Problem 1: Optimal Cross-Hedging Ratio and Contract Sizing

An airline anticipates purchasing 500,000 barrels of jet fuel in 3 months. Because jet fuel futures
are illiquid, the firm hedges using heating oil futures contracts.

●​ Standard deviation of jet fuel price changes ($\sigma_S$): $0.28$

●​
●​ Standard deviation of heating oil futures price changes ($\sigma_F$): $0.22$
●​
●​ Correlation coefficient between price changes ($\rho$): $0.85$
●​
●​ Heating oil futures contract size: $42,000\text{ gallons}$ ($1\text{ barrel} = 42\text{
gallons}$, so 1 contract = $1,000\text{ barrels}$)
●​
1.​ Calculate the optimal hedge ratio $h^*$.
2.​
3.​ Calculate the number of heating oil futures contracts $N^*$ required to construct the
optimal hedge.
4.​
5.​ Calculate the hedging efficiency ($R^2$), representing the proportion of spot price
variance eliminated by the hedge.
6.​

Solution

1. Optimal hedge ratio ($h^*$):

$$h^* = \rho \times \frac{\sigma_S}{\sigma_F} = 0.85 \times \frac{0.28}{0.22} = 1.0818$$

2. Number of futures contracts ($N^*$):

$$N^* = h^* \times \frac{\text{Total Spot Exposure}}{\text{Futures Contract Size}}$$

$$N^* = 1.0818 \times \frac{500,000\text{ barrels}}{1,000\text{ barrels/contract}} = 540.9 \approx
541\text{ contracts}$$
3. Hedging efficiency ($R^2$):

$$\text{Hedging Efficiency} = R^2 = \rho^2 = (0.85)^2 = 0.7225\text{ (or } 72.25\%)$$

The cross-hedge reduces the variance of the airline's fuel cost by $72.25\%$.

Problem 2: Comparative Advantage and Interest Rate Swap Structuring

Firm A (rated AAA) and Firm B (rated BBB) face the following annual borrowing rates in the
fixed and floating markets:

Firm Fixed Rate Floating Rate

Firm A $5.00\%$ $\text{SOFR} + 0.20\%$

Firm B $6.80\%$ $\text{SOFR} + 1.00\%$

Firm A desires a floating-rate loan, while Firm B desires a fixed-rate loan. A swap bank
structures an interest rate swap between the two firms and charges an intermediation fee of
$0.10\%$ ($10\text{ bps}$) per year. The remaining net swap surplus is split equally ($50/50$)
between Firm A and Firm B.

1.​ Calculate the total comparative advantage gain (swap surplus) available to be shared.
2.​
3.​ Determine the net effective interest rate achieved by Firm A and Firm B after entering
the swap.
4.​

Solution

1. Total comparative advantage surplus:

●​ Fixed rate differential: $6.80\% - 5.00\% = 1.80\%$ (Firm A has a $1.80\%$ advantage in
fixed)
●​
●​ Floating rate differential: $(\text{SOFR} + 1.00\%) - (\text{SOFR} + 0.20\%) = 0.80\%$
(Firm A has a $0.80\%$ advantage in floating)
●​
●​ Total Surplus: $1.80\% - 0.80\% = 1.00\%\text{ (or } 100\text{ bps})$
●​

2. Net effective interest rates for Firm A and Firm B:

●​ Net surplus after bank fee: $1.00\% - 0.10\% = 0.90\%$

 ●​
●​ Gain per firm ($50/50$ split): $\frac{0.90\%}{2} = 0.45\%\text{ (or } 45\text{ bps})$
●​
●​ Firm A (Wants Floating):
●​ ​

●​ $$\text{Effective Rate} = \text{Direct Floating Rate} - \text{Net Gain}$$

●​ $$\text{Effective Rate} = (\text{SOFR} + 0.20\%) - 0.45\% = \text{SOFR} - 0.25\%$$
●​ Firm B (Wants Fixed):
●​ ​

●​ $$\text{Effective Rate} = \text{Direct Fixed Rate} - \text{Net Gain}$$

●​ $$\text{Effective Rate} = 6.80\% - 0.45\% = 6.35\%$$

Problem 3: Scaled Multi-Period Value at Risk (VaR) with Non-Zero Drift

An investment fund manages a portfolio worth $25 million. The annualized expected return
($\mu$) is $8.0\%$, and the annualized volatility ($\sigma$) is $18.0\%$. Assume 252 trading
days per year and that returns are normally distributed.

