1

2006 Financial Engineering Competition

Xinhua Development Company
1


Glancing at his Blackberry, Brad sees he has another email Irom Cynthia Yang.

Brad Kaiser is a senior VP in the interest rate structuring group at Wright Derivatives. Ms
Yang is the deputy treasurer oI Xinhua Development Company in Shanghai.

The Xinhua Development Company is a large quasi-public developer which takes on
large utility inIrastructure development projects inside China. Since the late 1990s it has
Iunded these projects by borrowing extensively Irom Japanese banks and insurance
companies. This debt is Yen-denominated with a Iloating annual coupon. Details about
this debt are in Exhibit 1. The completed water works, power plants, and industrial parks
which are Xinhua`s primary assets are critical in sustaining the booming Chinese
economy. As a result, the Iees collected Irom its industrial customers are now producing
a steady revenue stream.

This business success has created a risk management problem Ior Ms Yang. The source
oI her problem is twoIold. First, Xinhua`s Iuture receivables are in Yuan but its Iuture
interest expenses are in Yen. This exposes Xinhua to Ioreign exchange Iluctuations in its
net earnings. Ms Yang could live with this risk when Yen interest rates were at their
historic lows, but Japanese rates are rising now that Japan shows signs oI rebounding
Irom its decade-long deIlation.

The most direct way to eliminate the Yen/Yuan risk would be Ior Xinhau simply to
reIinance by borrowing in Yuan and then either buying back its own Yen debt or, Iailing
that, buying other Iloating rate Yen-denominated bonds as a hedge. This leads to the
second element in Ms Yang`s problem: Borrowing in Yuan in the tightly regulated
internal Chinese banking system is diIIicult. In addition, there is no Yuan-linked swap
market in which she can borrow synthetically.

The solution Ms Yang is currently considering is to enter into a cross-currency interest
rate swap in which Xinhua would receive a Iloating rate in Yen and pay a Iloating rate in
US dollars. The swap would reduce her FX risk because the Yuan is oIIicially pegged to
the US dollar. Currently, the peg is around 8.02 Yuan/USD. Assuming that the peg holds
in the Iuture, Yuan receivables (Irom its ongoing business operations) are almost as good
as USD receivables in terms oI the FX risk oI servicing USD debt.


1
2006 Duane J. Seppi. The companies, persons, and events in this case are Iictional and are intended
solely as a basis Ior discussion in the 2006 Financial Engineering Competition organized by the Tepper
School oI Business at Carnegie Mellon University and sponsored by Lehman Brothers and Appaloosa
Management. This case does not necessarily reIlect the views oI any oI the sponsors. Fei Zhou contributed
many indispensable insights into the cross-currency interest rate derivatives market. Chris Telmer, Mark
Broadie, Burton HolliIield, and Richard Stanton also provided important advice on the case. In addition, I
am very grateIul to SteIano Risa both Ior Iacilitating the writing oI this case and Ior his role in organizing
the competition.
2
The problem with a plain vanilla swap is that the new USD coupons are likely to be a lot
higher than the historical average coupon Xinhua paid on its existing Yen-denominated
debt. OI course, Ms Yang understands that the rising Yen rates will also raise her Yen
coupons in the Iuture, but she is worried that the risk management merits oI switching to
dollars will still be lost on Xinhua`s senior management given the large initial step-up in
the coupon rate. Somehow the swap needs to be structured in a way that will lower the
base USD rate Xinhua will pay.

Prior to contacting Brad, Ms Yang received a proposal Irom Rob Dudley at Wrong & Co.
Mr. Dudley suggested a swap in which Xinhua would receive, in Yen, a Iloating rate
equal to the 1-year Libor Yen rate 125 basis points on a constant JPY 50 billion
notional Irom Wrong & Co. In exchange, Xinhua would pay Wrong & Co., in dollars,
the 1-year Libor dollar rate a contractual base spread on a comparable USD notional
2

minus the payoIIs Irom a series oI straddles with annual caplets and Iloorlets on 1-year
Libor dollar Ior the next seven years. The straddles would all be struck at-the-money-
Iorward. The idea is simple: The more straddles Xinhua writes to Wrong & Co., the
lower the USD base spread in the swap.

