BAFI1026: Present your initial portfolio, including information on why you have invested in the stocks in your initial portfolio: Derivatives and Risk Management Report, RMIT

Trading philosophy: (2 marks)

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.

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).

The overall market and macroeconomic condition (3 marks)
Industry consideration and/or diversification, specific stock’s strengths/positive prospects
Risk identification:

In this part, you should discuss the risk profile of your portfolio. Use daily historical stock price between 1 October 2017 and 31 August 2022 to calculate the VaR of your Portfolio (VaR template can be found in Week 11’s material on Canvas). The discussion should include the following points:

Calculation and discussion of the one-day 5%-Value at Risk (95% confidence level) of each stock in your portfolio using historical simulation approach. That means, if you have four stocks in total, you need VaR for each. (8 marks)
Calculation and discussion of the five-day 1%-Value at Risk (99% confidence level) of your portfolio using model- building approach. Show key steps of workings. (3 marks)
Calculation and discussion of the five-day 1%-Value at Risk (99% confidence level) of your portfolio using a historical simulation approach. (3 marks)
Discuss the performance of VaR in (b) and (c), by comparing your calculated VaR results and the portfolios’ actual five-day returns (Thursday, 15 Sep 2022 – Wednesday 22 Sep 2022). (3 marks)
Calculation and discussion of the 5%-Expected Shortfall (CVaR) (95% confidence level) of your portfolio using a historical simulation approach.
Hedging using Options:
On any day between Thursday, 15 Sep 2022 and the assessment due date, how will you use the option contract to hedge one of your three selected stocks in your Portfolio[1]. You need to determine and explain which option you want to use (i.e., specify whether it is a call or put, when the expiration date is, appropriate strike price, whether you should go long or short, number of contracts, etc.). Provide justification for your decision. (7 marks)

Note: If you are not able to backdate historical price for the option, feel free to use the available price whenever you start drafting the answer to this question. For example, if your start to look at this question on 10 Oct 2022, and cannot find the historical option price on 5 Oct 2022, then it is fine to use the option price on 10 Oct 2022.

Discuss when you will exercise your option and its potential payoff. (5 marks)
Hedging using CDS

You would like to include corporate bonds into your existing portfolio. To hedge the potential default risk, you decide to purchase CSD (credit default swap) from Bank A.

Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur half way through each year in a new five-year credit default swap. Suppose that the recovery rate is 35% and the default probabilities each year conditional on no earlier default is 3%. Assume payments are made annually.

What is CSD? Is it risky?
Estimate the credit default swap spread? (List your calculation process in tables).
The professionalism of the report. (e.g., Usage of professional Figures and Tables, with numbering and captions.)

[1] You can choose any stock from the three stocks you selected for the Portfolio.

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