Developing Knowledge, Communication, And Ethics In Finance Essay.

On Successful Completion of this assessment, students can: Graduate Learning

Develop and demonstrate knowledge of interest rate measurement, fixed income securities, forwards, futures, and options

Justify the mechanics of no arbitrage and apply to real worldsituations

Develop and demonstrate effective communication skills, including the ability to clearly explain graphs, data, statistics and algebra, in a manner appropriate for finance peers and academics.

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Compute the duration of the bond on GSBG23 on 10 July 2018 14:00. Using graphs to demonstrate the effect of coupon and interest rate on duration respectively. Briefly discuss your graph results.

Note:

(1) You can solve all questions without any need of Excel build-in Functions, except “goal seek…” which is necessary to find yield-to-maturity. If you choose to do it manually, i.e., use bruteforce searching, it would be very time-consuming.

(2) In order to finish Part A, you need skills to use Excel. The information contained in appendix A may provide some extra help.

(3) You are encouraged to use Excel build-in functions as long as you can use them correctly. Warning: Some functions in Excel may cause confusion. For example, the description of “PRICE” function is “Returns the price per $100 face value of a security that pays periodic interest.”

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Interest rate measurement and fixed income securities

Figure 1: Indicating the cash flow structure of hedges for MGRM

(Source: Mello and Parsons 1995)

Journal of Applied Corporate finance highlights significant information regarding the speculative measures, which was taken into consideration by the management of MG Refining and Marketing (MGRM). The measure taken by the management of MGRM was not accurate, as they were not hedging for the underlying assets that were being committed by every month. Moreover, the company mainly focused on short term valuation of the oil prices and opted to buy contract with short term duration, while the actual sales were conducted for long term. This mainly increased the mismatch of maturity structure of the company, as derivatives used for hedging purpuras did not match the delivery of the contracts. This increased overall variance of the organisation, while dealing with the hedging instruments and exposed the organisation to the excessive amount of basic risk. The accumulated risk structure of the organisation was shared when the prices were going down and increased the cash flow deficit from the mismatched hedges (Neuberger 2015).

Figure 2: Present Value relationship

(Source: Mello and Parsons 1995)

The second major loophole in the decision of MGRM was the hedging measures used for long term contracts. The organisation did not account on the present value of derivatives, which was negatively affecting their hedge position. This can be considered that biggest mistake, as the hedging period and delivery period of the context did not match and exposed the organisation to high volatility. The organisation also used one to one hedge ratio, which is not advisable for shorty term contract, which was being used by MGRM. This mainly increased the negative hedge value for the rolling contracts of MGRM and exposed the organisation to exponential losses (Abdel-Khalik 2014).

The claims regarding the purpose of hedging futures are correct, as the organisation needs to comply with the choice of asset underling the future contract and the delivery month. The underlying asset mismatch directly affects the level of pricing, which can be conducted for the particular asset. Therefore, in context of hedging it can be detected that underlying asset mismatch arises only when the underlying asset does match the hedging instrument. This mainly creates an imperfect hedge, which increases the level of risk attributes for the organisation conducting the hedge. Dickinson et al. (2017) indicates that investors and organisation mainly use hedging process for reducing the risk attributes of their portfolio exposure. On the other hand, Corbett and Smodis (2018) criticises that without adequate research the hedging measure mainly increases the risk level and raises the chances of loss from fluctuating prices.

Therefore, organisations dealing with jet oil cannot hedge their exposure in the commodity by hedging an underlying asset of heating oil futures, as the price valuation and output of the commodities are different. This measure will not allow the organisation to adequately hedge their products and reduce the actual exposure. As an alternative, the hedging measure will increase the level of risk for the organisation and exponentially increase the chance of losses. In addition, this kind of measure mainly leads to speculation and not hedge the underlying assets that needs to be hedged by the organisation is not being targeted.

No arbitrage mechanics and real-world applications

The maturity mismatch is also considered to one of the problematic conditions for organisation, as it increases the risk attribute of the hedging measure. In addition, the maturity mismatch arises, when the underlying asset maturity does not match the hedging instrument maturity. This difference in contract maturity level mainly raises the basic risk of the underlying asset, which is being used by the organisation for its hedging purpose. Furthermore, the organisation needs to follow the roll over method for continuing the hedge, as the maturity level of the product delivery is not being hedged by the organisation. Magnan, Menini and Parbonetti (2015) mentioned that companies use the maturity mismatch to improve the effectives of the hedge, which can only be possible with adequate research and detection of the fluctuating prices. Bessis (2015) further indicated that when the beta of the stock is 1 and no maturity mismatch is present then risk from the underlying asset is nullified.