1.​ Calculate the 1-day $99\%$ Value at Risk ($\text{VaR}_{1\text{-day, } 99\%}$) using $z =
2.326$.
2.​
3.​ Calculate the 10-day $99\%$ Value at Risk ($\text{VaR}_{10\text{-day, } 99\%}$) by
adjusting both mean drift and volatility over the 10-day horizon.
4.​

Solution

1. 1-day 99% VaR:

●​ Daily expected return: $\mu_d = \frac{0.08}{252} = 0.0003175$

●​
●​ Daily standard deviation: $\sigma_d = \frac{0.18}{\sqrt{252}} = 0.0113389$
●​ ​

●​ $$\text{VaR}_{1\text{-day, } 99\%} = -V_0 \times (\mu_d - z \times \sigma_d)$$

●​ $$\text{VaR}_{1\text{-day, } 99\%} = -\$25,000,000 \times (0.0003175 - 2.326 \times
0.0113389)$$
●​ $$\text{VaR}_{1\text{-day, } 99\%} = -\$25,000,000 \times (0.0003175 - 0.0263743) =
\$651,420$$
2. 10-day 99% VaR:

●​ 10-day expected return: $\mu_{10} = 10 \times \mu_d = 0.003175$

●​
●​ 10-day standard deviation: $\sigma_{10} = \sqrt{10} \times \sigma_d = \sqrt{10} \times
0.0113389 = 0.0358568$
●​ ​

●​ $$\text{VaR}_{10\text{-day, } 99\%} = -V_0 \times (\mu_{10} - z \times \sigma_{10})$$

●​ $$\text{VaR}_{10\text{-day, } 99\%} = -\$25,000,000 \times (0.003175 - 2.326 \times
0.0358568)$$
●​ $$\text{VaR}_{10\text{-day, } 99\%} = -\$25,000,000 \times (0.003175 - 0.0833029) =
\$2,003,198$$

Problem 4: Money Market Hedge vs. Forward Market Hedge

A US corporation must pay £2,000,000 to a British supplier in 6 months.

●​ Current spot exchange rate: $1.3000 / £

●​
●​ 6-month Forward exchange rate: $1.2900 / £
●​
●​ 6-month US risk-free interest rate: $4.0\%$ per annum ($2.0\%$ per 6 months)
●​
●​ 6-month UK risk-free interest rate: $6.0\%$ per annum ($3.0\%$ per 6 months)
●​
1.​ Calculate the guaranteed total USD cost under a Forward Market Hedge.
2.​
3.​ Calculate the guaranteed total USD cost under a Money Market Hedge (present value
of GBP liability discounted and converted at spot, funded by borrowing USD).
4.​
5.​ Identify which hedging alternative is cheaper and determine the cost savings.
6.​

Solution

1. Forward Market Hedge:

$$\text{Total Cost} = £2,000,000 \times \$1.2900/£ = \$2,580,000$$

2. Money Market Hedge:
 ●​ GBP required today to grow to £2,000,000 in 6 months:
●​ ​

●​ $$\text{GBP Today} = \frac{£2,000,000}{1 + 0.03} = £1,941,747.57$$

●​ USD needed today to buy $£1,941,747.57$ at the current spot rate ($1.3000):
●​ ​

●​ $$\text{USD Today} = £1,941,747.57 \times \$1.3000/£ = \$2,524,271.84$$

●​ Total USD repaid in 6 months (after borrowing at the 2% 6-month US rate):
●​ ​

●​ $$\text{Total Cost} = \$2,524,271.84 \times (1 + 0.02) = \$2,574,757.28$$

3. Comparison:

●​ The Money Market Hedge is cheaper than the Forward Market Hedge.
●​
●​ Cost savings = $\$2,580,000 - \$2,574,757.28 = \$5,242.72$.
●​

Problem 5: Dynamic Delta-Hedging of an Option Portfolio

A market maker sells (writes) 1,000 European call options on Stock X. Each option contract
covers 1 share.

