Individual Assignment Risk Management Question 1: (8 points) The pre-tax profit of a company is uncertain and is either EUR -50 (a loss) or EUR 250 (a profit), both with a probability of 0.5. The corporate tax schedule is the following: in case of a loss, there are no tax payments. In case of a profit, the tax rate is 40 percent. Suppose the company can eliminate the risk of the profits (i.e. through hedging for no costs) and can instead realize a certain profit of EUR 100. By how much does risk management reduce the expected tax burden? Explain briefly the results. Do you find real life examples in which tax decisions might increase the firm value? Question 2 (8 points): Core risks A bank’s core business is trading financial derivatives e.g. interest rate swaps and fx forwards with corporate clients. The derivatives are used for hedging purposes. The following risk and return numbers for the trading portfolio are given for the last year. The return of 9 from market risk is driven by 8 from commission income and 1 by income from open position (proprietary trading). Risk Return Market Risk e.g. from basis risk 10 9 Counterparty risk e.g. from derivatives business 10 -6 Total risk in the trading portfolio after diversification 15 3 a. What is the core competence and what is the core risk of the trading department? b. Losses in counterparty risk occurred because of a couple of defaults of corporate clients. The CEO states, that this risk is core, whereas the chief trader states that it is non-core. What is your opinion? What could the bank do to mitigate this risk? Question 3 (26 points): Hedging Lufthansa needs to buy oil for US$ 10 million in three months time. Interest rate for T=0.25 years (3 months) in US $ is 0.27% and the € interest is 0.77%. The current spot FX is SFX,0=1.31. Current oil spot price is SComm,0=100. a) For a full fx hedge, what would be the appropriate forward position? Assume, so far that the commodity risk is fully hedged. b) Determine the fair…