Problem 1: Commodity Hedging with Forward Contracts

A jewelry manufacturer requires 1,000 ounces of gold in 6 months to fulfill a production order.
The current spot price of gold is $2,000 per ounce, and the 6-month forward price is $2,050 per
ounce. The firm enters into a forward contract to buy 1,000 ounces at $2,050 per ounce.

1.​ Calculate the total locked-in purchase cost for the manufacturer using the forward
contract.
2.​
3.​ If the spot price of gold in 6 months is $2,200 per ounce, calculate the payoff on the
forward contract and the net cost to the firm.
4.​
5.​ If the spot price of gold in 6 months drops to $1,900 per ounce, calculate the payoff on
the forward contract and the net cost to the firm.
6.​

Solution

1. Total locked-in cost:

$$\text{Total Cost} = 1,000\text{ oz} \times \$2,050/\text{oz} = \$2,050,000$$

2. Spot price rises to $2,200/oz:

●​ Payoff on Forward Contract:

●​ ​

●​ $$\text{Payoff} = 1,000 \times (\$2,200 - \$2,050) = +\$150,000$$

●​ Unhedged spot purchase cost: $1,000 \times \$2,200 = \$2,200,000$.
●​
●​ Net Cost: $\$2,200,000 - \$150,000 = \$2,050,000$.
●​

3. Spot price falls to $1,900/oz:

●​ Payoff on Forward Contract:

●​ ​

●​ $$\text{Payoff} = 1,000 \times (\$1,900 - \$2,050) = -\$150,000$$

●​ Unhedged spot purchase cost: $1,000 \times \$1,900 = \$1,900,000$.
●​
 ●​ Net Cost: $\$1,900,000 - (-\$150,000) = \$2,050,000$.
●​

Problem 2: Currency Exchange Rate Risk

A US exporter sells machinery to a European customer for €500,000, with payment due in 90
days. The current 90-day currency forward rate is $1.10 per euro (€).

1.​ Calculate the guaranteed USD cash flow if the exporter hedges using the forward
contract.
2.​
3.​ If the spot exchange rate in 90 days turns out to be $1.05 per euro, how much would the
unhedged firm lose compared to its hedged position?
4.​
5.​ If the spot exchange rate in 90 days turns out to be $1.18 per euro, what is the
opportunity cost of having hedged?
6.​

Solution

1. Guaranteed USD cash flow:

$$\text{USD Cash Flow} = €500,000 \times \$1.10/€ = \$550,000$$

2. Unhedged position at $1.05/€:

●​ Unhedged USD received: $€500,000 \times \$1.05/€ = \$525,000$.

●​
●​ Loss relative to hedged position: $\$550,000 - \$525,000 = \$25,000$.
●​

3. Opportunity cost at $1.18/€:

●​ Unhedged USD received: $€500,000 \times \$1.18/€ = \$590,000$.

●​
●​ Opportunity cost of forward contract: $\$590,000 - \$550,000 = \$40,000$.
●​

Problem 3: Interest Rate Sensitivity and Duration

A fixed-income portfolio has a market value of $10,000,000 and a duration of 6.0 years. Market
interest rates are currently at 5.0%.

1.​ Using the duration approximation, estimate the percentage change in the portfolio value
if interest rates increase by 50 basis points (+0.50%).
2.​
3.​ Calculate the estimated dollar loss on the portfolio resulting from this interest rate
increase.
4.​

Solution

1. Percentage change in portfolio value:

$$\% \Delta P \approx -\text{Duration} \times \Delta y$$

$$\% \Delta P \approx -6.0 \times (+0.0050) = -0.030\text{ (or }-3.0\%)$$
2. Dollar loss on the portfolio:

$$\Delta P = -\text{Duration} \times \Delta y \times P_0 = -6.0 \times 0.0050 \times \$10,000,000
= -\$300,000$$
Problem 4: Protective Put Strategy

An investor owns 10,000 shares of stock currently trading at $50 per share. Concerned about a
potential market downturn, the investor purchases put options with a strike price of $45 per
share for a premium of $2.00 per share.

1.​ Calculate the total cost of purchasing the put options.

