Consider the FTZ Company. Suppose the financial price uncertainty faced by FTZ has increased drastically for the next budget year. In particular, the annualized standard deviation of euro/dollar exchange rate has increased to 14%, the standard deviation of aluminum price to $80 and the standard deviation of interest rate is 2%.

 

(a) Determine the 95% Value at Risk for FTZ by doing 10,000 simulations on its pre-tax earnings. Explain the meaning of the 95% Value-at-Risk. 

(b) Suppose FTZ's management has decided not to hedge any of the identified market risks. FTZ's financial controller figures that next year's cash flow will be very tight and the cash reserve is estimated to be $7 million only. FTZ is applying for a line of credit from Nopay Bank that can cover the potential shortfall of the pre-tax earnings with 95% confidence level. Determine the size of the line of credit.

(c）FTZ has a good project that can start next year.  The cost of investment is $3 million.  The cash reserve is estimated to be $7 million next year.  FTZ's management has engaged you as their consultant on risk management.  The management's risk appetite is that they do not prefer a perfect hedge against all market risks because they still want to keep some upside potential in the pre-tax earnings.  They want to hedge the market risk(s) such that (1) the line of credit will no longer be needed and (2) the cash reserve will be enough to cover the investment in the good project next year.  What risk(s) would you advise to hedge?  Explain