Cases: FAQ, Goals and Tips for Class Assignments (FINA 7360)


FAQ: Q1 Q2 Q3 Q4
Goals and Tips: Case 1 (LN V) - Case 2 (LN VIII) - Case 3 (LN XVII) - Case 4 (LN X) - Case 5 (LN XII) - Case 6 (LN XIII) - Case 7 (LN XIV) - Case 8 (LN XV)

* CASES: FAQ
1.- What is the purpose of the cases?
Each case applies the most relevant concepts discussed in the corresponding chapters of the LN. In general, the cases emphasize hedging and international diversification issues. Also, the cases allow students to review and apply old material (regression, NPV, Black-Scholes formula).

2.- What quetions should I answer before each Case presentation?
Students will have to read the case and answer the questions in the case under the header Class Assignment.

3.- How much effort should I put?
Case assignments are part of your grade. They are to be taken seriously and an honest effort to solve them is expected. Incomplete solutions, lack of effort in the solution, or solutions done during the presentation will result in no credit toward your "homework" grade. No late homework is accepted.

4.- Can I talk to you if I am lost with the Class Assignment?
Of course, you can. You can call me, send me an e-mail or drop by my office with any questions. I expect, however, students to have a basic knowledge of the pre-requisites for this class. If you don't know remember what is the CAPM or what is a t-statistics, check your old textbooks at home (and read the Review Chapter), before talking to me.

Remember, I expect students to be familiar with all the concepts discussed on the the Review Chapter.

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* CASE GOALS AND TIPS

*CASE 1 (LN V)
Goals
  • Forecast exchange rates with different models, in-sample and out-of-sample
  • Estimation of different exchange rate models (using regression analysis)
  • Evaluation of forecasts

    Tips for Case 1
  • You need to read Chapter V, Section 1.A (first six pages).
  • You need to do a regression to estimate the parameters alpha, beta1, beta2, and beta3.
  • Excel has a regression wizard (Analytical ToolPak), which students have found very helpful and easy to use.
  • Any regression package -Excel, SAS, SPSS, etc.- will estimate the coefficients and also calculate R2 and t-statistics for you.)
  • The regression uses changes (in percentage) in exchange rates, not exchange rates (St). That is, before doing the regression, you need to calculate st.
  • As stated in the case, you should use percentages as a decimal number. For example, you should use .01 instead of 1%.
  • Remember that interest rates are annualized rates. In order to calculate the 3-month interest rate, you need to multiply the annualized rate by 90/360.
  • The regression should be estimated using the sample period 1978:II to 2015:III. You'll leave the rest of the sample (till 2016:III) to do forecasting.
  • Your forecasts are in-sample forecasts. That is, you are calculating equilibrium exchange rates -see Example V.1. (The group presenting the case will also do out-of-sample forecasting.)
  • When you calculate the forward rate, Ft,T=3-month, you need to multiply the annualized 3-month interest rates by 90/360.
  • To calculate the Mean Absolute Error (MAE), you need to divide the sum of errors (absolute value) by the number of forecasts that you have generated.
  • The lower the Mean Absolute Error (MAE) or Mean Square Error (MSE), the better the model.

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    *CASE 2 (LN VIII)
    Goals
  • Measure Transaction Exposure (TE)
  • Manage TE (use futures and options to hedge currency risk)
  • Evaluation of different hedging techniques

    Tips for Case 2
  • Go to the Nasdaq.com site to search for PHLX currency options info. This is the current link http://www.nasdaq.com/asp/currency-options.asp
  • Remember: The lower the volume, the less liquid the market.
  • Your underlying position is short (you need JPY 200,000,000 in a couple of months).
  • The expiration dates of the CME futures and the PHLX options (Sep and Dec) are not close to the payment date. You need to compare decisions: rollover (using 3-mo contracts) or use a longer contract and close it before expiration (using the Dec contract).
  • The value of a forward contract can be calculated using the IRP formula in section 1.B (Chapter VI). See Example VI.4.
  • VAR refers to Value-at-Risk, a concept first discussed in Chapter V.
  • It's Dec 6. You expect the shipment to arrive by April 17. You need to base your VAR and best/worst case scenarios on 4-month (Dec-April) changes. For VAR calculations, see Review Chapter (Appendix, section 2.A) to see how you can transform 1-month changes to 4-month changes.
  • The 6-mo money market hedge is straightforward. Remember that interest rates are annualized!. Check LN VIII (Section 1.B.1).

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    *CASE 3 (LN IX-X)
    Goals
  • Evaluation of Country Risk (through a country report)
  • Application of NPV to an international context
  • Forecast exchange rates with PPP
  • Application of Black-Scholes formula
  • Discussion of hedging issues and country risk

    Tips for Case 3
  • HAC receives a 70/160 proportion of the cash flows generated by the project. Analize the project as a whole, not just from the perspective of HAC.
  • You need to discount cashflows with an appropriate discount rate. To select an appropriate discount rate, think about the risk associated with those cashflows. Is the risk a U.S. risk or is it a Brazilian risk?
  • To answer question 4, think about hedging issues. Think about Example VI.1.
  • You can look for Brazilian data using the Internet. But for historical data, it's better to go to the library. There, you can read the International Financial Statistics, published by the IMF and held in the Reserve section at the UH Anderson Library. It has monthly and quarterly data, going back to 1973.

