EOM Exercise Task 3

[JoAnne]

If Megalon is "invested in a portfolio of publically traded securities" aren't they really hedging in some way already?
I am a bit confused about this.

[LoneGirl]

If Megalon is "invested in a portfolio of publically traded securities" aren't they really hedging in some way already?
I am a bit confused about this.

Not really. Their GMMB liability is based on the performance of their portfolio....so if the market goes bad, their portfolio is going to have poor results and they are going to be liable for more of the GMMB cost. That is what they would need to hedge against.

[JoAnne]

I see, they would have to hedge with "safe" investments in case the market goes bad.
According to the question it implys that GMMB would not have to hedge in a perfect MM world, but MM discusses debt and not hedging. What am i missing?

[LoneGirl]

I see, they would have to hedge with "safe" investments in case the market goes bad.
According to the question it implys that GMMB would not have to hedge in a perfect MM world, but MM discusses debt and not hedging. What am i missing?

Think about how the company would use debt for hedging....(bonds are a form of debt).....

[JoAnne]

I see (I hope) they need to raise capital and the question is what is the best way to do it. MM would say it does not matter.

[Chris100]

Is anyone currently working on Task 3 and would like to discuss?

[Prince William]

I am, although I really have no idea where to go with it. The module did not seem to help at all.

[jakebala]

I am, although I really have no idea where to go with it. The module did not seem to help at all.
Ditto.

I'm done my appendices and task 1 written and everything.

Just need to write the task 3 executive summary and analysis and then a half page conclusion and i'm all set.

Been sitting on this EOM for like 3 weeks now and w/ the new yr work starting i'm pretty screwed.

Anyone have any hits or can recommend any readings from the module?

[brucebond]

bump.

I'm working EOM now and I'm stuck on Task 3.

[saskia]

Ditto.

I'm done my appendices and task 1 written and everything.

Just need to write the task 3 executive summary and analysis and then a half page conclusion and i'm all set.

Been sitting on this EOM for like 3 weeks now and w/ the new yr work starting i'm pretty screwed.

Anyone have any hits or can recommend any readings from the module?

would Investment Guarantees be helpful?

[ckoneak]

If anyone is working on this and would like to discuss it, let me know.

[Muidiri]

No movement. Add me to the list too.

[ugastat06]

I'm lost here, anyone currently working on this or someone who has finished that can help out? TIA

[panda10]

I had an awesome Corporate Finance class in college, and Task 3 is cake. The module didn't provide me with squat.

The question can essentially be broken down into three (probably two) parts.

Part 1:
The MM theory is based on a certain set of violations. There is even an expanded theory that eliminates some of the violations, but that is beyond this module. Why this is important is described below.

If none of the assumptions are violated, nobody cares how a company manages its capital structure (i.e. debt issues, equity issues, firm specific risk management, hedging, etc.). Reality, however, tells us that all of these things are of dire importance. In effect, MM has identified the only issues that actually matter and labelled them as violations.

Take-Away: The EOM wants you to identify each violation, and why it is essential for this company's hedging program. If the company doesn't hedge, how could each violation potentially become an issue? If it does, what then?

Part 2:
The four entities it lists all have different incentives. If the company hedges, what is the affect on those incentives? Because these entities are all people, maybe some behavioral finance might come into play...

Part 3:
The same as part 2; but an institutional, rational mindset is adopted for these three entities. The relationship of these institutions to insurance companies has been beaten to death in the other parts of our education.

[The Better Idiot]

Thanks Panda10... this was taking forever.

[wg2113]

Hi,

I am having problem with the existence of taxes influence hedging decisions. Is it because hedging cost money therefore would act as a tax deductible. Does anyone have a better answer? Call me if you want to work with me on the EOM. My number is : 6463880199

[EA4ME]

The forums are pretty quiet, but I thought I'd give it a shot. I am having trouble with Task 3. I understand about MM and describing the violations, but as others have said in the past, I am having trouble connecting this with the decision to hedge.

At first I was thinking that with the hedging we would potentially be taking on more debt (i.e. buying bonds) but I don't think I'm thinking about it right. As part of the hedging strategy the company would by buying bonds, not issuing bonds so the hedging program wouldn't really be affecting the D/E ratio of the company from what I can see. Is there anybody that would care to shed some light on this? Anyone out there?

[moniccazz]

hi- anyone working on this??

