PGPM SEMESTER –III (Class of 2023)

Mid Term Examination-August 2022

FINANCIAL RISK MANAGEMENT (SLFI 608)

Max. Marks: 100 (Weightage 10%) Max. Time: 2 Hrs

Instructions:
 Question paper comprises of three Parts A, B and C. All Questions are compulsory.
 Part A contains 6 short answer questions 5 marks each. Suggested time to complete: 30 minutes.
 Part B contains 4 questions 10 marks each. Suggested time to complete: 60 minutes.
 Part C contains 1-2 case-lets or numerical 30 marks. Suggested time to complete: 30 minutes.

PART-A
(Testing Conceptual Understanding)

1. An investor enters into a short position in a gold futures contract with the following characteristics The
initial margin is $3000 The maintenance margin is $2250 The contract price is $1300 Each contract
controls 100 troy ounces If the price drops to $1295 at the end of the first day and $1290 at the end of
the second day, Calculate the variation margin required at the end of the day. (5 Marks)

2. A corn farmer sells 10 futures contracts of 5000 bushels each at Rs.4.00 per bushel. The spot price is
Rs.3.30 per bushel. At the time of harvesting, which is four months from now, if the price per bushel
reaches Rs.4.15, what is the basis at the time of expiration of the contract? Does the farmer gain or lose
and by how much amount with respect to futures price and spot price four months ago? (5 Marks)

3. Calculate the current market price of a 10-year, Rs. 1000 face value bond paying an annual coupon of
10%? The prevailing market yield (discount rate) for the said bond is 8%. (5 Marks)

4. An interest rate is quoted at 8% p.a. with semiannual compounding. What will be the equivalent rate
continuously compounded? (5 Marks)

5. Consider a 10-month forward contract on a stock when the stock price is $50. We assume that the risk-
free rate of interest (continuously compounded) is 8% per annum for all maturities and also that
dividends of $0.75 per share are expected after 3 months, 6 months, and 9 months. Calculate forward
price. (5 Marks)

6. On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30 per share. The
investor is interested in hedging against movements in the market over the next month and decides to
use the September Mini S&P 500 futures contract. The index is currently 1,500 and one contract is for
delivery of $50 times the index. The beta of the stock is 1.3. What strategy should the investor follow?
Under what circumstances will it be profitable? (5 Marks)

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 PART-B
(Testing analytical ability, situational analysis and application of concepts)

7. A US importing firm has a payable of euro one million on December 11th. Today is September 8th and
the firm wants to hedge against appreciation of the euro. The following are the rates prevailing today:
Spot EUR/USD – 0.8950
December future EUR/USD – 0.8967
a. What is the hedge?
b. If the following are the rates that prevail on December 11th,
i. Spot EUR/USD – 0.8972
December EUR/USD future – 0.8985
ii. Spot EUR/USD – 0.8942
December EURO/USD future – 0.8939
The standard size of the contract is 1,25,000 euro.
What are the gains/losses of the hedge? What is the effective purchase cost of euro? (10 Marks)

8. October Soyabean Oil futures are selling at 19.44 cents per lb. The standard size of the contract is
60000 lbs. Initial margin requirement is $3000 while the maintenance margin is $1500. If a trader goes
long in two October futures contracts and the prices on the subsequent 4 days are 19 19.4 19.6 and 19.8
cents/lb, explain how the margin account changes. Assume that money in excess of the initial margin is
withdrawn immediately. (10 Marks)

9. A Fund Manager is handling a portfolio worth 5 Cr. with an average Beta of 1.20. She wishes to change
the overall Portfolio exposure but is wary of the transaction costs involved in cash trades. Hence, she
has decided to use NIFTY futures to achieve her desired Targeted Beta exposure. NIFTY futures are
currently trading@16,000 with a lot size of 50. Calculate the no. of NIFTY Future lots to be
longed/shorted if she wishes to:
Completely hedge her portfolio
Increase the Portfolio Beta to 1.80
Reduce the Portfolio Beta to 0.60 (10 Marks)

10. Supreme Industries will have a requirement of Rs. 5 crs after 6 months for a duration of 6 months. The
current MIBOR is 9% p.a., and the 6/12 FRA is available at 9.25%. Supreme believes that interest
rates will go up in the economy and hence buys the said FRA. Calculate the effective borrowing cost
for Supreme under the two possible MIBOR (10 Marks)
scenarios:
a) MIBOR increases to 10%
b) MIBOR falls to 8.60%

PART-C
(Case Study/ Practical Problems)

11. Nicholas Leeson joined the Singapore division of Barings Bank PLC in 1992 as a back office and
settlement head. He was eventually promoted as a General Manager and Head of Trading. As head of
settlement, he was reporting to London office and as a floor manager on SIMEX (Singapore
International Monetary Exchange) he was reporting to Director Finance, Singapore Office. The dual
reporting led to disinterest in his superiors in exercising supervisory control over his activities.

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 Nick Leeson was given a mandate to arbitrage on NIKKEI 225 between OSAKA STOCK
EXCHANGE (OSE) and SIMEX. i.e., simultaneously buy in SIMEX and sell on OSE or vice versa,
depending on price differences. He was additionally allowed the following unhedged trades:

1) 200 NIKKEI FUTURES CONTRACTS

2) 100 JAPANESE BOND CONTRACTS
3) 500 EUROYEN CONTRACTS
Leeson however embarked upon doing directional trades and right from beginning started making
losses. He hid the losses in the error account (88888) and manipulated the accounting reports because
he knew what exactly was monitored in the London Head Office.
By end of 1992 he had lost around 2 million pounds. He lost another 21 million in 1993 and a further
185 million in 1994. By end of 1994 the accumulated losses stood at 208 million pounds.
In late 1994, Leeson started selling straddles (calls and puts) believing that Nikkei 225 would remain
range bound. By Jan 1995 he had sold 37,925 calls and 32,967 puts and had a long position of 1000
contracts in Nikkei futures. The strategy would have made money had Nikkei remained range bound.
On 17th January 1995, earthquake struck in Kobe, Japan and the markets reacted badly to this event and
corrected by 1500 points over the next 5 days. Leeson’s short put and long futures were now making
huge losses. He, however, felt that the markets had overreacted and kept on increasing his exposure. By
Feb 95, he was long 61,000 NIKKEI Futures representing 49% of MAR series and 24% of JUN series.
He was additionally short on 26,000 JGB Bond Futures representing 88% of JUN series and
approximately 5% of open interest in Euroyen Futures. All his bets went wrong and resultantly Barings
faced massive margin calls. Till then the senior management were oblivious to what was happening in
Singapore and were led to believe that losses in one exchange would be compensated by gains in the
other exchange because this was arbitrage. However, it was no longer possible to hide such huge losses.
On 24th Feb, Leeson faxed his resignation and fled to Europe. He was detained by authorities in
Frankfurt, Germany and later extradited to Singapore. Leeson pleaded guilty to all the charges and was
sentenced to 6-1/2-year prison term.
Barings lost close to 925 million pounds on the unauthorized bets, and this was enough to wipe out the
entire net worth of the bank. It was later declared bankrupt and was taken over by the ING Group
Netherlands.

Questions

1) How was it possible for a single rogue trader to bring down a 230-year-old institution? Briefly describe
the chain of events that led to such a debacle. (15 Marks)

2) Will this be categorized as a Risk Management failure? How could the management be completely
unaware of its trading operations in Singapore given the fact that the losses were accumulated over a
period of three years. (15 Marks)

End of Question Paper