Risk Management

Risk Management

Mid-term Assignment

Dear Student,

On the following three pages, you will find a total of 5 questions to be solved for the

mid-term assignment. The questions cover the material of the first 7 lectures.

The solutions to these questions have to be delivered in hard copy by Friday, 27

November, 4 pm to the letter box on the 9th floor of building K (the Finance

Department’s floor). Only copies that are delivered in time will be considered!

The final score of this course, to the extent that your score on the final exam is at least

5/10, is calculated as

where F is the score on the Final exam, A the score on this assignment, and C the

score the case study. Both the case study and this assignment are hence not

compulsory.

You can work in groups of maximum four persons on this assignment. All persons

within the group receive the same mark. There is no penalty (premium) whatsoever for

the number of students within a group.

Good luck,

Lieven Baele

1. You are the finance director of CR7, a US based manufacturer of luxury products.

The CEO has just signed a large contract with ‘Hotel de Paris’ from Monaco for a

large delivery of accessories, worth € 1 million. Both delivery and payment are due

in 6 months from now. At the current exchange rate of about 1.25 $ per €, this

contract is worth about $ 1.25 million.

a. Represent graphically the cash flow (in $) of CR7 in six months on a figure

as a function of the $/€ exchange rate, supposing that CR7 remains long in

€, i.e. if it does not hedge.

b. The current US interest rate is 3% annually; the euro area interest rate is 1%

annually. Calculate the arbitrage-free 6-month forward price for the $/€

exchange rate. Show how this currency forward contract can be replicated

by buying / lending $ and/or €’s.

c. Describe the position in this forward contract if management of CR7 would

decide to fully eliminate exchange rate risk (long/short, hedge ratio).

Represent graphically the...