●​ Current stock price ($S_0$): $100.00

●​
●​ Initial option delta ($\Delta_1$): $0.60$
●​

On Day 2, Stock X drops to $95.00, and the option's delta decreases to $0.45$.

1.​ Calculate the initial stock position required on Day 1 to make the market maker's
option-and-stock portfolio delta-neutral.
2.​
3.​ Determine how many shares of stock the market maker must buy or sell on Day 2 to
maintain delta neutrality.
4.​
5.​ Calculate the net cash flow resulting from the Day 2 rebalancing trade.
6.​
Solution

1. Day 1 initial hedge position:

●​ Option position delta: $-1,000 \times 0.60 = -600\text{ shares}$.

●​
●​ To achieve $\Delta_{\text{portfolio}} = 0$, the market maker must buy 600 shares of
Stock X at $100.00 per share (Total outlay = $\$60,000$).
●​

2. Day 2 rebalancing:

●​ New option position delta: $-1,000 \times 0.45 = -450\text{ shares}$.

●​
●​ Required stock holding for delta neutrality: $450\text{ shares}$.
●​
●​ Current stock holding: $600\text{ shares}$.
●​
●​ Adjustment required: Sell 150 shares ($600 - 450$).
●​

3. Cash flow from Day 2 trade:

$$\text{Cash Inflow} = 150\text{ shares} \times \$95.00/\text{share} = +\$14,250$$

Problem 6: Balance Sheet Immunization with Interest Rate Futures

A commercial bank has the following balance sheet profile:

●​ Total Assets ($A$): $500 million with average duration $D_A = 5.5\text{ years}$
●​
●​ Total Liabilities ($L$): $420 million with average duration $D_L = 2.0\text{ years}$
●​
●​ Bank Equity ($E$): $80 million
●​

The bank plans to fully immunize its net equity value against parallel shifts in interest rates using
interest rate futures contracts.

●​ Current futures contract market price ($P_f$): $110,000 per contract

●​
 ●​ Duration of underlying instrument ($D_f$): $7.0\text{ years}$
●​
1.​ Calculate the bank's duration gap ($D_G$).
2.​
3.​ Calculate the number of futures contracts $N^*$ needed to fully immunize equity value,
specifying whether the bank should take a long or short position.
4.​

Solution

1. Duration Gap ($D_G$):

$$D_G = D_A - \left( \frac{L}{A} \right) \times D_L$$

$$D_G = 5.5 - \left( \frac{\$420\text{M}}{\$500\text{M}} \right) \times 2.0 = 5.5 - 0.84 \times 2.0 =
5.5 - 1.68 = 3.82\text{ years}$$
2. Number of futures contracts ($N^*$):

To offset the change in equity value ($\Delta E \approx -D_G \times A \times \Delta y$), the
required futures position must satisfy:

$$\Delta V_f \approx -N^* \times D_f \times P_f \times \Delta y = D_G \times A \times \Delta y$$
$$N^* = \frac{D_G \times A}{D_f \times P_f}$$
$$N^* = \frac{3.82 \times \$500,000,000}{7.0 \times \$110,000} =
\frac{\$1,910,000,000}{\$770,000} = 2,480.52 \approx 2,481\text{ contracts}$$
●​ Since rising interest rates decrease equity value ($\text{Asset duration} > \text{Liability
duration}$), the bank must take a short position in 2,481 futures contracts to gain
value when interest rates rise.
●​

Problem 7: Value Created by Risk Management under Tax Convexity

A firm faces a progressive corporate tax structure with loss carryforward rules.

●​ If pre-tax earnings are positive, corporate tax rate ($\tau_c$) = $21\%$.

●​
●​ If pre-tax earnings are negative, corporate tax paid = $0$, but the tax loss carryforward
generates a tax savings in Year 2 worth a present value equal to $90\%$ of the
immediate tax shield ($\tau_c \times \text{Loss} \times 0.90$).
●​

Next year's unhedged earnings before tax (EBT) are volatile:

 ●​ State 1 ($50\%$ probability): $+\$10,000,000$
●​
●​ State 2 ($50\%$ probability): $-\$10,000,000$
●​

By executing a risk management hedge, the firm can guarantee EBT of $\$0$.

