1. 1 Finance School of Management FINANCE Review of Questions and Problems Part IV: Chapter 10-12

2. 2 Finance School of Management  Three analytical “pillars” to finance: Optimization over Time （ intertemporal trade-offs ） : Part II Asset Valuation （ Principals of Asset Valuation & Valuation of Bond and Stock ） : Part III Risk Management—Part IV & V ： Hedging (Future/Forward), Insuring (Option/Equity Value ), Diversifying (Portfolio Theory/CAPM )

3. 3 Finance School of Management Chapter 10: A Overview of Risk Management  Main Contents: The concepts of uncertainty and risk The process of risk management The concepts and discrimination of hedging, insuring, diversifying Risk transfer and its contributions to economic efficiency  Problems of homework: to understand accurately the meanings of questions and to choose properly the instruments for hedging and insuring

4. 4 Finance School of Management  Solutions: 10.3 – Treasury Bill is a common risk-free (default-free) investment instrument  a. 3-months T-Bill  b. (zero coupon)20-years T-Bill  c. There are many risk-free investment instruments depending upon circumstances. Investment time horizon is critical to choosing the best risk-free investment instrument (matching in-payments with out-payments so that you are left with no risk) A zero coupon bond is riskless or risk-free only in term of certain unit of account and only if held to maturity

5. 5 Finance School of Management 10.6 –Inflation is a key risk factor  a. The inflation-indexed T-Bill offers a fixed real rate of return of 3% over the life of the investment. The real return on the conventional T-Bill’s real return depends upon the expected rate of inflation over the life of the investment. The safer investment is the Inflation Plus T-Bill  b. The answer depends upon the expected rate of inflation over the life of the investment  c. The real return on the index-linked T-Bill is 3%

6. 6 Finance School of Management 10.7 –To answer question b & c given your choice in question a  a. Choose the 30-year fixed rate at 9%  b. The instrument in question a is the hedging, but not insuring  c. Risk management costs = the opportunity cost = at least 4% since I could get a variable rate loan at 5%

7. 7 Finance School of Management Chapter 11: Hedging, Insuring, and Diversifying  Main Contents: Hedging: Forward (Swap Contract), Future, Matching Assets to Liability Insurance: Financial Guarantees, Options Diversifying: Measures of expected payoffs and risk (variance), diversifiable risk (firm-specific risk)/ non-diversifiable risk (market risk)  Problems of homework: understand accurately the meanings of questions and give your answers correctly

8. 8 Finance School of Management  Solutions: 11.1 – Discriminate the proceeds from sale on spot market and cash flows from future contract  a. Give the loss or gain (cash flows) from future contract  b. Give the proceeds from sale of orange on the spot market  c. After the hedging, the total receipts are fixed at 250,000

9. 9 Finance School of Management 11.8 –Swap contract is equivalent to a series of forward contracts  a. Enter into a swap contract with a counterparty whereby you would agree now to receive or pay each year an amount of cash equal to 2,700,000,000 yen times the difference between the 90 yen/dollar forward rate and spot rate at the time  b. $30,000,000 per year or 2.7 billion yen per year  c. Anyone or any company interested in hedging a possible appreciation in the dollar versus the yen. Perhaps a Japanese company with sales in the US

10. 10 Finance School of Management 11.13 –Option is an insuring instrument  a. a call option gives someone rights to buy something at a promised price (exercise price) in the future. Note that the option is the right, but not the obligation to buy or sell, which should be distinguished from forward /future contract  b. the right is valuable, so you must pay some fee for the option contract, and the option fee is less than the change of spot price, that is to say, no one would be willing to pay a fee that exceeds the difference between today’s price and next year’s expected price

11. 11 Finance School of Management Chapter 12: Choosing an Investment Portfolio Objective: trade-off between expected return and risk, that is to say, to offer investors the highest expected rate of return for the degree of risk they are willing to bear Process:  Find the optimal combination of risky assets  Mix the optimal risky asset portfolio with the riskless asset Models and implications of Portfolio Theory:  William F. Sharpe, Gordon J. Alexander, Jeffery V. Bailey. Investments. 6th Edition, Prentice Hall, 1995; 清华大学出版社, 影印版, 2001. （ Chapter 6 & 7 ）

12. 12 Finance School of Management Riskless Assets Risky Assets A asset is riskless or risk-free only in term of certain unit of account and only if held to maturity Combining: risk-reward trade-off line (Relationship between the standard deviation and the expected return) Combining: parabola trade-off line (minimum-variance portfolio) Combining the riskless and risky asset (the tangency portfolio)

13. 13 Finance School of Management  Solutions: 12.3 –The implications and derivation of Risk- Reward Trade-Off Line  a. the independent variable is Standard Deviation and dependent variable is Expected Return  b. Intercept: the return of riskless asset Slope: extra expected return to investors for each unit of extra risk that she bears  c. 0.15 = w*return of riskless asset + (1-w)* expected return of risky asset w=?

14. 14 Finance School of Management 12.6 & 12.7 – To derive the tangent portfolio and calculate its expected return and standard derivation  Step 1 : derive the weights of risky assets in the tangent portfolio by formulas on page 332.  Step 2 : calculate expected return and standard derivation of tangent portfolio by formulas on page 329.  Step 3 : calculate expected return and standard derivation of any portfolio by formulas on page 329.

15. 15 Finance School of Management 12.8 – Implications of portfolio selection  Locations on Risk-Reward Trade-Off Line and the investment strategies  The investment strategies and the type or preference of investor  This strategy calls for borrowing additional funds and investing them in the optimal portfolio of AT&T and Microsoft stock. A risk-tolerant, aggressive investor would embark on this strategy. this person would be assuming the risk of the stock portfolio with no risk-free component; the money at risk is not only from this person’s own wealth but also represents a sum that is owed to some creditor (such as a margin account extended by the investor’s broker).