Q1. Discuss the JP Morgan RiskMetrics Model for measuring market risk and explain how it can be applied for FX, equity and bond portfolios.

Q2. John Orange, Vice President of operations of ABC Bank, is estimating the aggregate DEAR of the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX), and common stock (EQ). The individual DEARs are £25,310, £23,155, and £67,328 respectively. If the correlation coefficients ρ_ij between L and FX, L and EQ, and FX and EQ are -0.2, 0.5, and 0.8, respectively, what is the DEAR of the aggregate portfolio?

Chapter 18

1Mr. De Cat is the CEO of an oil company. If he decides to drill, he will drill only one well. He believes the outcomes of the drilling are

Dry Well                                              $0

Small Amount                                   Large Amount

$25 Million                                          $60 Million

It costs $ 10 million to drill a well. Mr. De Cat’s u-curve is

u1x2 = 56.37*x - 324.5

Mr. De Cat asks the company geologist to assess the probabilities of each possibility. The geologist says this assessment depends on whether or not a dome exists. The geologist says there is a 0.7 chance that a dome does exist. He also provides Mr. De Cat with the following information:

5Dry Hole兩Dome, &6 = 0.5 5

Small amount of oil 兩Dome, &6 = 0.3 5

Dry Hole兩No Dome, &6 = 0.7 5

Small amount of oil 兩 no dome, &6 = 0.25

a. What is Mr. De Cat’s certain equivalent for this drilling site?

b. What is the value of information on the presence of the dome?

c. What is the value of information on the amount of oil present?

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $5.7 million. The equipment will be depreciated straight line over 6 years to a value of zero, but in fact it can be sold after 6 years for $671,000. The firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. The firm estimates production costs equal to $1.80 per trap and believes that the traps can be sold for $8 each. Sales forecasts are given in the following table. The project will come to an end in 6 years, when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 11%. Use the MACRS depreciation schedule.

a. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 4 decimal places.)

Recording Entries under the Fair Value Option—Equity Method

Assume that Fireside Inc. purchased 30% of the common stock of Theater Supplies Corporation on January 1, 2020, for $270,000. Fireside Inc. elected to account for its investment using the fair value option. During the year, Fireside Inc. reported net income of $216,000 and declared and paid dividends of $40,500. The fair value of Fireside’s investment in Theater Supplies common stock is $283,500. Assume that Fireside Inc. has significant influence over Theater Supplies Corporation.

a. What amount would Fireside Inc. report on its balance sheet on December 31, 2020, for its investment in Theater Supplies Corporation?

b. What amount would Fireside Inc. report in its income statement for the year ended December 31, 2020, for its investment in Theater Supplies Corporation?

Note: Use a negative sign to indicate a loss.

Option #1: NFP financial reporting

The Four Corners Theater’s mission is to increase access to the arts for the community of Four Corners. The Theater group owns a debt-financed theater and puts on several plays throughout the year, as well as providing facilities for many other activities. Four Corner’s Theater is a well-established, not-for profit organization exempt under IRC Sec. 501(c)(3).

Identify whether the following activities would be subject to unrelated business income tax (UBIT) and explain why or why not.

1. Rental of the facility to the high school drama club.
2. Fees for summer acting classes for primary school students.
3. Sale of tickets to plays put on by the Four Corner’s Theater group.
4. Sale of season ticket membership list to a local book store.
5. Rental of two apartments in the facility.
6. Rental of meeting space to other local 501(c)(3) organizations for their monthly meetings.
7. Internet sales of gift shop items with the Four Corner’s Theater logo.
8. Lease of the facility’s parking lot to the local university on football game days.

You are given the following information on probabilities of events happening, and rates for return for possible projects A and B.

1. Calculate the expected returns of A (E[rA]) and B (E[rB]) .

2. Calculate the absolute risk levels of A and B.

3. Calculate the relative risk levels of A and B. If you have to invest in one asset which asset would you invest in and why?

4. A portfolio is formed with a w_A invested in project A and w_B invested in project B. Calculate the expected return E[rp] and standard deviation σp for the portfolio when w_A=0.5 and w_B=0.5. The correlation between A and B is 0.5.

5. Assume that there is another possible project C. You decide to create a new portfolio with all three projects A, B, and C. The return for the new portfolio with three assets will be the weighted average of the expected returns of the three assets. A variance of a portfolio with three assets is:

σp2=wA2σA2+wB2σB2+wC2σC2+2wAwBσAσBρA,B+2wAwCσAσCρA,C+2wBwCσBσCρB,C

where w denotes the weight, σ denotes the standard deviation, and ρ denotes the correlation between two denoted assets of the subscript.

The expected return of C is 13% and the variance is 16. The correlation between A and C is 0.7, and the correlation between B and C is -0.1. The correlation between A and B is again 0.5. You allocate 50% of your capital into A, 25% into B, and 25% into C.

For the new portfolio with three assets, calculate (1) the expected return and (2) standard deviation. Then briefly discuss the relationship between the risk and the number of holdings in a portfolio based on your findings from this question and from (d) .

You are a consultant with 10 years experience in the health care insurance industry. A group of 20 doctors is considering forming a new medical group. The group has asked you to prepare a report on whether it should build a facility within 30 miles of the downtown center of a city with a population of 500,000 for $100 million dollars. Prepare a report for the management team of the doctor’s group on your proposed $100 million expenditure plan. In your report, reflect on the key course objectives as well as the financial, legal, and alternative health care models.

2 large retail companies (W and T) are compared on a Census variable, percent of people who own their home within 3 square miles of the store. The percent that own their home for W is:

84, 79, 73, 81, 74, 77, 64, 78, 78, 78, 61

Percent for T is:

58, 61, 57, 62, 61, 59, 56, 64, 61, 70

- Try the jackknife bootstrap and find the estimate of difference in percentage owning their home between the two companies as to central tendency. Use lambda=.05

2 large retail companies (W and T) are compared on a Census variable, percent of people who own their home within 3 square miles of the store. The percent that own their home for W is:

84, 79, 73, 81, 74, 77, 64, 78, 78, 78, 61

Percent for T is:

58, 61, 57, 62, 61, 59, 56, 64, 61, 70

- Try the jackknife bootstrap and find the estimate of difference in percentage owning their home between the two companies as to central tendency. Use lambda=.05