BAFI1029 Derivatives and Risk Management Assessment Question |RMIT

Assessment Task

This is an individual task. In this assessment, students are required to form an equity portfolio, evaluate their risks, and provide a solution to manage those risks. The goal of this individual assignment is to gain a deeper understanding of the portfolio investment process in the US stock market and risk management. Below are the tasks:

• to build one equity investment portfolio and justify the stock selection
• to hold the portfolio from Monday, 3rd March 2025 (beginning of Week 8), to Friday 21st March 2025 (end of Week 10) and observe its changes
• to identify the portfolio risk by reporting the portfolio’s VaR
• to provide suggestions for managing the risk
• to communicate your investment and risk management process using a professional
  report

Portfolio Creation

Please follow the following steps to build one portfolio.

1. Create an account (with your real first & surname) on www.marketwatch.com

2. Create a watchlist of one Portfolio based on the close price as of Monday, 3
rd March 2025

Note: The specified date here is used to start the observing period of your portfolios, not the date on which you must perform the task. For example, you can create portfolios either on Monday, 3rd March 2025, or on dates such as 10th March 2025 or 1st April 2025, but you will still observe the price change
between the sample period Monday, 3rd March 2025 to Friday 21st March 2025.

3. This watchlist of Portfolio consists of four stocks:

a. Choose any three stocks from Table 1 plus NextEra Energy Inc. (NEE)

b. For Nextera Energy stock, the number of Nextera Energy shares must equal
“the last four digits of your student ID”. For example, if your student I.D. is
S3612345, you would hold 2,345 shares of Nextera Energy in your portfolio.

c. Determine the weights and shares for the rest of the stocks you chose in step a.

d. You have USD 1.2 million for this portfolio.

Note: Since the shares can’t be bought in fraction, a tiny variation from the specified budget is acceptable. You can choose to hold some Cash if you believe the investment opportunity is not good enough, but you will need to justify this decision in your report. The total $1.2 million investment you
have is based on the share prices on Monday, 3rd March 2025.

4. Take screenshots of your portfolio and the necessary information in all sections. Make sure you attach them in the Appendix of your submitted report.

5. Suppose this is a Buy-and-Hold strategy; therefore, do not change your portfolio setting during your holding period Monday, 3rd March 2025 to Friday 21st March 2025.

Questions and Marking Guide:

Your report must include the following sections:

1. Trading philosophy: 

Give an overview of your philosophy to form the portfolio. You should identify yourself as a value or growth investor or a mixture of both. Provide brief definitions for value/growth investing.

2. Portfolio construction:

Present your initial portfolio, including information on why you have invested in the stocks in your initial portfolio (three stock selections for Portfolio).

a. The overall market and macroeconomic condition

b. Industry consideration and/or diversification, specific stock’s strengths/positive prospects.

3. Risk identification:

In this part, you should discuss the risk profile of your portfolio. On Monday, 3
3rd March 2025, calculate the VaR of your Portfolio using 2-year daily historical stock price between 28th February 2023 (inclusive) and 28th February 2025. The discussion should include the following points:

a. Calculation and discussion of the one-day 99% Value at Risk of each stock in your portfolio using historical simulation approach. That means, if you have four stocks in total, you need VaR for each. 

b. Calculation and discussion of the 7-day 95% Value at Risk of your portfolio using model-building approach. Show key steps of workings. 

c. Calculation and discussion of the 7-day 95%-Value at Risk of your portfolio using a historical simulation approach. 

d. Discussion of the performance of VaR in (b) and (c), by comparing your calculated VaR results and the portfolios’ actual 7-day returns from 4th March 2025 to 12th March 2025. 

e. Calculation and discussion of the one-day 99%-Expected Shortfall (CVaR) of your portfolio using a historical simulation approach. 

4. Hedging using Options:

Suppose you hold the portfolio until the submission date, on any day between Monday, 3rd March 2025 and the submission date, 11th April 2025, you will use the option contract to hedge any one of your three selected stocks in your Portfolio1. (Please take the screenshot of the option quote and spot price as of the same day and attach them in the Appendix of your submitted report).

a. You need to determine and explain which option you want to use (i.e., specify
whether it is a call or put, the transaction date, when the expiration date is,
appropriate strike price, whether you should go long or short, number of contracts, etc.). Provide justification for your decision.

Note: The budget for option transaction is not limited and not included in the initial $1.2 million budget. You can construct the option trading strategy anytime during the portfolio holding period.

b. Discuss when you will exercise your option and its potential payoff. 

5. Hedging using Swaps:

As an Australian-based investor, you want to borrow 1.2 million U.S. dollars at a fixed interest rate to match your investment cash flows. To achieve this, you enter into a two-year currency swap agreement with Mrs. Phoebe Phan, who wishes to borrow Australian dollars at a floating interest rate. The amounts required by both parties are roughly the same at the current exchange
rate. You and Mrs. Phoebe Phan have been quoted the following interest rates, which have been adjusted for the impact of taxes:

Design a swap that will net a bank (Bank A), acting as an intermediary, 50 basis points per annum. Unlike a swap equally attractive to both parties, this task requires you to design a swap that allocates 60% of the advantage (i.e., gain) to you and 40% of the advantage (i.e., gain) to Mrs. Phoebe Phan. Determine the rates of interest that you and Mrs. Phoebe Phan will end up paying. Explain, list your calculation process, and use a figure to illustrate the swap structure. 

Note:

• To complete tasks 1-4, you are required to use/download relevant historical stock price data. For task 5 (Hedging using swap), please use the information given only. No additional data is needed.
• Besides the working steps/summary of key results of your calculations that should be discussed in the report, you also need to submit a separate Excel file to Canvas to show your detailed calculations.
• This instruction includes suggestions on items to include in the report; more information for parts you think are important may be included as you feel necessary, keeping in mind the word limit.
• The teaching team is not supposed to comment on your calculation workings or identify your calculation mistakes. The teaching team will guide you to make sure that you are on the right track. However, it is still your responsibility to investigate your work and identify the errors.

Submission

• All submissions must be made electronically on Canvas, accompanied by a cover sheet through Canvas => Assignments => “Assessment 3: Individual Risk Management Report”.
• The report should follow a structured format, starting with an executive summary and followed by sub-sections addressing all questions/tasks. Essential components of the report include page numbering, section numbering, main body, executive summary, reference list, introduction and conclusion.
• The report should be no longer than 2500 words (-/+ 15%), excluding the executive summary, references and appendix. The student can have up to a 2-page appendix. Citation and reference must be provided. The Excel file contains your workings to support the reported analysis.
• The submission must be using 1 or 1.5 spacing and 12-point Times New Roman font.
• Students must ensure their reports are free from academic issues like copying, plagiarism, sharing work, collusion, and collaboration with other groups, maintaining a similarity rate below 30%. Academic misconduct can result in course failure, permanent academic records, and graduation delays due to the investigation time by the COBL Integrity office.
• Students are required to keep backups of all submitted work just in case any are lost.

Table 1 List of stocks