Problem 1: Corporate Insurance, Financial Distress Costs, and Tax Shields

A firm faces a $20\%$ probability of experiencing a catastrophic factory fire over the next year
that would cause $\$50\text{ million}$ in physical damage. The firm's expected asset value at
$t=1$ before any fire loss is $\$100\text{ million}$, and it has $\$70\text{ million}$ in face value
of debt due at $t=1$. If the firm defaults (asset value strictly below debt obligation), it incurs a
direct financial distress cost of $\$20\text{ million}$, which is deducted from remaining assets
before debt holders are paid. Fire risk is completely unsystematic ($\beta = 0$), and the risk-free
rate is $r_f = 5\%$. An insurer offers a policy covering $100\%$ of fire losses for an upfront
premium at $t=0$ equal to the present value of expected losses plus an administrative loading
fee of $10\%$ of the expected loss present value.

1.​ Compute the total market value of the firm $V_0^{\text{unhedged}}$ at $t=0$ without
insurance.
2.​
3.​ Compute the upfront insurance premium $P_0$ required at $t=0$.
4.​
5.​ Compute the net market value of the firm $V_0^{\text{hedged}}$ at $t=0$ if the firm
purchases full insurance.
6.​
7.​ Determine the Net Present Value ($\text{NPV}$) of purchasing insurance and explain the
source of value creation.
8.​

Solution to Problem 1:

Step 1: Calculate $V_0^{\text{unhedged}}$

Analyze firm cash flows at $t=1$ across both states:

●​ State 1: No Fire (Probability = $0.80$)

●​ ​

●​ $$\text{Assets}_1 = \$100\text{M}$$
●​ Since $\text{Assets}_1 (\$100\text{M}) > \text{Debt} (\$70\text{M})$, there is no default.
Total cash flow distributed to investors (debt + equity) $= \$100\text{M}$.
●​
●​ State 2: Fire (Probability = $0.20$)
●​ ​

●​ $$\text{Assets before distress} = \$100\text{M} - \$50\text{M} = \$50\text{M}$$

 ●​ Since $\text{Assets} (\$50\text{M}) < \text{Debt} (\$70\text{M})$, the firm defaults.
Distressed asset value $= \$50\text{M} - \$20\text{M} = \$30\text{M}$. Equity receives
$\$0$, and debt holders receive $\$30\text{M}$. Total cash flow distributed to investors
$= \$30\text{M}$.
●​

Expected total cash flow at $t=1$:

$$E[\text{CF}_1] = (0.80 \times \$100\text{M}) + (0.20 \times \$30\text{M}) = \$80\text{M} +

\$6\text{M} = \$86\text{M}$$
Since $\beta = 0$, discount at $r_f = 5\%$:

$$V_0^{\text{unhedged}} = \frac{\$86\text{M}}{1.05} = \$81.9048\text{M}$$

Step 2: Calculate Upfront Insurance Premium $P_0$

$$\text{Expected Loss at } t=1 = 0.20 \times \$50\text{M} = \$10\text{M}$$

$$\text{PV of Expected Loss} = \frac{\$10\text{M}}{1.05} = \$9.5238\text{M}$$
$$P_0 = \text{PV of Loss} \times (1 + \text{Loading Fee}) = \$9.5238\text{M} \times 1.10 =
\$10.4762\text{M}$$
Step 3: Calculate $V_0^{\text{hedged}}$

With insurance, the firm receives $\$50\text{M}$ if a fire occurs, maintaining total assets at
$\$100\text{M}$ in both states. Financial distress is completely eliminated.

$$E[\text{CF}_1^{\text{hedged}}] = \$100\text{M}$$
$$\text{Gross Firm Value at } t=0 = \frac{\$100\text{M}}{1.05} = \$95.2381\text{M}$$
$$V_0^{\text{hedged}} = \text{Gross Value} - P_0 = \$95.2381\text{M} - \$10.4762\text{M} =
\$84.7619\text{M}$$
Step 4: Determine Insurance NPV

$$\text{NPV} = V_0^{\text{hedged}} - V_0^{\text{unhedged}} = \$84.7619\text{M} -

\$81.9048\text{M} = +\$2.8571\text{M}$$
Explanation: Insurance avoids the present value of expected distress costs ($\frac{0.20 \times
\$20\text{M}}{1.05} = \$3.8095\text{M}$) while incurring a loading cost of $10\% \times
\$9.5238\text{M} = \$0.9524\text{M}$. The net value created is $\$3.8095\text{M} -
\$0.9524\text{M} = +\$2.8571\text{M}$.