Therefore, it can be detected that organisations using the mismatch underlying asset and mismatch maturity will eventually increase the level of basic risk from their hedging instrument. In addition, from the evaluation it can be detected that the measure increases the level of risk from investment and does accurately hedge the exposure of the organisation. However, utilisation of the both the mismatch underlying asset and mismatch maturity can be conducted by the organisation, when the actual commodity instrument cannot be found in the market for hedging. The use of excessive research and correlation data can be used for conducting the hedge and securing the exposure (Goodhart and Perotti 2015).

The case study of MGRM directly sheds light on the criticality of the maturity mismatch, which needs to be taken into consideration by the organisation. In addition, the case study of MGRM also depicts that the hedging instruments maturity needs to be at the same level with the underlying asset delivery maturity. The occurrence of mismatch maturity will eventually raise the level of basic risk for the organisation, which led to the high losses incurred by MGRM at the end of 1993. The implementation of the strategy raised two critical consequences for MGRM, which led to the massive liquidity crisis for the company. This increment in massive liquidity problem did not indicate the use of adequate hedging measure imposed by the organisation.

Figure 3: The income and losses from delivery contract and Hedged contract

(Source: Mello and Parsons 1995)

The above figure relates to the cash inflow and outflow of MGRM, where the mismatch hedges were used by the organisation, which led to the accumulation of high cash outflows. In addition, the use of mismatched hedges increased the level of variance for the forms cash flow and exposed MGRM to excessive amount of basic risk, as the short dated future contracts were not compensated by the long dated delivery obligations. Hence, the use of short term hedge position for long term delivery obligations led to cash flow troubles for the organisation, which can be seen in the above figure. The use of rolling method for mismatched maturity is directly affecting the level of cash flows of MGRM and escalated the losses from the hedging instrument, as the basic risk from investment rose exponentially (Culp and Miller 1995).

The scenario of the cash flow problems is depicted in figure 1, where the continuous decline in short term future prices was directly increasing the negative balance in accumulated net cash flow. The rollover method also played a vital role in accumulating the losses, where the actual deliver of the contract was not being hedged by the organisation, which was being conducted in short term (Converse 2017). The delivery on monthly basis was at 1.28 million bbl, while the monthly hedge position was 154.0 million bbl and declining. This mismatch in maturity date raised the basic level of risk and projected a non-functionally hedge position for MGRM.

Reference:

Abdel-Khalik, A.R., 2014. Prospect Theory predictions in the field: Risk seekers in settings of weak accounting controls. Journal of Accounting Literature, 33(1-2), pp.58-84.

Bessis, J., 2015. Risk management in banking. John Wiley & Sons.

Converse, N., 2017. Uncertainty, capital flows, and maturity mismatch. Journal of International Money and Finance.

Corbett, T.P. and Smodis, S., 2018. Buy-side liquidity risk management best practices. Journal of Risk Management in Financial Institutions, 11(3), pp.207-217.

Culp, Christopher L. and Miller, Merton H., 1995, Metallgesellschaft and the Economics of Synthetic Storage, Journal of Applied Corporate Finance, Vol. 7.4, P62-76

Dickinson, D.L., Chaudhuri, A. and Greenaway-McGrevy, R., 2017. Trading while sleepy? Circadian mismatch and excess volatility in a global experimental asset market.

Goodhart, C.A. and Perotti, E., 2015. Maturity mismatch stretching: banking has taken a wrong turn. CEPR Policy Insight, 81.

Magnan, M., Menini, A. and Parbonetti, A., 2015. Fair value accounting: information or confusion for financial markets?. Review of Accounting Studies, 20(1), pp.559-591.

Mello, A.S. and Parsons, J.E., 1995. Maturity structure of a hedge matters: Lessons from the Metallgesellschaft debacle. Journal of Applied Corporate Finance, 8(1), pp.106-121.

Neuberger, A., 2015. Rollover Risk. Wiley Encyclopedia of Management, pp.1-2.