Chapter 23

Question 1

What are the objectives of this chapter? (just read you do need to memorise)

Answer 1

j) Describe the main types of derivative contract, including how they can be used by an investment manager.
o) Discuss the principal techniques in the pf management including risk control techniques.
iv) Discuss the use institutional investor of financial futures, options, forwards and over-the-counter contracts
v) Discuss the use institutional investor of financial interest rate, currency and inflation swaps
vi) Discuss the use institutional investor of financial forward foreign exchange contracts for currency hedging
viii) Discuss the problems of making significant changes to the investment allocation of substantial pf
ix) Transition management and asset allocation techniques (including overlay strategies)

Question 2

Section 3 uses of futures and section 4 Using options - OBJ (iv)

List the six main uses of futures and options in portfolio management.

Answer 2

1. Hedging to reduce market risk - both (3.1& 4.1)
2. Speculation to increase returns by using highly geared nature of futures if have a strong view of movement of market - both (4.2)
3. Arbitrage profits based on mispricing - both
4. portfolio management (In particular, Transition management) - both
5. Synthetically track an index - both
6. Income enhancement - by writing options only

Question 3

iv) Uses of futures (and/or options)

Describe HEDGE in the context of futures contracts.

Answer 3

Involves taking a position in the future which is opposite to the position held in the cash market –> loss or profit made in the cash market will be counterbalanced by a profit or loss on the future.

Question 4

iv. uses of futures

Explain how a future can protect (HEDGE) against a:

1. fall in the equity market
2. rise in bond yields
3. rise in the market

Answer 4

Fall in the equity market:

• Sell index futures with contract value equal to the size of pf –> equities have been sold in the future at a fixed price –> Any fall in equities will be offset by profits on futures –> useful if fund going to disinvest large sum of money in few months and want to avoid any future risk
• Also used when manager feels market is over-priced and vulnerable to a fall

Rise in bond yields

• similarly to the equity pf, sell interest rate (bond)) futures with contract value equal to the value of the pf
• If interest rates rise, bond portfolio decreases in value, the price of the futures contracts will likely increase. A profit on the futures contracts is made, which helps offset the losses in bond portfolio.

Protecting against risk in the market:

• An investor expecting a large cash inflow (and want to invest it) in the future may wish to protect against a rise in the market by buying futures

Question 5

iv. uses of futures

outline two risks that remain when using futures to HEDGE

Answer 5

1. Basis risk - even though over time the futures price closely tracks the value of the cash position, there is a risk of deviation due to supply and demand factors that affect the two markets differently, resulting in the basis not moving exactly as expected, because:

• it is not possible to predict exactly what future interest rates and dividends will be over the term of the future.
• delivery costs
• liquidity –> less liquid futures contracts have wide bid-offer spreads
• quality differences

2. Cross-hedge risk - arises because asse underlying futures contract differs from pf to be hedged this could be due to:
   - imperfect correlation
   - basis risk

(3. Term/roll-over risks – may not be able to roll over the futures before selling all its shares.)

(4. Market risk due to incomplete hedge – if the bank was not able to secure a sufficient number of futures contracts.)

(5. Operational risk – an error in executing the hedge.)

(6. Liquidity risk – not having sufficient liquidity to pay for margins when needed by the clearing house.)

(he asset manager has to choose the index or a combination of indices that most closely matches the portfolio to be hedged; however unless the equity portfolio is being run on an indexed basis, it is unlikely that the hedge will be perfect and there will be differences between the movements of the portfolio and the index.)

Question 6

iv. Uses of options

Explain how options can be used to protect (HEDGE) against:
1. fall in the market
2. rise in the market
3. change in interest rates

Answer 6

Fall in the market
- use a protective put (pf insurance)\

Rise in the market

• buying a call option (especially if expecting a large cashflow in a few month)

Rise in interest rates

• buy put option on interest rate futures

Question 7

iv. uses of options
Define:
- delta
- the hedge ratio

Answer 7

Delta:
- d = change in option price/change in price of underlying asset
- measures the sensitivity of option price to small changes in the price of underlying asset
- it a function of T, price relatively to exercise price and volatility
- to maintain fully-hedge position requires continual adjustment of number of options held

Hedge ratio
- number of options needed to hedge each share
- Equal to 1/d (call) or -1/d (puts) - delta neutral position/delta of the option

Question 8

iv. uses of futures (and options)

Five advantages of using futures and options to SPECULATE, rather than dealing in the cash market.

Answer 8

1. Lower dealing costs
2. Ability to implement large deals due to greater liquidity
3. Ability to gear up investment returns.
4. Ability to speculate on market falls if unable to sell short, e.g., by buying puts.
5. Options can be used to speculate on volatility, ie, extent as well as direction of price movement.
   - Buying Options During Low Volatility
   - Selling Options During High Volatility

Question 9

iv. uses of options

How can you use options to enhance returns?

Answer 9

By using a:
1. Covered call
- enhances performance in a falling or flat market
- sacrifice all potential gains above the exercise price of the options that would have been made if markets rose
2. Naked call (extremely risky)
3. Naked put

Question 10

iv. Uses of options (futures)

Describe three ways in which options can be used to SPECULATE.

Answer 10

1. Simple directional
   - expect the market to rise (fall) buy call (put)
   - Gives high level of gearing and low dealing costs
2. Spreads
   - simultaneously buying and selling calls (or puts) on the same underlying asset where there is a difference in the exercise price or expiry date.
   - gives profits and losses in line with movements in the share price around the exercise prices, but limits both upside and downside
   - profitable even if underlying price movement is limited
   - Believe stock price will moderately increase –> Bull call spread (lower strike call)
3. straddles
   - buying a put and a call on asset with same strike price and date
   - sensible if you are sure underlying asset is volatile but not sure which way it will move

Question 11

iv. use of options and futures

Describe the basis idea behind transition management

Answer 11

• Time passes and currently pf suboptimal
• investor identifies new optimal pf and makes revisions to current pf
• but transaction costs (brokerage, price impacts, b/o spread and possibly tax liabilities) and management and administration costs.
• May take time to transition
• So use derivatives to transition

Question 12

iv. Uses of futures

Explain how futures can be used in transition management.