Problem 2: Commodity Futures Hedging with Basis Risk and Mismatched Quantities
A copper producer plans to sell $500,000\text{ pounds}$ of high-grade copper in 6 months
($t=0.5$). To hedge, the firm uses exchange-traded copper futures contracts, where each
contract covers $25,000\text{ pounds}$. The current spot price is $S_0 = \$4.00/\text{lb}$ and
the 6-month futures price is $F_0 = \$4.10/\text{lb}$. Regression analysis on historical price
changes indicates:

$$\Delta S = 0.85 \Delta F + \epsilon$$

where $\text{Var}(\Delta F) = 0.0400$ and $\text{Cov}(\Delta S, \Delta F) = 0.0340$.

1.​ Calculate the optimal hedge ratio $h^*$ and the optimal number of futures contracts
$N^*$ to short.
2.​
3.​ At $t=0.5$, the spot price falls to $S_{0.5} = \$3.50/\text{lb}$ and the futures price falls to
$F_{0.5} = \$3.51/\text{lb}$. Calculate the total revenue realized by the firm across spot
and futures positions.
4.​
5.​ Compute the basis at $t=0$ and $t=0.5$, and evaluate how basis risk impacted the
effective selling price per pound.
6.​

Solution to Problem 2:

Step 1: Calculate $h^*$ and $N^*$

$$h^* = \frac{\text{Cov}(\Delta S, \Delta F)}{\text{Var}(\Delta F)} = \frac{0.0340}{0.0400} = 0.85$$

$$N^* = h^* \times \frac{\text{Quantity to Hedge}}{\text{Futures Contract Size}} = 0.85 \times
\frac{500,000}{25,000} = 0.85 \times 20 = 17\text{ contracts (Short)}$$
Step 2: Calculate Aggregate Realized Revenue

●​ Spot Market Revenue:

●​ ​

●​ $$\text{Spot Revenue} = 500,000\text{ lbs} \times \$3.50/\text{lb} = \$1,750,000$$

●​ Futures Market Payoff:
●​ Futures position size $= 17 \times 25,000 = 425,000\text{ lbs}$.
●​ ​

●​ $$\text{Gain per pound on Short Futures} = F_0 - F_{0.5} = \$4.10 - \$3.51 =

\$0.59/\text{lb}$$
 ●​ $$\text{Total Futures Gain} = 425,000\text{ lbs} \times \$0.59/\text{lb} = \$250,750$$
●​ Total Realized Revenue:
●​ ​

●​ $$\text{Total Revenue} = \$1,750,000 + \$250,750 = \$2,000,750$$

●​ $$\text{Effective Selling Price} = \frac{\$2,000,750}{500,000\text{ lbs}} =
\$4.0015/\text{lb}$$

Step 3: Basis Analysis

$$\text{Basis}_0 = S_0 - F_0 = \$4.00 - \$4.10 = -\$0.10/\text{lb}$$

$$\text{Basis}_{0.5} = S_{0.5} - F_{0.5} = \$3.50 - \$3.51 = -\$0.01/\text{lb}$$
$$\Delta \text{Basis} = \text{Basis}_{0.5} - \text{Basis}_0 = -\$0.01 - (-\$0.10) =
+\$0.09/\text{lb}$$
Evaluation: The basis strengthened (became less negative by $\$0.09/\text{lb}$). Because the
firm was hedging a long spot position by shorting futures, a strengthening basis improves the
net outcome relative to a perfect cross-hedge.

Problem 3: Covered Interest Parity (CIP) and Cash-and-Carry Arbitrage

A European corporate entity expects to receive $€10,000,000$ in 1 year. The market

parameters are as follows:

●​ Spot Exchange Rate: $S_0 = 1.1000\text{ USD/EUR}$

●​
●​ 1-Year Forward Exchange Rate: $F_1 = 1.1200\text{ USD/EUR}$
●​
●​ 1-Year USD Annual Interest Rate: $r_{\$} = 5.0\%$
●​
●​ 1-Year EUR Annual Interest Rate: $r_{\text{EUR}} = 2.0\%$
●​
1.​ Calculate the theoretical 1-year forward exchange rate $F_1^*$ implied by Covered
Interest Parity.
2.​
3.​ Identify whether $F_1$ is overpriced or underpriced relative to CIP, and design an exact
arbitrage strategy for a institutional trader with $€10,000,000$ borrowing capacity.
4.​
5.​ Show all cash flows at $t=0$ and $t=1$, verifying the exact riskless arbitrage profit in
USD.
6.​
Solution to Problem 3:

