinsen J. Risk Takers: Uses and Abuses of Financial Derivatives, Pearson AddisonWesley 2005, some very good case studies including Barings and LTCM. Additional Reading 1. Carew E., Derivatives Decoded, Allen & Unwin Australia 1995. Easy to read. You should research some cases in full detail from other sources. 2. Terry B. International Finance and Investment 3rd edition 1994 Bankers Books Limited 3. Poniachek H. A. Cases in International Finance John Wiley & Sons, Inc New York 1993 Cases 1 to 10 332.042. 4. Lewis M. K., Wallace R. H., The Australian Financial System, Financial Training and Analysis Services Pty. Ltd. 1991. 5. Carew E., The Techniques of Foreign Exchange, Heinemann Asia, 1994. 6. Beaver W.H. and Parker G., Risk Management Problems and Solutions, Stanford University, McGraw Hill 1995. 7. Satyajit D., Swaps and Financial Derivatives 2nd Edition. The Law Book Company. 8. Leeson Nick, Rogue Trader, His story BIC REF 332.632 L487 Easy read. J. STUDENT LEARNING PROGRAM Where do I start? Week Week 1 Topic 1 TOPIC Introduction and Overview of Risk Management ISSUES COVERED REFERENCE Introductory ideas and Notes and various classifications of readings risk released on Learning Hub Course notes. Structure and operation of FX Markets, Bid/Offer pricing conventions. FX Forwards, FX Swaps No Lecture/Demo Lecture No Lecture/Demo Lecture Interest Rate Risk Measures: PVBP, Duration, Convexity, DGAP

Week 2 Topic 2

FX Risk, Markets & Trading Issues (Incl briefing for FX dealing simulations and assignment). Practice Dealing Simulations FX Dealing Simulation 1 Perdisco Quiz 1 – Topics 1&2 FX Dealing Simulation 2 Interest Rate Risk - measures of risk (Incl briefing for MM dealing simulations and assignment)

Week 3 Week 4 Week 5 Topic 3

Course notes.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

STUDENT LEARNING PROGRAM (Contd.) Week Week 6 TOPIC MMkt Dealing Simulation 1 Perdisco Quiz 2 – Topic 3 ISSUES COVERED No Lecture/Demo Lecture No Lecture/Demo Lecture Structure, operation, pricing and applications of forward contracts in commodity, FX and interest rate markets. Structure, operation, pricing and applications of futures contracts in commodity, equity and interest rate markets. Structure, operation, pricing and applications of futures/options in commodity, equity and interest rate markets. Structure, operation, pricing and applications of options/swaps in equity, commodity and interest rate markets. Structure, operation, and applications of swaps in interest rate and commodity markets. Course notes and readings. REFERENCE

(Mid-Semester Break) MMkt Dealing Simulation 2 Week 7 Assignment 1 Due 5pm, Friday 10/09/10 The Risk Management Product Week 8 Set (1) – Forward Contracts. Topic 4 Sample Exams Released

Week 9 Topic 5

The Risk Management Product Set (2) – Futures Contracts.

Course notes

Week 10 Topics 5-6

Week 11 Topics 6-7

The Risk Management Product Set (2) – Futures Contracts. (contd.) The Risk Management Product Set (3) – Options. Perdisco Quiz 3 – Topics 4&5 The Risk Management Product Set (3) – Options (contd.) The Risk Management Product Set (4) – Swaps. The Risk Management Product Set (4) – Swaps. Revision (if time permits) Perdisco Quiz 4 – Topics 6&7 Assignment 2 Due 5pm, Monday 18/10/10 SWAT VAC

Course notes

Course notes

Week 12 Topics 6-7

Course notes

Week 13

No Class

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

K. LECTURE TIMETABLE*

Lectures/Demonstration Lectures: Vineet Kapoor Vineet Kapoor Wed Mon** 10.30 17.30 - 13.30 - 20.30 108.09.16 108.07.26

* This timetable is subject to change; please check the Student Timetabling System for any updates before classes start. ** Prior approval from course coordinator is required for full-time students to attend the part-time lecture stream

L. DEALING SIMULATION TIMETABLE

Dealing Simulation Sessions: Week 3 (w/c Binesh Seetanah 02/08/10) Guillaume Galanos FX DS– 1 Week 4 (w/c 09/08/10) FX DS– 2 Week 6 (w/c 23/08/10) MMkt DS– 1 Week 7 (w/c 06/09/10) MMkt DS– 2 Binesh Seetanah Guillaume Galanos

Binesh Seetanah Guillaume Galanos

Binesh Seetanah Guillaume Galanos

Mon 2nd Aug, 1:30pm-4:30pm Mon 2nd Aug, 5:30pm-8:30pm Tue 3rd Aug, 10:00am-1:00pm Tue 3rd Aug, 1:30pm-4:30pm Wed 4th Aug, 10:30am-1:30pm Mon 9th Aug, 1:30pm-4:30pm Mon 9th Aug, 5:30pm-8:30pm Tue 10th Aug, 10:00am-1:00pm Tue 10th Aug, 1:30pm-4:30pm Wed 11th Aug, 10:30am-1:30pm Mon 23rd Aug, 1:30pm-4:30pm Mon 23rd Aug, 5:30pm-8:30pm Tue 24th Aug, 10:00am-1:00pm Tue 24th Aug, 1:30pm-4:30pm Wed 25th Aug, 10:30am-1:30pm Mon 6th Sep, 1:30pm-4:30pm Mon 6th Sep, 5:30pm-8:30pm Tue 7th Sep, 10:00am-1:00pm Tue 7th Sep, 1:30pm-4:30pm Wed 8th Sep, 10:30am-1:30pm

All Dealing Simulation workshops will be held in the Financial Markets Trading Simulator Level 3, Building 108 (Note: attending these workshops is compulsory. For each dealing session that you do not attend, you will lose 50% of the available marks for that assignment.)