[meshuganasoa]

anyone working through this module this Memorial Day weekend? I am working on it if anyone would like to discuss.

[Philanthrope]

anyone working through this module this Memorial Day weekend? I am working it if anyone would like to discuss.

I am working on this exercise for the week-end (sunday off but I will be on it all monday).

I would like to know what you got for task 1 in the RSLN model. I saw much of the consensus on answers from another thread (here is a post that summarize what others have got)

I got the following results:
LN RSLN
Hedge C$67.75423 $67.75423
Mean $(2.42011) $2.28016
St. Deviation $16.56173 $26.73366
90% CTE $20.46777 $46.34433
80% CTE $29.01960 $64.58074

These results seem to be right based on a lot of posts. I started off by trying to match the exercise on pages 145-146 of Hardy's book and did match the numbers, however this wasn't very helpful for the actual task. I used exercise 3 solution in section 9 (Sheet 1) exactly and was able to match the results. Pay attention to how the numbers are calculated in the last month - it's all in the exercise. Substitute 119 for 23 and 120 for 24. r and sigma need to be monthly (0.005 and 0.051961524 respectively). For the discount factor I used: exp(-0.06*t/12) starting at time 1, there is no Hedging Error at t = 0.
My first 5 simulations HEPVs are below for each model.

LN
1 -14.00316367
2 20.59500345
3 -1.463129339
4 -9.491591029
5 34.13564897

RSLN
1 -2.45440491
2 -20.26727164
3 17.83030534
4 3.981946219
5 -2.443323834

For RSLN, I have a different mean (2.89) and scenario #2 I have HEPV of -18.38 instead of -20.27 (all other 5 scenarios I have exactly the same as cited above -2.45, 17.83, 3.98, -2.44). I really don't see for the moment what could be my error and am wondering if they changed St values for some scenarios to change answers compared to prior candidates who did this last year... That would explain why my scenario 2 is different as well as why I have different mean..

What do you have on your side?

[Philanthrope]

Mmmmm.... Just found out my error... My last Ft at time 24 at deduction for manag.exp.ratio... Removed this and I match results above. It only affected scenario 2 in the list because that is a scenario where GMMB is in the money at t=24

[meshuganasoa]

I am still working through the math. I am pretty sure my F(t) are correct and I made all the right adjustments to the spreadsheet. [To confirm, you removed references to the GMDB and mortality from the spreadsheet since it isn't relevant to this assignment]. But for the first RSLN I am getting a NPV of 3.88, not -2.45. I am pretty sure it is something with my d1 & d2. I did make the updates to the time periods but the 3.88 sounds familiar so I think I need to go back through the threads and figure out where I went wrong. If you have any suggestions, let me know.

[meshuganasoa]

OK, got it! Someone else made the same stupid mistake which helped me but gave the reason in cell references (which were different from mine) so I will describe it in words for those of you having the issue:

Hedging Error = Column labeled "Net Hedge Cost" NOT "Net Cash Flow"
When doing the NPV you wan to start at t=1, i.e. exclude the initial cost of the hedge.

[wangwwzj]

wow, i think i learned much ffrom the discussion.

[moniccazz]

Been bumming around the last few months. Anyone working on this? EOM 3 seems to be a real pain, anyone wants to brainstorm? I have my notes, just wanted to discuss with someone else to see if i'm missing something..

[PadawanOKC]

Is there any reading someone can point to that helped them with this task?

The only thing I found doesn't seem to be cutting it

[2M]

yeah the module readings don't help much

I am still writing this one and have been stuck for a few days

[PadawanOKC]

Someone posted this in that big, older thread.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/MM40yearslater.htm

Because so much of that is old (and involving the first, non-GH task) I skipped all the way to the end and worked backwards. I was able to find a couple things about this task to help out. I set myself a deadline of getting this done today, so that is what I will do.

[surdahl]

Someone posted this in that big, older thread.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/MM40yearslater.htm

Because so much of that is old (and involving the first, non-GH task) I skipped all the way to the end and worked backwards. I was able to find a couple things about this task to help out. I set myself a deadline of getting this done today, so that is what I will do.

Thanks PadawanOKC! This link looks pretty helpful at first glance! I finished the technical stuff last night (getting the PVHEs to match consensus, and proving E(Y) and Var(Y) were equal for LN vs RSLN), now on to the writing! Good luck getting yours in today!!