Step 1: Calculate Theoretical CIP Forward Rate $F_1^*$

$$F_1^* = S_0 \times \frac{1 + r_{\$}}{1 + r_{\text{EUR}}} = 1.1000 \times \frac{1.0500}{1.0200}

= 1.132353\text{ USD/EUR}$$
Step 2: Identify Discrepancy and Strategy

The market forward rate $F_1 = 1.1200\text{ USD/EUR} < F_1^* = 1.132353\text{ USD/EUR}$.

The market forward rate underprices EUR relative to synthetic forward creation. To exploit this:

●​ Borrow EUR today at $r_{\text{EUR}}$.

●​
●​ Convert EUR to USD in the spot market.
●​
●​ Lend USD at $r_{\$}$.
●​
●​ Buy EUR forward at $F_1$ to lock in the repayment of the EUR loan.
●​

Step 3: Cash Flow Execution Table

Time Transaction Cash Flow (EUR) Cash Flow (USD)

$t=0$ Borrow $+€9,803,921.57$ $\$0.00$

$\frac{€10,000,000}{1.02}$
at $2.0\%$

Convert EUR to USD at $-€9,803,921.57$ $+\$10,784,313.73$

$S_0 = 1.1000$

Invest USD at $r_{\$} = $€0.00$ $-\$10,784,313.73$

5.0\%$
 Enter forward contract to $€0.00$ $\$0.00$
buy $€10,000,000$ at $F_1
= 1.1200$

Net $€0.00$ $\$0.00$

$t=0$

$t=1$ Receive proceeds from USD $€0.00$ $+\$11,323,529.41$

investment ($10,784,313.73
\times 1.05$)

Execute forward: Pay USD $+€10,000,000.00$ $-\$11,200,000.00$

to receive $€10,000,000$

Repay EUR loan principal + $-€10,000,000.00$ $\$0.00$

interest

Net $€0.00$ $+\$123,529.41$

$t=1$

Net Arbitrage Profit at $t=1$: $+\$123,529.41$ risk-free.

Problem 4: Currency Hedging: Forwards vs. Options and Breakeven Analysis

A US importer must pay $¥500,000,000$ (Japanese Yen) in 6 months ($t=0.5$). The current
exchange rate is $S_0 = 0.007500\text{ USD/JPY}$. The 6-month risk-free interest rates are
$r_{\$} = 2.0\%$ (effective 6-month rate) and $r_{\text{JPY}} = 0.5\%$ (effective 6-month rate).

The firm considers two hedging strategies:

●​ Strategy A: Lock in a forward contract at $F_{0.5} = 0.007612\text{ USD/JPY}$.

 ●​
●​ Strategy B: Buy 6-month call options on $¥500,000,000$ with strike price $K =
0.007600\text{ USD/JPY}$ for an upfront premium of $\$0.000150\text{ USD/JPY}$ per
Yen.
●​
1.​ Compute the total cost in USD at $t=0.5$ under Strategy A.
2.​
3.​ Derive the total cost in USD at $t=0.5$ under Strategy B as a function of the spot rate
$S_{0.5}$.
4.​
5.​ Calculate the breakeven spot rate $S_{0.5}^*$ at $t=0.5$ where Strategy A and Strategy
B yield identical total costs.
6.​
7.​ Specify the exact range of $S_{0.5}$ for which Strategy B results in a lower total cost
than Strategy A.
8.​

Solution to Problem 4:

Step 1: Total Cost under Strategy A

$$\text{Cost}_A = 500,000,000\text{ JPY} \times 0.007612\text{ USD/JPY} = \$3,806,000$$

Step 2: Total Cost under Strategy B

$$\text{Upfront Premium paid at } t=0 = 500,000,000 \times \$0.000150 = \$75,000$$

$$\text{Future Value of Premium at } t=0.5 = \$75,000 \times (1 + r_{\$}) = \$75,000 \times 1.02
= \$76,500$$
●​ If $S_{0.5} > 0.007600\text{ USD/JPY}$: Exercise option at $K$.
●​ ​

●​ $$\text{Cost}_B = (500,000,000 \times 0.007600) + \$76,500 = \$3,800,000 + \$76,500 =