M. DEALING SIMULATION REGISTRATIONS

Registrations for the Dealing Simulations will start in Week 1. All students must register for the Dealing Simulation sessions by the end of Week 2. Registration Venue: Financial Markets Trading Simulator located on Level 3, Building 108 Registration Times: (You must register in person (no emails) at one of the following times) Wednesday Thursday Friday Monday 21st July 22nd July 23rd July 26th July 1.30PM – 3:00PM 10.30PM – 12:00PM 10.30PM – 12:00PM 10.30AM – 12:00PM

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

BAFI1026 Risk Management

DEMONSTRATION PROBLEMS
(Please note that solutions to problems will be covered in class as time permits. The “D&V problems” referred to are available under course content on the learning hub)

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

Topic 1 – Introduction to Risk Tutorial/Demonstration Questions: 1. What does “Risk” mean in the study of Finance? 2. Briefly describe the following forms of Risk, giving examples of each (a) Market Risk (b) Liquidity Risk (c) Political Risk (d) Country Risk (e) Credit Risk (f) Settlement Risk (g) Operational Risk 2. How is the practice of risk management similar to hedging and how is it different? 3. A country’s central monetary authority decides to revalue its currency – how would you characterise the associated risk(s)? The following questions relate to the readings provided for topic 1: 4. What role should senior management play in a risk management system? 5. List the three main responsibilities of a corporate treasurer. 6. List and briefly describe the three most important components of a competent Treasury, and the important attributes of each component.

Topic 2 – FX Risk Tutorial/Demonstration Questions: 1. Outline the features of the main types of contracts that are created in the FX market. 2. Exposure to foreign exchange risk is a significant factor that must be considered when deciding to access international capital markets. One of your Australian corporate clients has borrowed in USD, and wants you to explain how his business might be affected if the AUD weakens against the USD. What would you tell him?

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide 3. As a trainee dealer on the corporate FX desk of PacWest bank, it is currently your responsibility assist your senior dealer on the desk to make prices for corporate clients. A power spike cripples all the PCs in your dealing room, and you must now manually calculate prices for your senior. Just before the power spike you had the presence of mind to take down a few rates on a note pad. You jotted down the following rates: Spot AUD/USD @ 0.6835/40; USD 90day t-bill rate @ 5.75/65; AUD 13 week T-Note rate @ 5.27/17. A client calls and urgently needs prices for a three month AUD/USD forward. What 2-way outright price will you quote? 4. Is the AUD at a forward discount or premium to the USD? Why?

Topic 3 – Interest Rate Risk Measures Tutorial/Demonstration Questions:

1. A 3-year bond has a Face value of 5,000,000, a 6% semi-annual coupon and a 5.5% yield. (a) Calculate the price and modified duration of the bond. (b) Use modified duration to estimate the effect on the bond’s price of a 1.5% decrease in the bond’s yield. (c) Recalculate the bond’s price directly at a yield of 4.0%. Is your price different to your estimate in part (b)? Explain why, with the aid of a diagram. 2. As a newly appointed consultant in the Risk Management advisory practice at Palachandran & Narayandran Worldwide Consulting Group, your first job is to advise a new client on the interestrate risk in a security they plan on buying. The Security in question is a 3 Year Bond with Face Value $15,000,000 and a 6% semi-annual coupon. You note that the current yield on the bond is 5.4%. a) Calculate the modified duration of the bond. b) What does the final measure you calculated in part (a) mean? c) The client decides to fund the bond acquisition by issuing a $7,000,000 FV 4yr ZCB, $5,000,000 FV180 day bank bills and $3,000,000 in new share capital via a rights issue. Calculate an appropriate interest rate risk measure for the client’s portfolio. d) What will happen to the value of the portfolio if interest rates increase? Why? e) What will you need to do if you anticipate a large change in bond yields in the near future?

