Recall the structured financial product (SFP) issued by a UK-based investment bank in the Assignment (Risk Management Case 1), on which you provided advice re financial risk exposures to an Australian-based, high net worth (HNW) client. While impressed with your teams analysis of the risk exposures associated with the SFP, your client has raised their concerns about the potential payoff at maturity, and how they might hedge against adverse shifts in this payoff. You again have the following information on this SFP, as well as information on key financial variables (as of the end of June 2018, the date you will assume for undertaking your calculations):

Face value of GBP 50,000, with term to maturity of three years, priced in GBP at a discount to face value

Discount rate (DISC) (% p.a.) = 3-yr spot + 3-yr spread 120 bp

3-yr spot is the 3-year spot rate on UK Government liabilities, 3-yr spread is the difference between the yield on 3-year UK Treasury Gilts and UK BBB-rated corporate bonds

The 3-yr spread at the end of June 2018 was 1.1 per cent, while the historical default rate on BBB-rated corporate bonds is 0.9 per cent

Payoff at maturity is max{GBP50,000, [FTSET/FTSE0 x GBP50,000]}

FTSET represents the value of the FTSE All Shares Index (GBP basis) at maturity of the investment product and FTSE0 the value of the FTSE All Shares Index (GBP basis) at inception of the investment in the structured product (i.e., the end of June 2018)

The Australian dollar-UK Pound exchange rate (AUD/GBP) as of June 2018 was 1.7869

You have been provided with monthly time series data, covering the period from the end of June 2003 to the end of June 2018, on the spot rates on UK Government liabilities (% p.a.) for 0.5, 1, 1.5, 2, 2.5 and 3 years, the AUD/ GBP exchange rate, and the value of the FTSE All Shares Index (GBP basis) (see the spreadsheet BANK 3003 FRA Assignment Data.xlsx).

Requirements: Prepare a brief (less than 3-page) report, supported by a spreadsheet of your calculations, in which: (a) Your group outlines the estimation of, and provides two alternative estimates on, your HNW clients potential payoffs at maturity of the SFP. (Hint 1: consider both likely payoffs and the probabilities of these payoffs.) (Hint 2: consider constructing the analytic variance-covariance and historical simulation measures of value-at-risk (VaR) to assist you in determining the potential payoffs.)

(b) Briefly outline a hedge strategy to protect your HNW client against the market risk exposure(s) relevant to their potential payoff from investment in this SFP. (Hint 3: you should identify and explain the operation of the portfolio of contracts that your group would use to hedge this exposure.)