Homework answers / question archive / GRA 65131 Financial Risk Management Exam component weight: 15% of GRA 65131 Term: Spring 2022 To be answered: In groups of 1-5 Answer paper size: 10 pages, excl

GRA 65131 Financial Risk Management Exam component weight: 15% of GRA 65131 Term: Spring 2022 To be answered: In groups of 1-5 Answer paper size: 10 pages, excl

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GRA 65131 Financial Risk Management

Exam component weight: 15% of GRA 65131

Term: Spring 2022

To be answered: In groups of 1-5

Answer paper size: 10 pages, excl. attachments and figures/tables. Number and type of attachments allowed: 1 .zip file.

Formal requirements: No additional requirements.

 

Your team has been approached by the risk management division at Exxon Mobil, a Fortune 500 energy company based in Irving, Texas and with operations around the world. They would like you to help analyze their risk management practices. Exxon’s primary line of business is the production, refining and sale of fossil fuels. Their traditional lines of business included exploration, drilling, and production of oil and natural gas. However, recently they have begun to consider diversifying into renewable energy initiatives. They would like your team to help evaluate the risks of investment into four different sources of energy production within the state of Texas. 

They are currently considering the following investment of 100 million USD, which can be divided as follows:

1. Investment into Offshore Oil production, where each million invested yields 50 barrels per day. You can assume the oil is sold at the Louisiana Sweet spot price, the per barrel cost of production is $57.50.
2. Investment into Shale Oil production, where each million invested yields 75 barrels per day. You can assume the oil is sold at the West Texas Intermediate spot price, the per barrel cost of production is $62.50.
3. Investment into Natural Gas production, where each million invested yields 1000 million BTU per day. You can assume the gas is sold at the Henry Hub spot price, the per million BTU cost of production is $3.00. 
4. Investment into Wind Energy production, where each million is equivalent to a capacity of 20 MW per day. You can assume the electricity is sold at all sector electricity price in Texas and has a per MW cost of 0. Note that the actual generation per day will depend on the utilization demands from the market and that per US Federal tax guidelines, each 1 MW of production provides a $1.5 dollar corporate tax credit. 

 

For simplicity, you can assume that production starts as of Jan 2022 and will continue at the above rates for the next 5-years at which each of the proposed investments will end. 

Exxon Mobil would like your team to evaluate their current risk management program and their investments. Specifically, they would like your team to evaluate the following scenarios: 

1. Investing everything in only one of the production technologies.
2. Splitting evenly among the four production technologies.
3. Some optimal mix of the four investments that your team determines. Note you cannot have negative investments.

For each they would want to know the expected value of the investments, as well as the potential tail risks they face. They are particularly interested in using more advanced analysis to analyze their risk exposures. Given the limited time, they propose that you use the following simplifying assumptions:

Assumptions

1. Focus only on these four investments, ignoring correlation with the rest of their asset portfolio.
2. For each investment, you can use XOM’s current cost of equity as the discount rate.
3. You can assume a risk-free rate of 2% (annualized). 
4. In terms of taxes, you only need to consider the benefits, if any, of the investments, e.g. tax credits. You do not need to worry about other expenses or depreciation. You can assume a corporate tax rate of 28%.  Treat operating cash flows as net income, and assume that any benefit of a tax credit applies to the value in the year it was earned.
5. Start all simulations as of Jan 1^st 2022.  
6. Assume there are 30-days per month (so 30/360 calendar).

 

 

 

 

 

 

 

 

 

 

 

 

 

Support Materials:

Attached are:

               •            Series of monthly prices from 01.01.2011-12.31.2021 for Electricity Price in

Texas($/MW), Texas Wind Power utilization, and spot prices for natural gas ($/million

BTU), West Texas intermediate ($/bbl), Louisiana Sweet – offshore ($/bbl), ExxonMobil Stock (XOM) and the S&P 500 index (SPX). All values are in the listed units. All energy price and utilization data is from US Energy Information Administration as of March 2022. Stock and S&P 500 price data is from Yahoo finance as of March 2022.

