A company holds a portfolio of CCC-rated 1-year bonds with market value of $800,000. In assessing credit risk of the portfolio, the company estimates that average probability of default is 20% and recovery rate in case of default is 22%. Required:

1) What is dollar amount of expected Loss Given Default in one year?

2) If risk free rate is 3.5%, what is required yield to compensate for holding this portfolio?

3) The company has another loan with increased default risk and decides to recognize loan loss provision based on present value of unexpected credit losses. Do you agree? Briefly explain.

Question 4 (16 marks)

A UK company expects to receive Euro 800,000 in three months. The current spot exchange rate is GBP 1 = Euro 1.250, and the three-month forward exchange rate is GBP 1 = Euro 1.239. Annual interest rates for 3-month deposit and borrowing in GBP are 5.0% and 7.5%, respectively. Annual interest rates for 3-month deposit and borrowing in Euro are 1.0% and 3.0%, respectively. Required:

1) Design a money market hedge for the UK company. Determine the synthetic forward exchange rate.

2) If the company use a currency forward to hedge the foreign currency risk, should the company buy or sell the forward on Euro? What are the cash flows from the forward contract if it is deliverable?

Question 5 (20 marks) A company has an equity stock portfolio with current market value of $2,000,000. The portfolio consists of 75% investment in the Stock AAA and 25% investment in the Stock BBB. The company is estimating potential future losses of its portfolio if stock market fluctuates significantly. The company adopts analytical Value-at Risk (VaR) method to assess its exposure to equity market risk. For the Stock AAA, expected monthly returns is 5% and standard deviation of monthly returns is 8%. For the Stock BBB, expected monthly returns is 3% and standard deviation of monthly returns is 6%. The correlation of monthly returns between the Stock AAA and the Stock BBB is 0.60. Required:

1) Determine the absolute monthly VaR at the 95% confidence level.

2) Determine the relative quarterly VaR at the 99% confidence level.

Question 6 (20 marks) A company is considering an investment in the Stock ZZZ currently trading at $42.0. The price of the Stock ZZZ is expected to be highly volatile in the subsequent months. Therefore, the company buys one call option and one put option on the stock. Both options expire in 3 months and have the same exercise price of $37.5. The call option premium is $6.0 and the put option premium is $1.5. Required:

1) What is the term commonly used for this option strategy?

2) For each of the following two independent scenarios, compute the value of the option position at expiration and the profit of the strategy.

a) The stock price at expiration is $43.5. b) The stock price at expiration is $22.5.

3) Compute the breakeven stock prices at expiration.