Ms Yang is dissatisIied with the Wrong & Co. structure because the interest rate implied
volatilities priced into the embedded straddles were not much greater than the empirical
volatility. This suggests that Xinhua is basically just writing Iairly priced options in the
Wrong proposal. 'Where is the gain in that?, she asks Brad. When she expressed this
objection to Mr Dudley, all she got was a lecture about market eIIiciency. 'Which totally
missed my point, she tells Brad. In her opinion, the point is not the correctness oI
arbitrage-Iree option pricing, but rather the need to identiIy options Ior which Xinhua will
earn a risk premium Ior going short volatility. 'Xinhua is willing to bear risk in Iact,
we are well-positioned to bear risk but we want to bear priced risk rather than unpriced
risk when we write options. In Irustration, Ms Yang contacted Brad at Wright
Derivatives.

Ms Yang has speciIically asked Brad to structure a cross-currency interest rate swap
based on three guiding ideas:

Xinhua will again receive, in Yen, the Iloating 1-year Libor Yen rate 125 bp on
a JPY 50 billion notional and will pay, in US dollars, the Iloating 1-year Libor
dollar rate a base spread on a comparable USD notional minus the payoIIs Irom
some new set oI embedded options to reduce its USD base spread. All payments
will be annual and will commence in year 2 and terminate in year 7.
The embedded options will be structured with a better risk/reward trade-oII Ior
Xinhua than the Libor USD straddles in the Wrong & Co. structure. In particular,
Ms Yang wants to write options with high prices because they include a high

2
There is indeterminacy since both the notional and the base spread need to be chosen on the USD side oI
the swap. For simplicity, consider using as the 'comparable USD notional the amount that would equate
values in a plain vanilla swap between Yen and USD Iloating payments with no spreads or options. OI
course you can use something else as the USD notional iI that makes more sense in your speciIic structure.
3
implicit risk premium rather than simply because they have a high Iair probability
oI expiring in the money.
II possible, the swap should be structured so that Xinhua`s maximum possible
coupon on the USD leg is capped in some absolute or relative way. 'My internal
political insurance policy, is how Ms Yang described this Ieature. 'II US rates go
against me, I don`t want my interest expense to explode.

Brad`s initial thoughts about the deal: Option pricing theory summarizes the
combined impact oI objective event probabilities and market risk premia on derivative
pricing in terms oI so-called risk neutral probabilities. Thus, Brad is basically looking Ior
events where the implied RN probabilities diIIer Irom the objective probabilities. By
writing options on events where the diIIerential between the RN and objective
probabilities goes the right way, he can help Ms Yang earn a risk premium which can
then be used to reduce the base spread on the dollar leg oI the swap.

Brad`s option pricing model will let him simulate the risk neutral probability distributions
Ior various events. To gain insights into the objective probabilities, Bran consults with
the in-house economists at Wright Derivatives about their Iundamental Iorecasts. From
these conversations, Brad determines that the 'smart money does not have strong views
about discrepancies between RN and objective probabilities Ior Iuture USD term
structure dynamics. However, big things may be aIoot Ior the Yen term structure along
two dimensions. First, the aIorementioned recent signs oI a reinvigorated post-deIlation
Japanese economy have widened the yield spread between 3-year and 1-year Libor Yen
rates. However, WD`s macroeconomic models oI the Japanese economy require an
unusually large risk premium to reproduce an interest rate term structure even halI as
steep as the current curve. SpeciIically, yield spreads larger than 20 basis points Ior the
3-year and 1-year Libor Yen zero rates seem excessive to the WD macroeconomists.
Second, there is always the tried-and-true strategy oI trading on possible diIIerences
between implied volatilities and statistical volatility estimates. (More details about the
volatility estimates are at the very end oI the case.) Given all this, Brad decides to Iocus
his search Ior risk premia, oI both varieties, on the yield spread between the 3-year and 1-
year Libor Yen zero rates.

