A. Initial evaluation

Comment on the structure of the attached portfolio, and on the financial risks facing Copper Based plc (CB), making use of what you know about how a portfolio "should" be structured, and about the ways in which many portfolios are actually structured.

B. Scenarios

Suggest ways in which to rebalance the portfolio in two scenarios;

1.       The world situation is just as reported in the papers on the day you do this scenario. (With the rather synthetic exception that prices and rates are as described in the attached document i.e. you are not expected to look up the current interest rates etc, the idea is to explain how you would reposition the portfolio to benefit from events that you expect over the next 3 months.) On your report you should note the day that you chose.

2.       The worldwide demand for most commodities is expected to rise sharply over the next 3 months as the European and US economies continue their recovery. Despite this there are concerns that the construction industry could move sharply into recession as residential house-building suffers from a continued lack of demand. It is also expected that the value of the dollar could fall significantly with a change in the exchange rate policy of the Chinese government.

C: Derivatives

The Board has asked you to recommend up to 5 derivative products that you would like to be able to hold. Provide a short report in 2 parts:

1.       Explain the benefits to CB of allowing the fund managers to hold these products in principle.

2.       Explain how these products would enable the company to deal better with the scenarios outlined in task B. You are not asked to provide quantitative recommendations here: a general discussion of the potential costs and benefits is all that is required.

Notes for Guidance: Tasks A and B.

You should keep in mind the fact that there are no „right answers? (although there are some wrong ones): you will be assessed on the recommendations you put forward, and, more importantly, on the coherence of the arguments you use to support them. The overall magnitude of any trades your recommend is less important than that they should be in the right general direction. The only exception to this is that any hedged trades should be calculated to a reasonable degree of accuracy.

The assignment aims to replicate the complexity and ambiguity that you would face in a real-world situation. For example, you will probably be unsure about exactly how large your trades should be, and you will also miss out things you later regard as important. But that's what fund management is like in practice.

You may find it useful to structure each scenario analysis along the lines of:

a.       Key observations on the scenario,

b.       Their likely impact on the current portfolio,

c.       Consequent opportunities for enhanced performance,

d.       Recommended action and supporting argument,

e.      The additional return you are expecting, and a grading of associated risk on a scale of;

1.       (fairly safe),

2.       (risky) and

3.       (very risky).

The last of these is particularly difficult since there is no way for you to quantify the expected return or risk. Nevertheless, this is the sort of thing you have to do when running a portfolio, particularly in retrospect if the trades go wrong i.e. you would face questions like, "what were you expecting to achieve, and did you regard this as a risky trade at the time?" It is quite possible that your job could depend on the answers you give to questions like this.

Keep in mind that in practice your manager would allocate about 5 minutes to reading your report so if you want to get agreement on any of your recommendations they will have to be clear, well argued, and to the point.

Notes for Guidance: Task C.

The company's portfolio does not include any derivatives such as options, futures, and so on. This part is simply about preparing a report that is aimed at persuading the company's Director's that its risk management, and its profits, could be improved by widening the portfolio.

You should draw on what you have learned in the course, and on any other sources that you think will help to make the case. You should also explore the possibility that real-world companies have faced the same issue, and may or may not have not have made the right decision. I.e. you may be able to learn from their experience.

XYZ plc

Background information: The company, its initial portfolio, its parameters, and position limits.

Your company, XYZ plc, is based in the UK. Its activities can be represented very simply: it purchases copper and sells it as pipes. You are not expected to know or to discuss any of the industrial aspects of this activity. The key points are that it buys one product, transforms it, and sells it as another. All other factor costs (such as labour) are assumed to be constant over time and the same in all scenarios.

Each year CB's expenditure on copper is approximately £800m, which it buys exclusively on the US market (in $US) for reasons that need not concern us here. Copper piping sales are of the order of £1.2bn. All sales are in the UK market and denominated in sterling. CB's current convention is to purchase copper in the spot market in 4 tranches per year; these are typically run down over 3 months. CB stores the copper in the UK and has capacity for only 3 months' supply. Surpluses and shortages accrue in CB's copper stocks from time to time towards the end of each 3-month period. Shortages typically lead to emergency spot purchases, or to demand for piping to go unmet. The market for copper piping is competitive, and supply shortages that are unique to CB do not lead to an increase in the product price.

One purchase has just been made, so the next purchase will be required in 3 months' time. You are not allowed to recommend any change in either the timing of deliveries of copper, sales of piping or the time profile of production. Storage costs are also beyond your control. (I.e. you should focus on CB?s financial position and leave purchasing, production and sales decisions to others.)

CB's shareholders require the managers of the company's financial portfolio to meet 2 objectives: the management of the risks faced by the company as a whole, and to enhance CB's profitability, i.e. the portfolio is expected to run at a significant profit (to be generated by active trading).

In order to keep things simple, we assume that CB?s standard practice is to purchase spot-copper at the start of each 3-month period, and to sell the piping at the end of it. This usually leads to a cash-flow surplus of about £100m, which is used to meet labour and other expenses. Any net surplus or deficit impacts on CB?s sterling cash account at the end of the period.

The "initial portfolio" is set out below. Your job is to rebalance the portfolio for a single 3-month period. There are limits on what you can do in terms of deviating from this initial portfolio i.e. you can take positions in assets without explicit permission from your managers provided that they remain within these limits. You are of course responsible for the consequences of these decisions and will be expected to justify them ex post. If you wish to go beyond these limits you will have to make a particularly strong supporting case to your management. At present the portfolio holds no derivatives of any kind (other than bonds).

You have a sterling/US-dollar portfolio with a combined value of $200m, where the sterling element has been converted to dollars for valuation purposes at the current exchange rate (assume this to be £1 = $1.5). The proportions allocated to various asset classes are as follows:

Investments in equities can be in the market indices only. 'Cash? is held in zero-notice bank accounts and earns 0%. In practice of course CB's would be able to earn more than this but this is a convenient assumption here and reflects the fact that holding cash involves a potentially large opportunity cost.

Some useful parameters are that the average duration of your 10-year bonds is 7.5 years, and that of 2-year bonds is 22 months. The current price of all bonds is 100 in local currency, and all bonds pay a coupon of 4 units of local currency p.a. The expected return on equities is 10% p.a. in both countries. You can find data to guide you as to expected returns and volatilities in the lecture hand-out from the first session of the course.

Your operating limits for each of the currencies are plus or minus 12 months duration on the bond portfolios. Each of the proportions of cash cannot fall below 5% and cannot exceed 80%. Your total dollar position must not exceed 70% of the total portfolio.

All of your trades can be undertaken at the prices and rates set out above i.e. we make the unrealistic assumption that the market is giving you time to think. You do not, however, have time to construct an efficient frontier etc -- this exercise is about active management.

Remember that the objective of senior management is to maximise profit while minimising risk. You may find it convenient to think of the above portfolio as both the initial trading portfolio, and as your performance benchmark portfolio. Finally, you may wish to have a copy of the FT to hand while completing this assignment.