2.​
3.​ If the stock price falls to $35 per share at expiration, calculate the net revenue realized
per share (including option exercise and option premium cost).
4.​
5.​ If the stock price rises to $65 per share at expiration, calculate the net revenue realized
per share.
6.​

Solution

1. Total cost of put options:

$$\text{Total Premium Cost} = 10,000\text{ shares} \times \$2.00/\text{share} = \$20,000$$
2. Stock price falls to $35/share:

●​ The investor exercises the put option to sell at the $45 strike price.
●​ ​

●​ $$\text{Net Revenue per Share} = \$45.00\text{ (strike price)} - \$2.00\text{ (premium)} =

\$43.00$$

3. Stock price rises to $65/share:

●​ The put option expires worthless. The investor sells the stock in the open market at $65.
●​ ​

●​ $$\text{Net Revenue per Share} = \$65.00\text{ (market price)} - \$2.00\text{ (premium)}

= \$63.00$$

Problem 5: Fixed-for-Floating Interest Rate Swap

A corporation has $10 million in variable-rate debt paying SOFR + 1.25% annually. To eliminate
interest rate risk, the firm enters into a interest rate swap where it pays a fixed rate of 4.00% and
receives floating SOFR on a notional principal of $10 million.

1.​ Derive the net effective interest rate paid by the firm after entering the swap.
2.​
3.​ Calculate the firm's annual dollar interest expense on the $10 million debt.
4.​

Solution

1. Net effective interest rate:

$$\text{Net Rate} = (\text{Variable Debt Payment}) + (\text{Pay Fixed}) - (\text{Receive

Floating})$$
$$\text{Net Rate} = (\text{SOFR} + 1.25\%) + 4.00\% - \text{SOFR} = 5.25\%$$
2. Annual interest expense:

$$\text{Annual Expense} = \$10,000,000 \times 5.25\% = \$525,000$$

Problem 6: Value at Risk (VaR) Calculation
An investment portfolio has a current total market value of $5,000,000. Daily portfolio returns
are normally distributed with an expected daily return ($\mu$) of 0% and a daily standard
deviation ($\sigma$) of 1.5%.

1.​ Find the 1-day Value at Risk (VaR) at a 95% confidence level ($z = 1.645$).
2.​
3.​ Interpret the calculated VaR value in practical terms.
4.​

Solution

1. Calculation of 1-Day 95% VaR:

$$\text{VaR}_{95\%} = \text{Portfolio Value} \times z \times \sigma$$

$$\text{VaR}_{95\%} = \$5,000,000 \times 1.645 \times 0.015 = \$123,375$$
2. Interpretation:

There is a 5% probability that the portfolio will lose at least $123,375 in a single trading day (or
95% confidence that the 1-day loss will not exceed $123,375).

Problem 7: Actuarially Fair Insurance with Deductible

A business faces a 4% chance each year of experiencing a severe property fire causing
$500,000 in damages. The firm purchases an actuarially fair insurance policy with a $50,000
deductible.

1.​ Calculate the maximum coverage payout by the insurer in the event of a total loss.
2.​
3.​ Calculate the actuarially fair premium charged by the insurance company.
4.​
5.​ Calculate the firm's expected annual cash outflow for fire loss and insurance coverage.
6.​

Solution

1. Maximum insurer payout:

$$\text{Insurer Payout} = \text{Total Loss} - \text{Deductible} = \$500,000 - \$50,000 =

\$450,000$$
2. Actuarially fair premium:

$$\text{Fair Premium} = \text{Probability of Loss} \times \text{Insurer Payout}$$

$$\text{Fair Premium} = 0.04 \times \$450,000 = \$18,000$$
3. Expected annual cash outflow:

$$\text{Expected Outflow} = \text{Premium} + (\text{Probability of Loss} \times

\text{Deductible})$$
$$\text{Expected Outflow} = \$18,000 + (0.04 \times \$50,000) = \$18,000 + \$2,000 =
\$20,000$$
Problem 8: Basis Risk in Cross-Hedging

An airline needs to hedge its future purchase of 100,000 gallons of jet fuel. Because jet fuel
futures contracts are illiquid, the airline cross-hedges using heating oil futures contracts at a
initial futures lock price of $2.85 per gallon.