The heavy lifting: A good option pricing model is essential when trading exotic cross-
currency interest rate options. For this deal Brad will need a model oI the risk neutral
zero-coupon term structure dynamics Ior Libor Yen, a model Ior the risk neutral zero-
coupon term structure dynamics Ior Libor dollar, and a model Ior the risk neutral
USD/JPY exchange rate dynamics. Since his anticipated swap structure speciIically
involves options on the Iuture '3-year minus 1-year Yen zero yield spreads, he decides
to use a two-Iactor interest rate model Ior Japan. Given that, he will use a two-Iactor
model Ior the US as well. Ultimately the deal will be priced and presented in USD terms.

Modeling the USD term structure: Let )
tT
USD
denote instantaneous Iorward rate that
can be locked in at date W Ior a Iuture date 7 and let

(1) G)
tT
USD
P(W, 7) GW V
1
(W, 7) G]
1t
USD
V
2
(W, 7) G]
2t
USD
4

denote the risk neutral dynamics Ior the change over the next GW in the Iorward rate Ior
period 7 i.e., holding the maturity date 7 Iixed and allowing the date W on which the
Iorward rate is set to move ahead. The Iactor 'loadings, V
1
(W, 7) and V
2
(W, 7), give the
sensitivities oI the change in the Iorward rate Ior date 7 (as oI date W) to two independent
Brownian motion 'Iactors G]
1t
USD
and G]
2t
USD
. The HJM model then gives the no-
arbitrage RN Iorward rate driIt P(W, 7) corresponding to the Iactor loadings. Given
Iunctional Iorms Ior V
1
(W, 7) and V
2
(W, 7), Brad can simulate paths oI diIIerent maturity
zero rates over time either by evolving term structures oI Iorward rates or, equivalently,
by evolving term structures oI zero-coupon bond prices.

The loading Iunctions V
1
(W, 7) and V
2
(W, 7) control the extent to which diIIerent maturity
Iorward rates react diIIerently to Iactors G]
1t
USD
and G]
2t
USD
and, thus, they control how
the shape oI the term structure oI interest rates and, in particular, the 1-year and 3-year
zero rates and the corresponding spread between them will change over time. Choosing
a Iunctional Iorm Ior the Iactor loadings and calibrating them is a key step in Brad`s
option valuation. WD Research suggests using Iorward rate Iactor loadings to model US
interest rates oI the Iorm:

(2) V
1
(W, 7) D(W) K
1
(7-W) D(t)

(3) V
2
(W, 7) D(W) K
2
(7-W) D(t) (exp|-2*(7-W-1)] 0.5)

where D(W) can take diIIerent values in diIIerent years W (but is the same Ior Iactors 1 and 2
within any given year W) and where K
1
(7-W) and h
2
(T-t) exp|-2*(7-W-1)] 0.5
determine the relative mix oI the two shocks on diIIerent Iorward rates.
3
Given this
recommendation, Brad needs to calibrate the constants D(W
1
) through D(W
6
) Ior the next six
4

years W
1
through W
6
and also calibrate the constant . To calibrate his US interest rate
dynamics, Brad has the current Libor dollar term structure in Exhibit 3, the market prices
Ior Libor dollar caplets in Exhibit 4, and some statistical correlation estimates in Exhibit
2.

Aside: The speciIication oI interest rate dynamics in terms oI Iorward rates in (1) is
simply Ior clarity about the deIinition oI the Iorward rate Iactor loadings. Associated
with these RN Iorward rate dynamics are corresponding RN dynamics Ior bond prices.
Either representation can then be discretized to simulate term structures over time.

