Outline the potential financial risks and operational risks faced by Hilditch and explain these risks in details.

Suppose you are a risk management professional working for iManageRisk firm which is located in Melbourne. iManageRisk provides consulting services to firms such as airline companies and mining companies on their risk management. Mr. Robert Lee, the treasurer of Hilditch Pte Ltd, approaches you today (assume it is now March 2020) to ask you for advice on the financial risk management of his company.
Hilditch (Australia) Pte Ltd is mining company which specializes in base oils, fuels and other refined oil products. In the decades, Hilditch has grown and evolved to supply many more products and services to markets around the world. Hilditch trades with groups in Korea, Japan, China, Singapore, Indonesia, Thailand, Malaysia, Taiwan, United Kingdom, Europe, South Africa, USA and of course Australia. As a growth company, Hilditch’s reveue is positively related to oil price and it aims to a growing cash flow from expanding oil trading operations and seeking to define up to 20 million gallons of jet fuel.

BAFI1026 Risk Management Group Assignment 2020 S1

 

Full Written Assignment

Weighting: 30%

 

This assignment requires students to provide a risk management consulting report to a client. It is used to assess the CLOs: 2, 4, 5 and 6. A marking rubric (in a separated rubric file) will be used to mark this report. In the report, students need to address the issues faced by the client as mentioned in the case. The report should follow the general format of a consulting report. 25 marks are allocated to the addressing of the questions indicated in the case. In addition, another 5 marks are allocated to the conclusion and other aspects of the report (including the format of the report, writing clarity, grammatical accuracy, relevance of justification, etc).

 

Requirements:

  1. Students may form a group of 3-4 students
  2. Answer all the questions raised in the case. Follow the general format of a consulting report, which could be, but not limited to, the sample posted on Canvas;
  3. Source Material: You need to use some source materials to support your arguments.
  4. Reference Style: Follow AGPS Harvard Style or APA style.
  5. The report should use proper English expression and grammar.
  6. The assignment must be submitted electronically via Submission Point on Canvas by the due date.
  7. Late submission will attract a deduction of 4 marks per day for penalty.
  8. Word Limit: 15 pages excluding references & appendixes.

 

SUBMISSION:

 

  1. Students are required to sign up their groups online via Canvas.
  2. Go to the course site on Canvas. Submit your assignment under the submission point. Only one submission is required per group.
  3. The assignment must be Word-processed, using Times New Roman, 12 Font, double-spaced for the main text, and single spaced for tables, figures & appendixes.
  4. Marks MAY be deducted if all requirements and submission instructions are not completed.

 

Academic integrity:

In order to ensure the academic integrity of your submission and to deter others from copying your work, your submission will be processed through a text-matching software.

Turnitin will provide a similarity report of your submission against a large database of academic and professional documents. If your submission’s similarity report is above 35%, you will receive a mark of zero and you will be referred to the academic disciplinary committee.

Further information can be found here

 

Scenario:

 

Suppose you are a risk management professional working for iManageRisk firm which is located in Melbourne. iManageRisk provides consulting services to firms such as airline companies and mining companies on their risk management. Mr. Robert Lee, the treasurer of Hilditch Pte Ltd, approaches you today (assume it is now March 2020) to ask you for advice on the financial risk management of his company.

 

Hilditch (Australia) Pte Ltd is mining company which specializes in base oils, fuels and other refined oil products. In the decades, Hilditch has grown and evolved to supply many more products and services to markets around the world. Hilditch trades with groups in Korea, Japan, China, Singapore, Indonesia, Thailand, Malaysia, Taiwan, United Kingdom, Europe, South Africa, USA and of course Australia. As a growth company, Hilditch’s reveue is positively related to oil price and it aims to a growing cash flow from expanding oil trading operations and seeking to define up to 20 million gallons of jet fuel.

 

The company’s profit and loss is subject to many risk factors, such as the price change of oil, foreign exchange rate fluctuations and the macroeconomic conditions. As the market price of oil is quite volatile, the company is considering using some strategies to manage its risk exposure. One way to hedge these exposures is to use futures contracts. For instance, the futures contracts traded in the NYMEX.

 

 

 

 

 

In your consulting report, please address the following questions.

 

  • Outline the potential financial risks and operational risks faced by Hilditch and explain these risks in details.

 

  • Explaining the impact of current macroeconomic conditions to Hilditch’s business[1], in your discussion, please include the discussion of at least two news items listed in Appendix 1.

 

  • Please devise a hedging strategy for Hilditch:
    1. What position should it take if Hilditch wants to use crude oil futures to hedge the exposure?
    2. What is the optimal hedge ratio?
    3. What is the optimal number of futures contracts with tailing of the hedge?
  • Robert is concerned with the use of derivatives. He has heard from his long-term friend, Mr MF, who graduated with a Master of Finance degree from RMIT University, on the dangers of misusing of derivatives products such as futures to firms. Mr MF also mentioned that derivatives pose a danger to the whole financial system, and thus they should be banned. Recently a complex derivatives trade has caused over $5 billion losses at J.P. Morgan. Above all, an investment guru, Warren Buffett, once referred derivatives to as “time bombs” and financial “weapons of mass destruction” (details can be found in the Appendix). In your report, please address his concerns. And you also need to address whether the company like Hilditch should use derivatives. Please use some source materials (such as academic journal articles and newspaper articles) to support your arguments in your report. Follow a proper referencing and citation style.

 

 

 

 

 

 

Appendix 1: Current affairs

RBA Rate Cut:

https://www.abc.net.au/news/2020-03-19/reserve-bank-to-cut-interest-rates-amid-more-economic-stimulus/12068366

https://www.abc.net.au/news/2020-03-19/rba-cuts-interest-rates-coronavirus-covid-19/12070494

Coronavirus outbreak & Global economy:

https://hbr.org/2020/03/what-coronavirus-could-mean-for-the-global-economy?ab=hero-main-text

https://www.cnbc.com/2020/03/12/coronavirus-impact-on-global-economy-financial-markets-in-6-charts.html

Oil price war:

https://edition.cnn.com/2020/03/13/business/saudi-arabia-oil-markets/index.html

Aussie dollar threatens 17-year low:

https://www.afr.com/markets/currencies/aussie-dollar-threatens-17-year-low-20200316-p54ag2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Appendix 2:  Warren Buffet on Derivatives

 

Following are edited excerpts from the Berkshire Hathaway annual report for 2002.

 

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

 

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

 

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

 

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

 

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

 

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

 

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.

 

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

 

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

 

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

 

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

 

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts.

 

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

 

[1] Please see the news items in the Appendix.

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