\$3,876,500$$
●​ If $S_{0.5} \le 0.007600\text{ USD/JPY}$: Let option expire; buy JPY in spot market.
●​ ​

●​ $$\text{Cost}_B = (500,000,000 \times S_{0.5}) + \$76,500$$

Step 3: Calculate Breakeven Exchange Rate $S_{0.5}^*$

Since the maximum cost of Strategy B ($\$3,876,500$) exceeds the fixed cost of Strategy A
($\$3,806,000$), Strategy B can only be cost-effective if the option is unexercised ($S_{0.5} \le
0.007600$).
Set $\text{Cost}_B = \text{Cost}_A$:

$$(500,000,000 \times S_{0.5}^*) + \$76,500 = \$3,806,000$$

$$500,000,000 \times S_{0.5}^* = \$3,729,500$$
$$S_{0.5}^* = \frac{\$3,729,500}{500,000,000} = 0.007459\text{ USD/JPY}$$
Step 4: Decision Rule

●​ Strategy B is strictly cheaper than Strategy A when $S_{0.5} < 0.007459\text{

USD/JPY}$.
●​
●​ Strategy A is strictly cheaper than Strategy B when $S_{0.5} > 0.007459\text{
USD/JPY}$.
●​

Problem 5: Macaulay Duration, Modified Duration, and Convexity Estimation

A financial institution holds a 3-year annual bond with a face value of $\$1,000$, a coupon rate
of $6.0\%$ paid annually, and a yield to maturity (YTM) $y = 8.0\%$.

1.​ Calculate the bond price $P$.

2.​
3.​ Calculate the Macaulay duration $D_{\text{mac}}$ of the bond.
4.​
5.​ Calculate the Modified duration $D_{\text{mod}}$ of the bond.
6.​
7.​ Estimate the new bond price using Modified duration if the YTM increases by 50 basis
points ($\Delta y = +0.50\%$).
8.​
9.​ Compute the exact actual bond price at $y = 8.50\%$ and calculate the estimation error.
10.​

Solution to Problem 5:

Step 1: Calculate Bond Price $P$

$$P = \frac{\$60}{(1.08)^1} + \frac{\$60}{(1.08)^2} + \frac{\$1,060}{(1.08)^3} = \$55.5556 +

\$51.4403 + \$841.4659 = \$948.4618$$
Step 2: Calculate Macaulay Duration $D_{\text{mac}}$
Macaulay duration weighted cash flow timeline:

$$D_{\text{mac}} = \sum_{t=1}^3 t \times \frac{\text{PV}(\text{CF}_t)}{P}$$

$$t=1: 1 \times \frac{\$55.5556}{\$948.4618} = 0.05857$$
$$t=2: 2 \times \frac{\$51.4403}{\$948.4618} = 0.10847$$
$$t=3: 3 \times \frac{\$841.4659}{\$948.4618} = 2.66157$$
$$D_{\text{mac}} = 0.05857 + 0.10847 + 2.66157 = 2.82861\text{ years}$$
Step 3: Calculate Modified Duration $D_{\text{mod}}$

$$D_{\text{mod}} = \frac{D_{\text{mac}}}{1 + y} = \frac{2.82861}{1.08} = 2.61908\text{ years}$$

Step 4: Duration-Based Price Approximation

$$\frac{\Delta P}{P} \approx -D_{\text{mod}} \times \Delta y = -2.61908 \times 0.0050 =

-0.013095 (-1.3095\%)$$
$$\Delta P \approx -0.013095 \times \$948.4618 = -\$12.4205$$
$$\text{Estimated New Price} = \$948.4618 - \$12.4205 = \$936.0413$$
Step 5: Exact Price at $y = 8.50\%$ and Error

$$P_{\text{actual}} = \frac{\$60}{(1.085)^1} + \frac{\$60}{(1.085)^2} + \frac{\$1,060}{(1.085)^3} =

\$55.2995 + \$50.9673 + \$829.8809 = \$936.1477$$
$$\text{Estimation Error} = P_{\text{actual}} - P_{\text{estimated}} = \$936.1477 - \$936.0413 =
+\$0.1064$$
Problem 6: Asset-Liability Balance Sheet Duration Immunization

A pension fund has a liability stream with a present value of $\$100\text{ million}$ and a
Macaulay duration $D_L = 12.0\text{ years}$. The yield curve is flat at $6.0\%$ per annum. To
immunize its equity position against parallel shifts in the yield curve, the fund allocates its
$\$100\text{ million}$ asset portfolio between two zero-coupon bonds:

●​ Bond A: 5-year zero-coupon bond ($D_A = 5.0\text{ years}$).