At contract maturity:

●​ The spot price of jet fuel is $3.10 per gallon.

●​
●​ The futures price of heating oil is $2.90 per gallon.
●​
1.​ Calculate the gain per gallon realized on the heating oil futures position.
2.​
3.​ Calculate the effective price per gallon paid by the airline for jet fuel after factoring in the
futures gain.
4.​

Solution

1. Futures gain per gallon:

$$\text{Futures Gain} = \text{Final Futures Price} - \text{Initial Futures Price} = \$2.90 - \$2.85 =
\$0.05/\text{gallon}$$
2. Effective price per gallon paid:

$$\text{Effective Price} = \text{Spot Price Paid} - \text{Futures Gain}$$

$$\text{Effective Price} = \$3.10 - \$0.05 = \$3.05/\text{gallon}$$
(Total expenditure for 100,000 gallons = $\$3.05 \times 100,000 = \$305,000$.)
Problem 9: Tax Savings from Risk Management (Tax Convexity)

A firm operates in a tax environment with a progressive corporate tax schedule:

●​ Tax rate on taxable income up to $1,000,000: 0%

●​
●​ Tax rate on taxable income above $1,000,000: 25%
●​

Without hedging, the firm expects taxable income next year to be either $0 (with 50%
probability) or $3,000,000 (with 50% probability). By hedging completely, the firm guarantees a
stable taxable income of $1,500,000.

1.​ Calculate the expected tax paid by the firm without hedging.
2.​
3.​ Calculate the tax paid by the firm with hedging.
4.​
5.​ Calculate the expected tax savings generated by hedging.
6.​

Solution

1. Expected tax without hedging:

●​ In State 1 ($0 income): Tax = $0.

●​
●​ In State 2 ($3,000,000 income): Tax = $(\$3,000,000 - \$1,000,000) \times 0.25 =
\$500,000$.
●​ ​

●​ $$\text{Expected Tax}_{\text{unhedged}} = 0.50(\$0) + 0.50(\$500,000) = \$250,000$$

2. Tax with hedging ($1,500,000 guaranteed):

$$\text{Tax}_{\text{hedged}} = (\$1,500,000 - \$1,000,000) \times 0.25 = \$125,000$$

3. Expected tax savings from hedging:

$$\text{Tax Savings} = \$250,000 - \$125,000 = \$125,000$$

Problem 10: Bank Asset-Liability Immunization

A commercial bank holds $100 million in total assets with an average duration of 4.0 years. The
bank finances these assets with $80 million in liabilities and $20 million in equity.

1.​ Calculate the required duration of liabilities ($D_L$) to fully immunize the market value of
equity against parallel shifts in interest rates.
2.​
3.​ If interest rates increase by 1.0% and the liabilities are fully immunized ($D_L$ from part
1), show that the net change in equity value is $0.
4.​

Solution

1. Immunizing liability duration ($D_L$):

To immunize equity value ($E = A - L$), the dollar duration of assets must equal the dollar
duration of liabilities:

$$\text{Dollar Duration}_{\text{Assets}} = \text{Dollar Duration}_{\text{Liabilities}}$$

$$D_A \times A = D_L \times L$$
$$4.0 \times \$100\text{M} = D_L \times \$80\text{M}$$
$$D_L = \frac{400}{80} = 5.0\text{ years}$$
2. Change in equity value given $\Delta y = +1.0\%$:

●​ Change in Asset Value ($\Delta A$):

●​ ​

●​ $$\Delta A \approx -D_A \times \Delta y \times A = -4.0 \times 0.01 \times \$100\text{M}
= -\$4.0\text{M}$$
●​ Change in Liability Value ($\Delta L$):
●​ ​

●​ $$\Delta L \approx -D_L \times \Delta y \times L = -5.0 \times 0.01 \times \$80\text{M} =
-\$4.0\text{M}$$
●​ Net Change in Equity Value ($\Delta E$):
●​ $$\Delta E = \Delta A - \Delta L = (-\$4.0\text{M}) - (-\$4.0\text{M}) = \$0$$