Your employer, an Australian-based investment bank, has issued a Structured Financial Product (SFP) to high net worth investors. You have been requested to determine the risk exposure to the bank and to hedge the market financial risks associated with the payoff at maturity on the SFP.

You have the following information on this SFP, as well as other information on key financial variables:

The face value of the SFP is USD25,000

The payoff is due in one year

Payoff at maturity is max{USD25,000, [(SP500_T/SP500₀)x USD25,000]}

SP500_Trepresents thevalue of the S&P 500 Indexat maturity of the investment product and SP500₀thevalue of the S&P 500 Indexat inception of the SFP (i.e., the end of June 2020)

USD/AUD represents the US dollar/Australian dollar exchange rate (price of AUD 1 in USD)

The discount rate for this SFP is the yield on the comparable U.S. government bond plus 200 basis points

You have been provided with time series data (as of the end of June 2020, the date you will assume as 'now/today' for undertaking your calculations) in the form of the yield on U.S. government bonds (% p.a.), the USD/AUD exchange rate, and the value of the S&P 500 Index (see the spreadsheet provided with the AssignmentBANK 3003 Risk Management Case Data.xlsx).

The Task

report in which you address the following:

a)You are informed that there might be resistances within the management to your risk management activities. What could their argument be and what would be your counter arguments?

(10 marks)

b)Your bank is especially concerned about extreme adverse movements associated with the payoff of this SFP. Provide estimates on the potential exposure(s) associated with the payoff at maturity of the SFP.

(40 marks)

(Hint 1: the exposure must relate to any amount in excess of USD25,000 in AUD that the investment bank may be required to pay out at maturity and should consider both likely payoffs and the probabilities of these payoffs.)

(Hint 2: you should consider measures such as value-at-risk (VaR) to assist you in determining the exposure(s). You can ignore the time value of money for this part since we are exclusively talking about the payoffs at maturity. Any proper attempts to further assess the extreme risk will be rewarded.)

c)Your macroeconomic team has estimated that the escalation or ending of the ongoing U.S.-China trade war in 6 months would significantly impact this SFP. The escalation would cause the S&P500 index to decline by 10% and the AUD to appreciate against the USD by 5%. The ending would have the opposite effect on the equity and currency markets. Briefly outline the value of the SFP given these two scenarios. Propose another scenario that would significantly impact the SFP.

(20 marks)

(Hint 3: keep the quantitative part simple. You should justify your proposed scenario without calculations.)

d)Provide a brief, but critical, evaluation of the limitations and model risks of each of the methods that you have used to develop the estimates in part a) and b).

(20 marks)

e)Briefly outline how you would hedge against the market risk exposure(s) associated with the payoff on this structured investment product.

(10 marks)

(Hint 4: you should identify the portfolio of simple contracts that you would use to hedge this exposure.)