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    *CASE 4 (LN XVII)
    Goals
  • Construction of an optimal portfolio, constrained and unconstrained
  • Measure performance of different portfolios
  • Evaluation of performance, in-sample and out-of-sample.

    Tips for Case 4
  • Go to my homepage or to Morgan Stanley to get the MSCI data. You need to get the data from 1993 to 2016 to calculate the annualized returns. The data is also on my website.
  • Remember to annualized the 1993-2013 and 2014-2016 returns.
  • The World is your market porfolio. It is used to calculate Betas.
  • The betas, volatilities and risk-free rate (90-day T-Bill) that you need to use are given in the case (see Data section) and/or the provided xls file (check top rows).
  • Volatility is the standard deviation. It's stated as an annualized percentage -i.e., SD=18.2 means that the country has an annualized stock return volatility of .1527 (15.27%).
  • Forget about the Cash and Bond positions. You will construct a portfolio with stocks only (actually, stock indexes only).
  • To calculate the optimal portfolio, follow Example XVII.11. First of all, remember to order the countries by RVOL. Then calculate the Ci for each country. And, finally, determine C*.
  • To calculate the optimal weights you need to use the formulas below Example XVII.11. (Also see Exercise XVII.3).
  • The formulas below Example XVII.11 have a typo the 3 should be a sumation sign (capital sigma). The typo is now corrected in the LN XVII. (For some reason, the Acrobat writer didn't interpret the font of capital sigma correctly.)
  • There is a constraint: you need to invest 50% in the US. Now, you need to recalculate the optimal weights (50%). There are different ways to do it: (1) Go back and recalculate the optimal portfolio without the US, or (2) using the previous optimal allocation, reallocate the 50% proportionally.

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    *CASE 5 (LN XII)
    Goals
  • Construction of an optimal (Mean-variance) portfolio, hedged and unhedged
  • Discussion of mean-variance optimization (optimal frontier)
  • Discussion of diversification in international markets (emphasizing differences between developed and emerging markets)

    Tips for Case 5
  • This case is straightforward. You need to use the same algorithm (or spreadsheet) you used in Case 3.
  • You need to calculate the betas to maximize the RVOL of a portfolio, based on Elton and Gruber's approach. All you need to calculate betas is the correlation coefficients and the standard deviations. (Check Review Chapter).
  • Is it hedging a good idea? Consider the returns in USD and in local currencies. What are the advantages and disadvantages of hedging in this case?

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    *CASE 6 (LN XIII)
    Goals
  • Price a new bond issue (Brady Bond issue)
  • Construction of a bond valuation model
  • Discussion of country risk and hedging

    Tips for Case 6
  • Follow the model discussed in class.
  • You need to provide the probability of default and YTM. Make an informed guess. Briefly justify your informed guess.
  • Bradynet.com used to be free. As of 2002, they charge. You can try the free trial. Otherwise, you need to look for info on the net. Best place is to go to Mexican financial newspapers or government sites.
  • You can get the above information from the original site at Ministerio de Hacienda de Mexico . (Unfortunately, the page is in Spanish. But, you can search for the Yield Curve link. You'll see it.)

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    *CASE 7 (LN XIV)
    Goals
  • Design a swap (currency and interest swap)
  • Decompose a swap into different swaps
  • Application of NPV in an internation context

    Tips for Case 7
  • Any future stream of cash flows can be exchanged by a swap dealer for another stream of cash flow with equal net present value.
  • If the net present values of both cash flows are not exactly equal, a side payment can make the swap work.
  • Remember that the value of the swap at inception is equal to zero. Thus, the net present value of both legs has to be equal.
  • There are many ways to smooth the profits of the company over time. You need to come up with two swap legs that reduce the volatility of the profits.
  • Given that revenue has three identifiable sources, you can decompose the value of this swap into three parts: value of Trend, value of Seasonal and value of ECI Factor. That is, you might be able to establish three diferent swaps.
  • Over time, the cash flows of the firm are growing. Note that the coupon is fixed. Thus, you need to adjust the notional principal.

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    *CASE 8 (LN XV)
    Goals
  • Hedge interest rate risk using eurodollar futures and FRAs
  • Hedge with of floor and caps
  • Determine a swap rate from the eurostrip
  • Evaluation of different interest rate hedging techniques

    Tips for Case 8
  • Standard Gap Risk Management case. See Lecture Notes.
  • You can use a 6x12 FRA or two FRAs (6x9 and 9x12).

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