• A set of factor weights for 3 common latent factors. This analysis was done via a principal component analysis of the returns series for the items listed above. You can use these as given. The factor weights given to you in the data file are the latent factor weights from a Common Factor Analysis. This is similar to an APT type framework from your asset pricing courses. The given weights for each of the series is their weight on the first three common latent factors. This is just a statistical tool to analyze sources of common variation for a given series to reduce the dimensionality. You do NOT have to use this setup in your analyses, it is just given for those that want to.
• Exxon Mobil’s 2021 10-K.

 

The report is due by 1200 CET on March 17^th. Please submit a PDF of the report as well as a .zip attachment of any backup material. You do not need submit the complete set of any provided data or your simulations, snippets of the data and simulations are sufficient. You need to submit enough such that a person with reasonable experience and knowledge could replicate your analyses. If submitting code, please submit it in its original form and not as a separate pdf (e.g., do not submit a PDF of Python code, instead submit the Python code in its native format).

 

A member of the Exxon Mobil team has agreed to provide a set of information sessions for your team to ask questions. These will be arranged separately.

             

Questions

You should examine the following items (not necessarily in this order) and report your findings to the  ExxonMobil’s risk management team. These questions are meant as a guide in writing your report, the final product should not be written in a question/response format. They would like to examine your work so please include any backup material and calculations. Your write-up should be less than 10 pages not including any tables, figures, or backup. 

1. What are the key risk exposures that Exxon Mobil faces? (5 points)

 

2. Why is Exxon Mobil concerned about movements in different types of energy prices? Does this relate to any of their current existing projects or potential regulation? (5 points)

 

3. Estimate a model for future monthly movements in the energy prices as well as the Wind Power utilization. If needed, you can choose to simplify your analysis by assuming that there are three common latent factors that drive the shocks to monthly movements as given by the factor weights provided to you. Note that there is not a single correct model or tool to simulate prices, you will need to justify your choices in your answers. (25 points)
   1. What are the main inputs that go into your model?

 

1. 2. Simulate the monthly return and movement series. Explain why you chose your method and discuss the advantages of the model you chose over other potential models. Can include discussion of parametric assumptions, how much historical data was used to form inputs, and the specifics of the model (copula types, volatility estimation, etc.).

 

1. 3. Discuss the sensitivity of your model to your modeling assumptions and technique. Perform a sensitivity analysis on some of your assumptions and discuss the sensitivity of your simulations.

             

 

 

4. Estimate Exxon Mobil’s monthly cash flows over the next 5-years using your price estimates from above in each of the 6 investment scenarios discussed (the four scenarios with 100% weight in each project, one scenario with equal weights among projects, and one scenario where your team choses the weights). Note you do not need to do this for the sensitivity analyses, just use the final model you chose for the price estimates. Note in your analysis that there might be potential outliers of prices, you can choose to deal with these as you see fit. (20 points)
   1. Use this to estimate Exxon Mobil’s expected monthly cash flows and the minimum and maximum monthly cash flows with 95% certainty over the next 5-years. Report your results.

 

1. 2. Give a discussion of these measures of cash flow risk and why it might matter to Exxon Mobil management. What other measures of risk could they use?

 

5. Discuss the expected value of the six scenarios. In your analysis, you should consider the initial investment relative to the cash flows discounting the cash flows properly. When determining the discount rate you should consider this project to be 100% equity financed using Exxon Mobil’s cost of equity. Again, for simplicity, you can assume the investment is made at the start and production begins immediately. (30 points).

 

1. 1. What is the discount rate you used? How did you calculate it? 

 

1. 2. Which of the scenarios appears to have the highest NPV? Which appears to have the lowest risk?

 

1. 3. Discuss if you could use derivatives as an alternative way to value the scenarios and how you might do this. Why might this be a useful exercise?

 

 

 

6. What general recommendations do you have for Exxon Mobil’s risk management team concerning this investment? This can include discussions of: (15 points)
   1. What other forms of risk might exist and how these risks might affect your estimates (i.e., other product prices, regulatory risk, etc.)?

 

1. 2. What types of things should they consider when implementing and deciding on a risk management strategy if they wanted to hedge some of their market risk with derivatives?

 

1. 3. Your overall recommendation for the investment strategy and why?