●​
●​ Bond B: 20-year zero-coupon bond ($D_B = 20.0\text{ years}$).
●​
1.​ Determine the dollar allocation $V_A$ and $V_B$ invested in Bond A and Bond B to
fully immunize the portfolio.
2.​
3.​ Calculate the total face value of Bond A and Bond B required.
4.​
 5.​ If interest rates immediately shift upward to $7.0\%$, calculate the new PV of assets, the
new PV of liabilities, and verify that net equity remains protected.
6.​

Solution to Problem 6:

Step 1: Calculate Portfolio Weights and Dollar Allocation

Set asset duration equal to liability duration:

$$w_A D_A + w_B D_B = D_L$$

$$5.0 w_A + 20.0 (1 - w_A) = 12.0$$
$$20.0 - 15.0 w_A = 12.0 \implies 15.0 w_A = 8.0 \implies w_A = \frac{8}{15} = 53.3333\%$$
$$w_B = 1 - \frac{8}{15} = \frac{7}{15} = 46.6667\%$$
Dollar allocations:

$$V_A = \frac{8}{15} \times \$100\text{M} = \$53.3333\text{M}$$

$$V_B = \frac{7}{15} \times \$100\text{M} = \$46.6667\text{M}$$
Step 2: Compute Required Face Values

$$\text{Face Value}_A = \$53.3333\text{M} \times (1.06)^5 = \$53.3333\text{M} \times 1.338226

= \$71.3720\text{M}$$
$$\text{Face Value}_B = \$46.6667\text{M} \times (1.06)^{20} = \$46.6667\text{M} \times
3.207135 = \$149.6663\text{M}$$
Step 3: Evaluate Portfolio at $y = 7.0\%$

●​ New Asset Value:

●​ ​

●​ $$PV(A) = \frac{\$71.3720\text{M}}{(1.07)^5} = \$50.8876\text{M}$$

●​ $$PV(B) = \frac{\$149.6663\text{M}}{(1.07)^{20}} = \$38.6775\text{M}$$
●​ $$PV(\text{Assets}) = \$50.8876\text{M} + \$38.6775\text{M} = \$89.5651\text{M}$$
●​ New Liability Value:
●​ Single cash flow equivalent with $D_L = 12$:
●​ ​

●​ $$\text{Liability Cash Flow at } t=12 = \$100\text{M} \times (1.06)^{12} =

\$201.2196\text{M}$$
●​ $$PV(\text{Liabilities at } 7\%) = \frac{\$201.2196\text{M}}{(1.07)^{12}} =
\$89.3122\text{M}$$
 ●​ Net Position:
●​ ​

●​ $$\text{Net Equity} = PV(\text{Assets}) - PV(\text{Liabilities}) = \$89.5651\text{M} -

\$89.3122\text{M} = +\$0.2529\text{M}$$

Result: Net equity is protected (showing a slight gain due to asset portfolio convexity exceeding
liability convexity).

Problem 7: Duration-Based Hedging with Interest Rate Futures

A commercial bank holds a bond portfolio valued at $V_P = \$250\text{ million}$ with a modified
duration $D_P = 6.5\text{ years}$. Anticipating a rate hike, the portfolio manager wants to
reduce the effective modified duration to $D_{\text{target}} = 2.0\text{ years}$ using Treasury
bond futures contracts.

Each futures contract has a market price of $115.00$ (quoted per $\$100$ face value,
representing a price $P_F = \$115,000$ per contract) and the underlying benchmark bond has a
modified duration $D_F = 8.0\text{ years}$.

1.​ Determine whether the bank should go long or short in futures contracts.
2.​
3.​ Calculate the exact number of futures contracts $N^*$ required.
4.​
5.​ If interest rates across all maturities increase by 75 basis points ($\Delta y = +0.75\%$),
compute the value change in the unhedged bond portfolio, the gain/loss on the futures
hedge, and verify the net change in portfolio value.
6.​

Solution to Problem 7:

Step 1: Position Direction

To reduce portfolio duration, the bank must take a short position in futures contracts.

Step 2: Calculate Number of Contracts $N^*$

$$(D_{\text{target}} - D_P) V_P = N^* \times D_F \times P_F$$

$$N^* = \frac{(D_{\text{target}} - D_P) V_P}{D_F \times P_F} = \frac{(2.0 - 6.5) \times
\$250,000,000}{8.0 \times \$115,000}$$
$$N^* = \frac{-\$1,125,000,000}{\$920,000} = -1,222.826$$
Action: Short $1,223\text{ contracts}$.