Answer 12

1. Buying or selling futures contracts on stock market indices or treasury bonds
2. (how futures help)
   - switch (removal of exposure) implemented immediately in a liquid market thus lower dealing costs
   - purchase right number of futures to achieve same re-weighting of effective exposure as from actual switch
3. if switch is for the long-term –> underlying securities bought and hold over extended period giving opportunities to buy and sell at favorable prices and so careful analysis for which shares to buy
4. Short-term - use futures contract for tactical derivative overlay and maintain for whole duration –> if equities unmarketable then they will not be included in index which the future is based –> so cross hedging

Question 13

v. Uses swaps

1. List three uses of swaps
2. State the two risks which each party is exposed.

Answer 13

Uses:
1. Match assets and liabilities (risk management - interest swaps and currency swaps (forward))
2. Lower the cost of borrowing
3. Transition management

Risks
1. Credit risk - risk that counterparty defaults
2. Market risk - risk that market conditions change so that present value of net outgo under swap increases

Question 14

v. uses of currency swaps

List seven potential difficulties with using currency swaps to hedge currency movements.

Answer 14

1. Extra cost of bid-offer spread compared with spot transactions (especially on smaller deals, such as hedging dividend receipts)
2. Removes possibility of favorable currency movements
3. counterparty credit risk
4. mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials
5. difficulty of hedging unknown future income
6. can only easily hedge income stream
7. available on fairly large principle amounts

Question 15

v. Uses of inflation swaps
Describe how an institution can use inflation swaps to HEDGE risk.

Answer 15

• An institution which holds an asset that has an income stream that is linked to an inflation index is exposed to variations in future expectations of the level of inflation
• for longer dated inflation payments this can be a source of significant market risk
• An inflation swap allows a receiver of inflation–linked payments to pay these to a counterparty in return for receiving a fixed payment
• institutional investors such as pension funds, with inflation-linked liabilities, can use inflation swaps to received inflation and thereby hedge the market risk from uncertain future inflation within their liabilities.

Question 17

v. uses of swaps

Explain how an equity swap could be used to swap (TRANSITION) exposure from equities to bond.

Answer 17

• Long position in equites agrees to pay stream of variable-size cash payments based on agreed stock market index
• in return, counterparty agrees to pay stream of fixed-size cash payments based on current bond yields
• investor has, in essences, sold shares and bought bonds, while counterparty has sold bonds and bought shares
• both have effectively restructured their pfs without having to pay any transaction costs other than relatively small fee to the swap bank that set up the contract.

Question 18

vi. Use of currency forwards

What is a currency forward?

Answer 18

Agreement to exchange currencies at a specified date in the future at a rate fixed now.

Question 19

vi. Use of currency forwards
How can currency forwards be used to hedge currency risk and what costs are associated with using currency them?

Answer 19

Hedging:
Expecting proceeds from a foreign currency investment –> sell the foreign currency forward.

Costs:
- removes possibility that an appreciation of the foreign currency will increase the domestic currency value of the expected proceeds
- b/o on forward deals is a Littlemore than the spread on spot market transactions –> so small additional cost for using forwards

Question 20

vi. Use of currency forwards

How can currencies be viewed as assets?

Answer 20

Use of forwards to hedge currencies allows investor to separate the decision to invest in a country from a decision to invest in a currency. so,
- invest in domestic or overseas assets
- use currency forwards (futures or swaps) or not

Question 21

vi. Use of currency forwards

Practical problems with using forwards for currency hedging

Answer 21

1. Can only bee used to hedge expected cashflow from foreign currency asset, so hedge unlikely to be exact
2. many investments are for longer term than contracts available in market, so forwards have to be rolled over on expiry at unknown rates
3. Costs associated with forward contracts may be significant when attempting to hedge smaller amounts.
   (plus problems experienced when using swaps)

Question 22

List five items that should be included when reporting to senior management on the use of derivatives.

Answer 22

SLAVE

1. Sensitivity analysis of pf to different factors, perhaps including VaR calculations
2. List individual derivatives used, each included within the relevant asset class
3. any Additional explanations need to ensure that fund’s exposure properly understood.
4. Valuation of derivatives (at market value)
5. resulting net Exposure of pf to different classes (&currencies), what is and how it has been changed through use of derivatives

Question 23

viii. problems with making significant changes to the investment allocation.

List four of these problems.

Answer 23

1. Possibility of shifting market prices
2. time needed to effect change and difficulty of making sure timing of deals is advantages
3. Costs involved (research, transaction, administration, changing managers?)
4. Possible crystallisation of capital gains leading to tax liability

(problems are acute when unmarketable securities are involved or where normal market size for deals in the securities is small)

Question 24

viii.

List:

• four different costs that may be incurred when making a change to the pf asset allocation
• four ways in which transaction costs may be reduce in the cash market

Answer 24

Costs:
1. research costs
2. transaction costs (bid-offer spread, commissions, stamp duty)
3. administration costs (recording, settling, accounting)
4. Costs of changing investment managers

Ways to reduce costs:

1. Implementing transition in stages (avoid market impact, price improvements, risk management)
2. Share exchanges between old and new managers (direct transfer - no bid-offer, commission etc and little admin)
3. Crossing, whereby investment bank looks amoung its clients for buyers and sellers of stock
4. use investment net of cashflows as a way of rebalancing pf (gradual rebalancing)