Modeling the Yen term structure: WD Research recommends using the same
Iunctional Iorms Ior the Yen Iorward rate Iactor loadings

(4) N
1
(W, 7) D(W) K
1
(7-W) E(t)
Yen

(5) N
2
(W, 7) D(W) K
2
(7-W) E(t) (exp|-2*(7-W-1)] 0.5)

3
Note that the Iunction exp|-2*(7-W-1)] 0.5 is between 0.5 and -0.5 Ior 7-W 1 where 7-W 1 year
is the shortest maturity Iorward rate given an annualized time step.
4
The Iinal payment in year 7 will depend on interest rates and spreads set in year 6.
5

on two diIIerent random Iactors, G]
1t
JPY
and G]
2t
JPY
. The calibration oI the Yen E`s and

Yen
will, however, diIIer Irom the USD calibration. Exhibits 2 through 4 also provide
market data and historical statistical inIormation Ior the JPY calibrations.

Modeling the USD/1PY spot exchange rate: Once he has the risk neutral spot interest
rate dynamics, Brad will need to simulate the corresponding RN spot USD/JPY exchange
rate dynamics. The current Yen/USD exchange rate is 117 Yen per USD (which will
need to be converted into USD/Yen). Brad estimates that the market implied
(proportional) volatility Ior USD/JPY is 11.75 percent which is well within the normal
range around the current statistical volatility estimate. 'No risk premium there, thinks
Brad.

Other correlations: All oI the random variables in the case are potentially correlated.
Since you already have plenty to do, you can make some simpliIying assumptions about
these other correlations in your numerical analysis. In particular, assume that the interest
rate and FX innovations and also the cross-currency interest rate Iactors are all
uncorrelated. Be Iorewarned, however: Qualitative questions about these correlations are
Iair game in the Q&A.

The WD volatility forecasts (revisited): Given the many potential numerical pitIalls in
this case, you should assume that when you talked to the WD economists, their objective
Yen yield spread volatility Iorecast happened to be exactly one halI oI the average oI
your six calibrated RN Yen yield spread volatilities over the liIe oI the swap. In addition,
assume that the objective Iorecast Ior the Yen 1-year zero rate volatility was only slightly
less than its calibrated RN counterparts. Remember that the volatilities we are talking
about here are Ior the levels oI the yield spreads at each date.

In the real world, you would have speciIic numbers Ior the macroeconomic Iorecasts oI
the Yen yield spread volatility which you would compare with your calculations oI the
RN Yen yield spread volatilities. Again, the point here is to insure that the 'optimal
structure Ior Ms Yang will be largely independent oI any diIIerences in parametric
calibration and/or numerical mistakes you might make.

Comments about modeling and numerical issues:

More ambitious numerical implementations are always preIerred to less ambitious
implementations, but don`t go overboard numerically! Your priority should be on
having a valuation that is logically sound and on understanding and being able to
explain the implications oI any numerical or modeling shortcuts. For example,
discretizations with annual time steps are Iine.
You can use any two-Iactor term structure model oI your choice given the data in
the case.
II additional background inIormation is needed Ior your sales pitch, Ieel Iree to
make up things as long as they are plausible and consistent with the spirit oI the
6
case. Your numerical analysis should, however, stay within the parameters oI the
case.

Preliminary technical questions: The general Q&A will begin with a Iew questions to
help the judges assess the technical accuracy oI your analysis independent oI the
particular structure you are proposing to Ms Yang.

What are your calibrated values oI the US Ds and and the Yen Es and
yen
?
What is your term structure oI volatility Ior the 3-year US zero rates? In
particular, what is the standard deviation oI your distribution oI simulated 3-year
Libor dollar rates Ior year 1, year 2, ., and year 6 (i.e., the levels oI the rates, not
the changes in rates)?
What is the corresponding term structure oI volatility Ior the 3-year Libor Yen
rates? For the Yen yield spread?

Some other considerations: Here are some additional issues to consider in this deal.

There is no liquid market Ior Yuan-linked derivatives, but the prices oI
comparatively illiquid, cash-settled 'non-deliverable Iorwards on the Yuan
suggest the FX market thinks the Yuan is overvalued at current peg. II the
Chinese government were to allow the Yuan to Iloat more Ireely against the US
dollar, how would that aIIect the qualitative logic behind this deal?
What risk exposures does Wright Derivatives have in this deal? How can it hedge
them?