1.​ Calculate the expected net tax liability under the unhedged policy (accounting for the
present value of loss carryforwards).
2.​
3.​ Calculate the expected net tax liability under the fully hedged policy.
4.​
5.​ Calculate the expected net tax savings created purely by managing corporate earnings
risk.
6.​

Solution

1. Unhedged expected tax liability:

●​ State 1 ($+\$10\text{M}$): Tax paid = $\$10,000,000 \times 0.21 = \$2,100,000$.

●​
●​ State 2 ($-\$10\text{M}$): Immediate tax paid = $\$0$.
●​ Present value of future tax shield from loss carryforward = $\$10,000,000 \times 0.21
\times 0.90 = \$1,890,000$.
●​
●​ Net tax burden in State 2 = $-\$1,890,000$ (benefit).
●​
●​ Expected Net Tax Liability:
●​ ​

●​ $$\text{Expected Tax}_{\text{unhedged}} = 0.50 \times (\$2,100,000) + 0.50 \times

(-\$1,890,000) = \$1,050,000 - \$945,000 = \$105,000$$

2. Fully hedged tax liability:

●​ Guaranteed EBT = $\$0$.

●​
●​ Tax paid = $\$0$.
●​
3. Tax savings from hedging:

$$\text{Expected Tax Savings} = \text{Expected Tax}_{\text{unhedged}} -

\text{Tax}_{\text{hedged}}$$
$$\text{Expected Tax Savings} = \$105,000 - \$0 = \$105,000$$
Problem 8: Zero-Cost Collar Strategy for Input Costs

An industrial manufacturer needs to buy 50,000 MMBtu of natural gas in 3 months. The current
spot price is $3.00 per MMBtu. To cap input costs without paying an upfront cash premium, the
firm constructs a zero-cost collar:

●​ Purchases a Call Option with strike $K_C = \$3.40/\text{MMBtu}$ for a premium of $0.20
per MMBtu.
●​
●​ Sells a Put Option with strike $K_P = \$2.70/\text{MMBtu}$ for a premium of $0.20 per
MMBtu.
●​
1.​ Calculate the total net cash premium paid at initiation.
2.​
3.​ Calculate the net total dollar expenditure for the 50,000 MMBtu order across three
potential spot price outcomes at expiration: $S_T = \$2.20$, $S_T = \$3.00$, and $S_T
= \$3.80$.
4.​

Solution

1. Net premium at initiation:

$$\text{Net Premium} = \$0.20\text{ (call bought)} - \$0.20\text{ (put sold)} = \$0.00$$

2. Expenditure under spot scenarios ($S_T$):

●​ Scenario A ($S_T = \$2.20/MMBtu$):

●​ ​

○​ Call Option expires worthless ($2.20 < 3.40$).

○​
○​ Put Option is exercised against the firm ($2.20 < 2.70$). Firm must pay $K_P =
\$2.70$.
○​
○​ Effective price per MMBtu = $\$2.70$.
 ○​
○​ Total expenditure = $50,000 \times \$2.70 = \$135,000$.
○​
●​ Scenario B ($S_T = \$3.00/MMBtu$):
●​ ​

○​ Both Call and Put expire out-of-the-money ($2.70 < 3.00 < 3.40$).
○​
○​ Firm buys natural gas at market spot price = $\$3.00$.
○​
○​ Effective price per MMBtu = $\$3.00$.
○​
○​ Total expenditure = $50,000 \times \$3.00 = \$150,000$.
○​
●​ Scenario C ($S_T = \$3.80/MMBtu$):
●​ ​

○​ Put Option expires worthless ($3.80 > 2.70$).

○​
○​ Call Option is exercised by the firm ($3.80 > 3.40$). Firm buys at strike $K_C =
\$3.40$.
○​
○​ Effective price per MMBtu = $\$3.40$.
○​
○​ Total expenditure = $50,000 \times \$3.40 = \$170,000$.
○​

Problem 9: Fair Value Pricing of Credit Default Swaps (CDS)

An investor holds a 1-year, $20 million par value corporate bond. To hedge default risk, the
investor purchases a 1-year Credit Default Swap (CDS).