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide Topic 4 – Forward Contracts Tutorial/Demonstration Questions: 1. What are the key characteristics of: (a) Forward Contracts; and (b) Forward Markets 2. Attempt D&V Questions 3.1, 3.2, 3.3 3. Assume there is a forward market for a commodity. The price of the commodity is $45, the contract expires in one year and the applicable interest rate is 10%. (a) What is the forward price at the contract’s inception? Six months later, new contracts with the same maturity date are being written at a new forward price of $54. (b) What is the value of the original forward contract at this time? (c) Explain why this is the correct value and how it is captured. (d) Explain why the value of a forward contract at its inception is zero. 4. What is an FRA? Define the Following terms relating to FRAs: * Run * Settlement * FRA rate *Agreed Rate *Contract rate *Maturity Date 5. What motivates the buyer of a FRA? 6. You buy a $5M face value 3:6 FRA, with a contract rate of 4.55%. If the market yield rises to 4.75% at settlement, what cash flows will occur under the FRA * at Settlement * at Maturity * what will your effective interest cost be? Show proof.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide Topic 5 – Futures Tutorial/Demonstration Questions: 1. What attributes distinguish a Futures contract from a Forward Contract? 2. Briefly describe the key characteristics of Futures markets. 3. If you took a long position in 5 September 3-Year Bond futures contracts on the SFE: a) What would your initial margin be? b) If the maintenance margin on such contracts is 50% of initial margin, What movement in the underlying bond yield would force a margin call? 4. On March 31 you issue $6.7M in 90 day bank bills to fund some unanticipated operational expenditure, with the expectation that you will need to roll these bills over at least twice. What risks do you face under the borrowing and how would you manage this risk using Futures? What factors might limit the effectiveness of your strategy? 5. You have been lucky enough to have been the successful applicant for a co-op position with Anderson Thomas Trustees, a small but prestigious, boutique superannuation fund manager. Your appointment is based on your demonstrated extensive knowledge of hedging equity portfolios with futures. You are given the following small portfolio to manage: Share RSL Ltd Cabot Industries Ltd BFD Ltd Hanson Mining NL Beta 0.70 0.95 1.12 1.35 Holding (shares) 200,000 200,000 175,000 150,000 Market Price 4.00 3.80 8.25 2.20

a) What is the beta of the portfolio? Would you describe the portfolio as risky? Why? b) The All Ordinaries index is currently (in June) at 2650. The nearest expiry SPI contract on the SFE is trading at 2665. At $25 per point, what will your optimum hedge ratio be for the portfolio? Would you overhedge or underhedge? Why? c) By September you have been proved right and the all ordinaries has corrected to 2600. The September SPI contract expires at 2625. Under these conditions, and based on the information you’ve determined in previous parts of the question, how would you have constructed a futures hedge to protect the value of the portfolio?

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide Topic 6 – Options Tutorial/Demonstration Questions: 1. What attributes distinguish a Futures Contract from an Option? 2. Outline the key assumptions that underpin the Black-Scholes Option Pricing Model. 3. List the inputs to the Black-Scholes option-pricing model and briefly outline the sensitivity of option premium to each input. The following questions will be available on myRMIT 4. Refer D&V Ch9: Do Questions 9.1, 9.2, 9.3, 9.4, and 9.5. 5. Refer D&V Ch10: Do Questions 10.1, 10.2, 10.3, 10.4, 10.5, 10.6, 10.7 6. Refer D&V Ch11: Do Questions 11.1, 11.2, 11.3.

Topic 7 – Swaps Tutorial/Demonstration Questions: 1. Briefly outline the comparative advantage rationale for interest rate swaps. 2. You are the treasurer of Dust Catchers Inc. The firm has recently developed the ‘There’s Only One” Tony Lockett commemorative figurine. Demand for the new product has been overwhelming, so the company needs to invest $8,000,000 in new plant and equipment. You can borrow at reasonable floating rates, but your board prefers certainty of cash flows on your borrowings. A larger associated company, Kitsch & Synck Pty Ltd, prefers floating rate finance. The borrowing rates for the two companies are as follows: Borrower Dust Catchers Kitsch & Synck Fixed 7.5% 6.0% Floating BBSW+0.75% BBSW+0.3%

Your CEO asks you to design an interest-rate swap that will suit both firms. Your bank will arrange the swap for an intermediation fee of 15 basis points. The CEO wants you to present your structure to the Board tomorrow morning, outlining: (i) (ii) (iii) Any benefits arising from the transaction; The effective cost of borrowing for each firm; and The interest flows under the swap (note: the board likes diagrams)

You must also justify any assumptions you have made.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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Supplementary Course Guide

3. As a newly-appointed treasurer of Dunning & Leech Investments Pty Ltd, you have a mandate to manage the company’s risk across a diverse portfolio of interests including Oil production, Wool growing, Australian shares, and shipping. a) Briefly describe the major risk exposures you have to manage at Dunning & Leech. b) As an example of one of the strategies you use in managing your oil price risk, show how you recently constructed an Oil swap between your Oil producing subsidiary and your Shipping subsidiary (which purchases large quantities of marine-grade diesel fuel). At the time of the swap, the spot price of marine diesel was $27.50 a barrel and West Texas Light Sweet Crude (the closest practical benchmark) was trading at $31.00 a barrel. Indicate by way of example what cash flows might happen at each settlement date if there is a relative price movement between the two commodities. c) Identify the specific risks arising from the oil swap. Discuss how these risks can be managed. If any of the risks you identify can’t be hedged, explain why.

Copyright ©2010 RMIT University. This course information is supplementary to your official course guide. You can locate your official course guide at http://www.rmit.edu.au/course-guides.

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