Competition Format: The Iormat is the same as in previous years.

You should give Ms Yang (and the judges) a short written 'term sheet outlining the
key terms oI your proposal (e.g., pricing, payoII rule) at the start oI your presentation.
Each presentation will begin with a 10-15 minute Iormal sales pitch addressed to the
client. Ms Yang, while knowledgeable about derivatives, is primarily interested in
how your proposal will help solve her business problem. Questions Irom the judges
during the sales pitch will be Irom the client`s perspective.
A single spokesperson can represent the team or more than one presenter can be
involved as you see Iit. Most presentations are in PowerPoint, but you may use other
media iI you choose.
Following the sales pitch, the judges will have 25-30 minutes Ior general Q&A about
the details oI the modeling and technical implementation and about the proIitability oI
the deal and risk management issues at Wright Derivatives. In the Q&A, the judges
are no longer restricted to the role oI a client.
The judges may ask questions about alternative parameter values. Bring your
spreadsheet (or whatever numerical package you use) to the presentation so you can
plug them in your model and discuss them.

1udging criteria: Teams will be evaluated on business intuition, marketing quality,
structuring creativity, and technical proIiciency. Some speciIic considerations are:
7

6DOHVPDQVKLS The sales pitch should Iocus on the 'Iorest (the business drivers
behind your proposal) rather than the 'trees (modeling details).
3ULFLQJDQGVWUXFWXUH Completing the analysis (i.e., structuring and pricing your
proposal) is clearly a necessary Iirst step. You should also be able to explain the pros
and cons oI your modeling choices.
&ODULW\ When working with technically complicated Iinancial products, clarity and
intuition are vital.

Good luck!






8

Exhibit 1
Key terms for outstanding yen-denominated debt of the Xinhua Development
Company

Currency: Japanese yen

Principal: JPY 50 billion

Remaining time to maturity now: 7 years

Coupon: Floating, payable annually

Coupon due in year t: 125 b.p. 1 year Libor Yen rate at end oI year t-1

Prepayment: Not allowed

Sinking Iund: No



Exhibit 2
Statistical correlation estimates

Correlation oI changes in the 1-year and 3-year Libor USD rates: 0.81
Correlation oI changes in the 1-year and 3-year Libor Yen rates: 0.72

Note: PerIect positive correlation 1.




9
Exhibit 3
Current market term structures for 1-year forward rates (1 percent 1.0)

Years
forward
Libor
USD
Libor
Yen
(spot rate) 0 5.20 0.50
1 5.25 0.80
2 5.13 1.51
3 5.22 1.92
4 5.30 2.19
5 5.35 2.38
6 5.38 2.54
7 5.42 2.64
8 5.47 2.71
9 5.50 2.77


Exhibit 4
Market implied volatilities from Black model (1 percent 0.01)

Time (years) Libor Dollar Libor Yen
1 0.172 0.192
2 0.164 0.165
3 0.155 0.146
4 0.146 0.132
5 0.140 0.122
6 0.136 0.111
7 0.131 0.109

Notes:
The caplet time convention is best explained by an example: The Black ISD oI
0.155 Ior the '3-year US caplet is Ior a caplet with a payoII contingent on the 1-
year rate set in 3 years (i.e., Ior the period between year 3 and year 4). The actual
payoII occurs in arrears one year later in year 4. See Hull Ior more detail.
All quotes are Ior caplets struck at-the-money Iorward. For example, the strike
Ior the '3-year US caplet is today`s 2-year ahead 1-year Iorward rate (i.e., 5.22
percent Irom Exhibit 3 which is the rate you can lock in today Ior the period
between year 3 and 4).
Caplet prices Ior Libor Dollar cap are quoted in USD. Caplet prices Ior Libor
Yen are in Yen.
Black model assumes lognormal interest rate. They are relative volatilities wrt
the spot interest rate level rather than absolute volatilities. This lognormality is,
however, just a quotation convention and is not relevant Ior the volatility
speciIication in your HJM model.