Step 3: Evaluate 75 bps Rate Shift ($\Delta y = +0.0075$)

●​ Unhedged Portfolio Value Change:

●​ ​

●​ $$\Delta V_P \approx -D_P \times V_P \times \Delta y = -6.5 \times \$250,000,000 \times
0.0075 = -\$12,187,500$$
●​ Futures Gain/Loss:
●​ ​

●​ $$\Delta P_F \approx -D_F \times P_F \times \Delta y = -8.0 \times \$115,000 \times
0.0075 = -\$6,900\text{ per contract}$$
●​ $$\text{Payoff on Short } 1,223\text{ Contracts} = -1,223 \times (-\$6,900) =
+\$8,438,700$$
●​ Net Portfolio Value Change:
●​ ​

●​ $$\Delta V_{\text{net}} = -\$12,187,500 + \$8,438,700 = -\$3,748,800$$

●​ Target Benchmark Verification:
●​ ​

●​ $$\Delta V_{\text{target}} = -D_{\text{target}} \times V_P \times \Delta y = -2.0 \times

\$250,000,000 \times 0.0075 = -\$3,750,000$$

The hedged outcome ($-\$3,748,800$) matches the target response ($-\$3,750,000$) within
integer contract rounding.

Problem 8: Interest Rate Swap Pricing and Mark-to-Market Valuation

A corporation enters into a 2-year plain vanilla interest rate swap with a notional principal of $N
= \$50\text{ million}$. The firm pays a 1-year floating spot rate and receives a fixed annual rate
$R_{\text{fixed}}$.

The zero-coupon discount curve at $t=0$ gives the following spot rates:
 ●​ 1-year spot rate: $r_1 = 4.0\%$
●​
●​ 2-year spot rate: $r_2 = 5.0\%$
●​
1.​ Calculate the 1-year forward rate $f_{1,2}$ for Year 2.
2.​
3.​ Determine the par swap rate $R_{\text{fixed}}$ at $t=0$.
4.​
5.​ At $t=1$, immediately after the first annual payment is settled, 1-year interest rates rise
to $r_1' = 6.0\%$. Calculate the mark-to-market value of the swap to the fixed-rate
receiver at $t=1$.
6.​

Solution to Problem 8:

Step 1: Calculate Forward Rate $f_{1,2}$

$$(1 + r_2)^2 = (1 + r_1)(1 + f_{1,2})$$

$$(1.05)^2 = (1.04)(1 + f_{1,2}) \implies 1.1025 = 1.04 (1 + f_{1,2})$$
$$1 + f_{1,2} = \frac{1.1025}{1.04} = 1.060096 \implies f_{1,2} = 6.0096\%$$
Step 2: Calculate Par Swap Rate $R_{\text{fixed}}$

Compute discount factors:

$$d_1 = \frac{1}{1 + r_1} = \frac{1}{1.04} = 0.961538$$

$$d_2 = \frac{1}{(1 + r_2)^2} = \frac{1}{(1.05)^2} = 0.907029$$
Apply the swap rate formula:

$$R_{\text{fixed}} = \frac{1 - d_2}{d_1 + d_2} = \frac{1 - 0.907029}{0.961538 + 0.907029} =

\frac{0.092971}{1.868567} = 4.9755\%$$
Step 3: Valuation at $t=1$

At $t=1$, one payment remains at $t=2$.

●​ Fixed Payment Received $= \$50,000,000 \times 4.9755\% = \$2,487,750$

●​
●​ Floating Payment Paid $= \$50,000,000 \times 6.0000\% = \$3,000,000$
●​
●​ Net Cash Flow at $t=2 = \$2,487,750 - \$3,000,000 = -\$512,250$
 ●​

Discount net cash flow back to $t=1$ at the prevailing 1-year spot rate ($6.0\%$):

$$V_{\text{swap},1} = \frac{-\$512,250}{1.06} = -\$483,254.72$$

The swap value to the fixed-rate receiver is $-\$483,254.72$ (a net liability).

Problem 9: Immunizing Corporate Equity Duration via Interest Rate Swaps

A commercial bank holds $\$1.2\text{ billion}$ in assets with a duration of $D_A = 5.0\text{
years}$, financed by $\$1.1\text{ billion}$ in liabilities with a duration of $D_L = 1.0\text{ year}$.
The bank's equity capital is $E = \$100\text{ million}$.

