Exercices (metrics in risk management)

Exercice 1
ERMM1 Corp wants to know its weighted average cost of capital. Indeed, the CEO wishes to
create a common risk-culture amongst business units and evaluate projects on a same basis.
He gave you some informations :
Actual Risk-free rate : 3%
Risk premium applied for the same class of risk as ERMM1 : 1%
Market portfolio return : 8%
Bêta of the firm : 0,9
Historical interest rate applied on ERM1’s outstanding financial debts : 4,8%
Balance sheet is as follow :
Assets M€ Liabilities M€
Fixed assets 420 Shareholders’equity 450
Working capital 580 Financial debts 550
Total 1 000 Total 1 000
Financial debts are repayable in 2 years and tax rate is 30%. There is actually 10 000 000
outstanding shares listed on the stock-market at a 52 €.
Recurring operating income is 77 M€ for the year.

1) Determine the WACC

2) Determine Economic Value Added

Exercice 2
ERMM Corp is a distributor of consumer goods. It has to decide how many pieces to order
every day. Three choices are available : small order, medium order and large order. The
demand that can be low, moderate, or high depending on many factors. If it buys too little
pieces, it will support opportunity costs and if it buys too many pieces it will support cost for
storage and wastes. After studying revenues and costs, profit per day (in 000 $) for these
situations and for small, medium or large order, company has stated profits as shown in table
below.
Table of profit (decision matrix).
Order/Demand Low Moderate High
Small 47 44 43
Medium 42 50 46
Large 36 45 55

1) Apply all decisions criterias you know and decide

2) If you can assign probability of 30%, 50% and 20% to demand

Exercice 3
The risk manager of ERMM2 gave you an excell spreadsheet that contains 500 values
simulated from an annual aggregate loss distribution. ERMM2’s total equities is 10 M€.

1) Determine mean and standard deviation of this loss distribution

2) Assuming that this loss distribution follow a Normal Law, find the 95% Value-at-
Risk of this loss distribution, based on the sample of 500 values. Is your answer
different if you relax this assumption and take empirical data?

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 3) Given that the company is exposed to other significant risks, the maximum
unexpected loss for any individual risk should be less than 1% of total equities. Find
the shortfall risk.
4) The “Tail VaR” is defined as the average loss on claims which have a loss size
greater than the VaR – i.e., the average of the losses given that the loss is above the
VaR threshold. Find the 95% Tail VaR.

Exercice 4
ERMM4 Corp., a small but promising chemical company actually wants to diversify its
activities. Because of the cyclical nature of its business (painting), returns are highly volatile.
Board of directors has been mandated to found a less volatile but complementary business.
They found in cosmetics market a potential use for ERMM2’s products.
Last shareholders’ annual meeting has adopted the resolution to proceed to an initial public
offering at a 2-years horizon. For well-diversified traded chemical companies, return and
standard deviation of return are expected to be 13% and 16% respectively.
On a 10 years history, the estimated correlation between returns on the two markets is
0,010165.

Market Probability Estimated Return for ERM2 Estimated return for new
conditions actual business business
1 20% -25% 1%
2 60% 20% 15%
3 20% 60% -7%

1) On available data, confirm the correlation between the two businesses.

2) Determine the weight of this new business in the portfolio of ERM2 if the Board
wants to achieve the targeted return and standard deviation? (help : you can use
simulation on excel)

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 Exercices (metrics in operational risk management)

Exercice 1
ERM 1 Corp. faces some technical problems with its furniture products. In order to know
actual risk exposure on a monthly basis, the risk manager collected statistical data on claims
for the past two years.
On collected evidences, he asks you to answer the four questions below.

Frequency Severity
Number of Frequency Size per claim
claims
0 50% 1 000 € 50%
1 30% 5 000 € 50%
2 20%

1) Determine the expected claim frequency

2) Determine the expected monthly aggregate Euros of loss
3) Determine the maximum possible annual Euros of loss
4) Determine the one-month 95% Value-at-risk aggregate Euros of loss

Exercice 2
ERM 2 Corp. is an ice-cream producer. It operates in French South-coast market during the
summer season. Based on empirical evidences, manager has found a relation between
operating margin and weather. Different simulation scenarios leads to the following formula :
Operating margin (€)= 100 000*(t°-23°)-200 000. Due to actual climate change, ERM2
manager is searching for alternative solutions to protect its revenues. A financial institution
offered him two solutions.
The first one is to contract insurance for loss. Insurance contract include a €5 000 € premium,
a €120 000 deductible and a €500 000 policy limit.
For derivatives, the bank suggests PUT options (the right to receive in € x times the difference
between (REFERENCE TEMPERATURE-observed average t°)) at the end of the summer
season. PUT24, is the right to receive €100 000 times (24°C-average observed temperature)
for a €10000 premium.

Probability distribution of temperature

Temperature (°C) 13 14 15 16 17 18 19 20 21 22 23 24 25
probability 0,5% 0,5% 0,5% 0,5% 0,5% 0,5% 2,0% 4,0% 4,0% 5,0% 9,0% 7,0% 7,0%
cumulated 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 5,0% 9,0% 13,0% 18,0% 27,0% 34,0% 41,0%

Temperature
(°C) 26 27 28 29 30 31 32 33 34 35 36 37 38
probability 6,0% 6,0% 6,0% 6,0% 6,0% 6,0% 5,0% 5,0% 4,0% 4,0% 3,0% 1,0% 1,0%
47,0 53,0 59,0 65,0 71,0 77,0 82,0 87,0 91,0 95,0 98,0 99,0 100,0
cumulated % % % % % % % % % % % % %

1) Determine for each solution the outcome profile

2) Given the probability distribution and a risk-adjusted rate of 4% determine the
actuarially fair insurance premium
3) Compare the different solutions

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4) Compute VaR 95% with and without transferring risk.

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 Exercices (metrics in financial risk management)

Exercice 1
ERMF1 is a raw materials retailer. It has been approached by Rhodia, a leading chemical
company to supply a fixed volume of products (12 000 000 €) per year on a 3-years
agreement. Informations on Rhodia’s financial position are as follow. At year end, the market
price was 23,85 € with 101085957 outstanding shares listed in Euronext market.
Compute Altman Z-Score? Is this information enough to help you entering in this LTA?

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Exercice 2

July 1st, 2008, PARTNER FL, group’s main financial subsidiary, invested 500 000 $ in
floating-rate bonds (libor+3%). At the same time, it borrowed $1 000 000 (floating rate :
libor+1%). Libor annual rate is actually 4,5%. The main Bank of the company proposes two
swaps :
- A $500 000 swap receiving floating rate (libor) and paying fixed 5% interest rate

- $500 000 swap paying floating rate (libor) and receiving fixed 5% interest rate

1) Describe the main risk the company actually faces? What can be hedging
objective?
2) Which solution would you recommend to the chief financial officer with respect
to the above objective?
3) What will be the outcomes for the next two semesters if libor rate will decrease to
3,5% in December and will increase to 4% in july 2009.

Exercice 3
ERMF1 buy one call option for 6 € with an exercise price of 40, and sell one call option for 5€
with an exercise price of 50. You buy for 1€ one PUT option with an exercise price of 60, and sell
for 10 € one PUT option with an exercise price of 70. All four options are European options, have
the same underlying asset, and have a common expiration date.

Determine the total net payoff from your option position.