MN-3503: Financial Innovation and Risk Management
Mock Exam
Question 1 (Total Marks 40)
Consider a publicly listed pharmaceutical company in the UK with 400 million shares outstanding and it has sales abroad. The company develops and commercialises new drugs. Assume the cost of equity is 8%. The company believes that there is an equal probability that total earnings next year will be either £1,100 million or £550 million. The firm has an existing debt with a face value of £600 million with 8% annual interest rate. Assume the bankruptcy costs are £100 million. The firm has identified 4 potential projects as follows:
|
Project
|
Fund required
|
Present Value (PV)
|
NPV
|
|
Project A: drug for Coronavirus Infection
|
£200 million
|
£550 million
|
£350 million
|
|
Project B: drug for Alzheimer (Dementia)
|
£500 million
|
£2,000 million (50%)
£400 million (50%)
|
£1,500 million (50%)
-£100 million (50%)
|
|
Project C: drug for
Liver Fluke Infestation
|
£200 million
|
£500 million
|
£300 million
|
|
Project D: drug for Sun Allergy
|
£100 million
|
£300 million
|
£200 million
|
Besides, the costs of issuing new debts or equity given the company’s existing leverage ratio are shown in below table.
|
New capital
|
Cost of debt
|
Cost of equity
|
|
£100 million
|
8%
|
10%
|
|
£200 million
|
9%
|
11%
|
|
£300 million
|
10%
|
12%
|
|
£500 million
|
12%
|
15%
|
(a) Based on above information, identify potential costs (problems) might rise due to risky earnings. Discuss how hedging can mitigate the costs (problems) identified if the earnings are 825 million after hedging. Use calculations to support your discussion. [20 marks]
(b) Discuss alternative strategies for resolving the problems identified in (a). [5 marks]
(c) Suppose the firm needs to redeem the existing debt (£600 million) and the firm decides to borrow £500 million new debts to fund projects.
(i) Explain the asset substitution problem. Use calculations to support your explanation. [10 marks]
(ii) Discuss the value of hedging on mitigating the asset substitution problem. Use calculations to support your discussion, assuming hedging could replace the lottery of £1,500 million and -£100 million NPV of project B with £700 million. [5 marks]
Question 2 (Total Marks 30)
Consider a financial institution with available capital of £30 million. Assume the gain from an investment portfolio of this financial institution during 3-month period is normally distributed with a mean of £6 million and a standard deviation of £12 million.
(a) Calculate and explain value at risk with a time horizon of 3 months at confidence level of 99% (α = 2.33). the 1% tail of the loss distribution has the following values: 0.6% probability corresponds to a £40 million loss and 0.4% probability corresponds to a £20 million loss. Calculate and explain expected tail loss. [10 marks]
(b) Suppose this bank uses 99% 3 month value at risk (calculated in part (a)) to set its economic capital. Calculate the annual Risk-Adjusted Return on Capital (RAROC) of the investment portfolio, considering the expected tail loss. [5 marks]
(a) Explain “Cat Bond” and discuss its advantages and disadvantages from issuer and bond holder’s perspective respectively. [15 marks]
Question 3 (Total Marks 30)
Mr. Adam Lee invests in two shares with the following details:
Share 1: r1=25%; σ1=15%; Share 2: r2=20%; σ2=25%
If the correlation coefficient between the two securities is -0.2
calculate the expected rate of return and standard deviation for the following portfolios:
100% share 1
80% share 1 and 20% share 2
50% share 1 and 50% share 2
20% share 1 and 80% share 2
100% share 2. [12 marks]
Draw the frontier of the portfolio and identify the efficient frontier. Explain why risk-averse investors invest into portfolios on the efficient frontier. [6 marks]
What is meant by minimum variance portfolio? Calculate the risk and return for the minimum variance portfolio comprising of share 1 and 2. [7 marks]
Explain the concept of naïve diversification and efficient diversification. [5 marks]