The bank wishes to immunize its equity completely ($D_E = 0$) using a pay-fixed /
receive-floating interest rate swap. The net duration of the swap position is $D_{\text{swap}} =
-4.0\text{ years}$ per dollar of notional principal.

1.​ Calculate the current duration of the bank's equity $D_E$.

2.​
3.​ State whether the bank should enter a pay-fixed or receive-fixed swap and explain why.
4.​
5.​ Calculate the required swap notional principal $N_{\text{swap}}$ to achieve $D_E = 0$.
6.​

Solution to Problem 9:

Step 1: Calculate Current Equity Duration $D_E$

The balance sheet identity for dollar duration is:

$$D_E \times E = D_A \times A - D_L \times L$$

$$D_E \times \$100\text{M} = (5.0 \times \$1,200\text{M}) - (1.0 \times \$1,100\text{M})$$
$$D_E \times \$100\text{M} = \$6,000\text{M} - \$1,100\text{M} = \$4,900\text{M}$$
$$D_E = \frac{\$4,900\text{M}}{\$100\text{M}} = 49.0\text{ years}$$
Step 2: Swap Strategy Selection
Because $D_E = +49.0\text{ years}$, rising interest rates substantially reduce equity value. The
bank must enter into a pay-fixed / receive-floating swap, which provides a negative duration
contribution ($D_{\text{swap}} = -4.0\text{ years}$) to offset asset-liability duration mismatch.

Step 3: Calculate Required Swap Notional $N_{\text{swap}}$

Set total dollar duration equal to zero:

$$(D_E \times E) + (D_{\text{swap}} \times N_{\text{swap}}) = 0$$

$$\$4,900\text{M} + (-4.0 \times N_{\text{swap}}) = 0$$
$$4.0 N_{\text{swap}} = \$4,900\text{M} \implies N_{\text{swap}} = \$1,225\text{M} =
\$1.225\text{ billion}$$
Result: The bank should enter a pay-fixed interest rate swap with a notional principal of
$\$1.225\text{ billion}$.

Problem 10: Integrated Risk Management: Unhedged vs. Forward vs. Option Hedging
with Financial Distress

An airline forecasts fuel consumption of $1,000,000\text{ barrels}$ of jet fuel next year. The spot
price per barrel next year ($F_1$) has three possible outcomes:

●​ High Price State (Probability $30\%$): $F_1 = \$140/\text{bbl}$

●​
●​ Medium Price State (Probability $50\%$): $F_1 = \$100/\text{bbl}$
●​
●​ Low Price State (Probability $20\%$): $F_1 = \$70/\text{bbl}$
●​

Operating earnings before fuel costs are fixed at $\$140\text{ million}$. Debt principal due at
year-end is $\$35\text{ million}$. If net earnings after fuel expenses fall below debt obligations
($\$35\text{M}$), the firm defaults and incurs a direct financial distress cost of $\$15\text{
million}$. Ignore taxes and discounting ($r = 0\%$).

The firm compares three hedging strategies:

1.​ Strategy 1 (Unhedged): Do not hedge.

2.​
 3.​ Strategy 2 (Forward Hedge): Lock in fuel price at $F_0 = \$100/\text{bbl}$ for
$1,000,000\text{ barrels}$.
4.​
5.​ Strategy 3 (Call Option Hedge): Buy call options on $1,000,000\text{ barrels}$ at strike
$K = \$100/\text{bbl}$ for an upfront premium of $\$5/\text{bbl}$ (total premium
$\$5\text{M}$).
6.​

Compute expected total fuel expenses, expected financial distress costs, and expected net firm
payoff for each strategy, and identify the optimal decision.

Solution to Problem 10:

Step 1: Evaluate Strategy 1 (Unhedged)

Default threshold: Net Earnings $< \$35\text{M} \implies \$140\text{M} - \text{Fuel Cost} <
\$35\text{M} \implies \text{Fuel Cost} > \$105\text{M}$.

