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Measuring Risk, Pricing Risk, Foreign Exchange Risk and P&L Impact


  1. CfarCo is a US based company with a German subsidiary. The consolidated revenue and expense forecast (in transaction currency) as well as the budget rate is provided in the accompanying excel file. As of the end of the year, the company has a cash balance of USD 20M which it has invested in securities that earn interest income at 1M LIBOR. The company reinvests any excess cash in the same set of securities at the end of every month. In addition, the company has a term debt of USD 25M that accrues interest at 3M LIBOR which is set at the beginning of every calendar quarter. The interest expense is due at the end of each calendar quarter.



  • cash tax rate of 20%
  • Net Income = operating cash flows
    • Profits from the German subsidiary are repatriated to the US at the end of every month at the current prevailing rate
    1. All transactions (revenue, COS, operating expense, interest income, interest expense, taxes etc) are settled in cash at the end of the month in which they are due


    1. What is the cash flow of the company at budget rates? (5 points)
    2. CFO is negotiating a new credit facility with the bank and wants your opinion on the minimum cash balance she should agree to as a financial covenant for the next year. What would you recommend? (15 points)


    • I will need to see your detailed excel model to grade this question
    • I should be able to see the formulae in your excel sheet
    • Please detail any assumptions you make


    1. Lin and Peter are analysts at a Wall Street trading firm who have just finished their training on portfolio risk management where they learn the Value-at-Risk model. To practice their newly acquired skills, Lin and Peter calculated VaR for their portfolio in the accompanying Excel sheet.


    1. What is the 99% 1 day VaR for Lin and Peter’s portfolio? (6 points)
    2. Peter has been watching Google stock soar and is getting tempted to invest in Google. Assuming he can sell any of his existing stock and use the proceeds to buy Google stock, which stock should he sell so that the impact to his 99% 1 day VaR is minimum? (8 points)


    1. Note: if he decides to sell any of his existing stocks, he will have to sell his entire position in that stock.


    1. Risk manager of the firm has asked Lin to adjust her portfolio such that the 99% 1 day VaR of her portfolio is lower by 10%. Lin’s portfolio is worth $600,000, so she is thinking of reducing her position in the stock that has the highest VaR by $60,000 (10% of $600,000). What would you recommend she does? Why? (3 + 3 points)


    • I will need to see your detailed excel model to grade this question
    • I should be able to see the formulae in your excel sheet
    • Please detail any assumptions you make



    1. DatacenterCo has entered into a 5 year contract with US government to rent space in its data center. The contractual rental revenue for DatacenterCo is as below. Risk free rate is 5% and risk adjusted rate is 10%


    Numbers in millions Year 1 Year 2 Year 3 Year 4 Year 5
    Revenue 1,000 1,200 1,500 1,800 2,000

    What is the present value of the revenue stream? (5 points)

    1. Lin is a newly minted analyst at ConfusedCo (gold mining company) and is evaluating an investment opportunity in a software business. The software business has two revenue streams – subscription based and non-subscription based. Lin remembered having learnt the CE cash flow model in business school and in order to impress her boss she split the cash flow of the project into two parts

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    1. Cash flow from the non-subscription based business– she estimated the NPV to be USD 2M using risk adjusted model
    2. Cash flow from the subscription based business – she estimated the NPV to be USD 3M using risk adjusted model


    During her review, Lin’s boss suggested she re-run the analysis as she used ConfusedCo’sWACC as cost of capital whereas given the risk profile of the project, the correct cost of capital should be 200 basis points less than WACC. Risk free rate is 4%.
    Lin goes back and re-runs her analysis. What are the revisedCE cash flows? What is the revised value of the subscription and non-subscription business? (5 + 5 points)

    Numbers in thousands Year 1 Year 2 Year 3 Year 4 Year 5
    Risk adjusted cash flow

    (non-subscription business)

    -4,000 1,200 1,500 1,700 1,845
    Terminal Value         2500


    Numbers in thousands Year 1 Year 2 Year 3 Year 4 Year 5
    CE cash flow

    (subscription business)

    -2,500 550 700 935 1,225
    Terminal Value         3000


    1. LayeredCo follows a layered hedging strategy to hedge its JPY revenue exposure. As a part of this strategy, every month LayeredCo hedges 50% of the exposure for the next month and 25% of the exposure for the following month at the month end exchange rate using FX forwards (assume forward points are zero). As an example, in Dec, LayeredCo hedged 50% of its Jan exposure and 25% of its Feb exposure at the Dec month end rate of 97.7 (refer to the accompanying excel sheet).



    Given the volatility in its revenue forecast, LayeredCo has decided to hedge only upto 75% of its exposure every month.


    1. Assuming LayeredCo does not qualify for hedge accounting, what is the unrealized and realized gain/loss from the forward contracts for months Jan through December (8 points)


    1. LayeredCo’s competitor UnlayeredCo does not believe in layered hedging strategy. They hedge 75% of the quarter’s exposure one month before the beginning of the quarter. As an example, 75% of Jan’s exposure, 75% of Feb’s exposure and 75% of Mar’s exposure is hedged in Dec at Dec month end rate of 97.7. Assuming LayeredCo had also adopted this strategy, what would be its unrealized and realized gain/loss for months Jan through December (8 points)


    1. LayeredCo’s goal of hedging is to mitigate foreign exchange volatility. Which of the above two strategies should it pursue? How can it further improve its hedging strategy? (1 + 3 points)



    1. DomesticCo is a US based company withEuroCo and JapanCo as its key competitors.


      DomesticCo EuroCo JapanCo
    Functional Currency USD EUR JPY
    Revenue 100% USD 30% EUR, 30% JPY, 40% USD 40% JPY, 40% USD, 20% EUR
    Cost of Sales 50% USD, 20% EUR, 30% CNY 50% EUR, 50% USD 30% JPY, 70% CNY
    Gross Margin 50% 50% 50%
    Operating expenses 100% USD 100% EUR 100% JPY
    Operating margin 20% 20% 20%
    Budget Rate EUR/USD: 1.30

    USD/CNY: 6.25

    EUR/USD: 1.40

    USD/JPY: 90

    USD/JPY: 100

    USD/CNY: 6.00

    EUR/USD: 1.35


    1. Assume the average foreign exchange rate during the year was

    EUR/USD: 1.35, USD/JPY: 95, USD/CNY 6.15


    All the three companies met the revenue and expense forecast per the budget in theirtransaction currency. At the end of the year, the companies prepared their financials in their functional currency and compared the actual results to the budget that was prepared at the beginning of the year. Identify whether the company outperformed or underperformed, (versus the budget) on the various P&L related items in the chart below (15 points)


      DomesticCo EuroCo JapanCo
    Cost of Sales      
    Gross Margin      
    Operating Expenses      
    Operating Margin      


    1. Which company(s)could have lowered prices and in which country without adversely impacting its margin target per the budget? (assume no incremental sales from lowering prices) (5 points)


    1. Which company(s) should have raised prices and in which country in order to meet its margin targets per the budget? (assume no loss of sales from raising prices) (5 points)



    • I will need to see your detailed calculations to grade this question
    • Please detail any assumptions you make

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