●​ Annual probability of default ($p$): $3.0\%$

●​
●​ Recovery rate in the event of default ($R$): $40\%$
●​
●​ Risk-free discount rate ($r$): $5.0\%$
●​
●​ CDS premium spread ($s$) is paid at year-end. If default occurs, the CDS pays the loss
given default at year-end.
●​
1.​ Calculate the expected CDS payout in the event of default.
2.​
 3.​ Derive the actuarially fair annual CDS spread ($s$) in basis points.
4.​

Solution

1. Expected CDS payout:

$$\text{Loss Given Default (LGD)} = (1 - R) \times \text{Par Value} = (1 - 0.40) \times

\$20,000,000 = \$12,000,000$$
$$\text{Expected Protection Payout} = p \times \text{LGD} = 0.03 \times \$12,000,000 =
\$360,000$$
2. Actuarially fair CDS spread ($s$):

●​ Present value of protection leg:

●​ ​

●​ $$\text{PV}(\text{Protection}) = \frac{\$360,000}{1 + 0.05} = \$342,857.14$$

●​ The premium payment is made at $t = 1$ provided the firm survives ($1 - p = 0.97$
probability):
●​ ​

●​ $$\text{PV}(\text{Premium Leg}) = \frac{s \times \$20,000,000 \times 0.97}{1 + 0.05}$$

●​ Equating PV of protection leg and PV of premium leg:
●​ ​

●​ $$\frac{\$360,000}{1.05} = \frac{s \times \$19,400,000}{1.05}$$

●​ $$s = \frac{\$360,000}{\$19,400,000} = 0.018557\text{ (or } 1.8557\%)$$
●​ CDS spread in basis points = $1.8557 \times 100 = 185.57\text{ bps}$.
●​

Problem 10: Value at Risk (VaR) vs. Expected Shortfall (Tail VaR)

A hedge fund holds a credit-sensitive portfolio subject to heavy-tailed loss distribution over a
1-day horizon:

Loss Amount Probability Cumulative Probability

 $0 $90.0\%$ $90.0\%$

$100,000 $6.0\%$ $96.0\%$

$500,000 $3.0\%$ $99.0\%$

$2,000,000 $1.0\%$ $100.0\%$

1.​ Determine the 1-day $95\%$ Value at Risk ($\text{VaR}_{95\%}$).

2.​
3.​ Calculate the 1-day $95\%$ Expected Shortfall ($\text{ES}_{95\%}$), representing the
expected loss conditional on exceeding the $95\%$ VaR cutoff.
4.​
5.​ Compare the two metrics and explain why Expected Shortfall is preferred for non-normal
distributions with extreme tail risk.
6.​

Solution

1. 1-day 95% VaR:

●​ The cumulative probability reaching $95\%$ falls within the outcome level of
$\$100,000$ (since losses $\le \$100,000$ cover $96.0\%$ of outcomes).
●​
●​ Thus, $\text{VaR}_{95\%} = \$100,000$.
●​

2. 1-day 95% Expected Shortfall ($\text{ES}_{95\%}$):

The worst $5\%$ tail of outcomes consists of:

●​ $1.0\%$ probability at $\$100,000$ (from $95\%$ to $96\%$)

●​
●​ $3.0\%$ probability at $\$500,000$ (from $96\%$ to $99\%$)
●​
●​ $1.0\%$ probability at $\$2,000,000$ (from $99\%$ to $100\%$)
 ●​

$$\text{ES}_{95\%} = \frac{(0.01 \times \$100,000) + (0.03 \times \$500,000) + (0.01 \times

\$2,000,000)}{0.05}$$
$$\text{ES}_{95\%} = \frac{\$1,000 + \$15,000 + \$20,000}{0.05} = \frac{\$36,000}{0.05} =
\$720,000$$
3. Comparison and Analysis:

While $\text{VaR}_{95\%}$ is $\$100,000$, it completely ignores the severity of losses beyond

the threshold. Expected Shortfall ($\$720,000$) incorporates the $3\%$ chance of a
$\$500,000$ loss and the $1\%$ chance of a $\$2,000,000$ catastrophic loss, making it a
coherent risk measure for non-normal tail risk.