●​ High State ($F_1 = \$140$, Prob 0.30):

●​ Fuel Cost $= \$140\text{M}$. Earnings after fuel $= \$140\text{M} - \$140\text{M} = \$0 <
\$35\text{M} \implies$ Default.
●​ Distress Cost $= \$15\text{M}$. Net Payoff $= \$0 - \$15\text{M} = -\$15\text{M}$.
●​
●​ Medium State ($F_1 = \$100$, Prob 0.50):
●​ Fuel Cost $= \$100\text{M}$. Earnings after fuel $= \$140\text{M} - \$100\text{M} =
\$40\text{M} \ge \$35\text{M} \implies$ No Default.
●​ Distress Cost $= \$0$. Net Payoff $= \$40\text{M}$.
●​
●​ Low State ($F_1 = \$70$, Prob 0.20):
●​ Fuel Cost $= \$70\text{M}$. Earnings after fuel $= \$140\text{M} - \$70\text{M} =
\$70\text{M} \ge \$35\text{M} \implies$ No Default.
●​ Distress Cost $= \$0$. Net Payoff $= \$70\text{M}$.
●​

Expected Metrics:

$$\text{Expected Fuel Cost} = (0.30 \times \$140\text{M}) + (0.50 \times \$100\text{M}) + (0.20
\times \$70\text{M}) = \$106.0\text{M}$$
$$\text{Expected Distress Cost} = 0.30 \times \$15\text{M} = \$4.5\text{M}$$
$$\text{Expected Net Payoff} = (0.30 \times (-\$15\text{M})) + (0.50 \times \$40\text{M}) + (0.20
\times \$70\text{M}) = \$29.5\text{M}$$
Step 2: Evaluate Strategy 2 (Forward Hedge)

Fuel cost locked at $\$100\text{M}$ across all states.

Earnings after fuel $= \$140\text{M} - \$100\text{M} = \$40\text{M} \ge \$35\text{M}$ in all states.
No default in any state.

Expected Metrics:

$$\text{Expected Fuel Cost} = \$100.0\text{M}$$

$$\text{Expected Distress Cost} = \$0.0\text{M}$$
$$\text{Expected Net Payoff} = \$140\text{M} - \$100\text{M} = \$40.0\text{M}$$
Step 3: Evaluate Strategy 3 (Call Option Hedge)

Total option premium $= \$5\text{M}$.

●​ High State ($F_1 = \$140$, Prob 0.30):

●​ Exercise option. Fuel Cost $= \$100\text{M} + \$5\text{M} = \$105\text{M}$.
●​ Earnings after fuel $= \$140\text{M} - \$105\text{M} = \$35\text{M} \ge \$35\text{M}
\implies$ No Default.
●​ Distress Cost $= \$0$. Net Payoff $= \$35\text{M}$.
●​
●​ Medium State ($F_1 = \$100$, Prob 0.50):
●​ Option at strike. Fuel Cost $= \$100\text{M} + \$5\text{M} = \$105\text{M}$.
●​ Earnings after fuel $= \$35\text{M} \ge \$35\text{M} \implies$ No Default.
●​ Distress Cost $= \$0$. Net Payoff $= \$35\text{M}$.
●​
●​ Low State ($F_1 = \$70$, Prob 0.20):
●​ Expire option. Fuel Cost $= \$70\text{M} + \$5\text{M} = \$75\text{M}$.
●​ Earnings after fuel $= \$140\text{M} - \$75\text{M} = \$65\text{M} \ge \$35\text{M}
\implies$ No Default.
●​ Distress Cost $= \$0$. Net Payoff $= \$65\text{M}$.
●​

Expected Metrics:

$$\text{Expected Fuel Cost + Premium} = (0.30 \times \$105\text{M}) + (0.50 \times

\$105\text{M}) + (0.20 \times \$75\text{M}) = \$99.0\text{M}$$
$$\text{Expected Distress Cost} = \$0.0\text{M}$$
$$\text{Expected Net Payoff} = (0.30 \times \$35\text{M}) + (0.50 \times \$35\text{M}) + (0.20
\times \$65\text{M}) = \$41.0\text{M}$$
Strategy Comparison Summary Table

Metric Strategy 1 Strategy 2 Strategy 3 (Call

(Unhedged) (Forward) Option)

Expected $\$106.0\text{M}$ $\$100.0\text{M}$ $\$99.0\text{M}$

Fuel Cost

Expected $\$4.5\text{M}$ $\$0.0\text{M}$ $\$0.0\text{M}$

Distress Cost

Expected Net $\$29.5\text{M}$ $\$40.0\text{M}$ $\$41.0\text{M}$

Firm Payoff

Conclusion: Strategy 3 (Call Option Hedge) is optimal. It completely eliminates expected

financial distress costs while retaining upside exposure when market fuel prices drop in the low
state.