Ch 22 - Portfolio Management (3) Flashcards
Main uses of swaps
Risk management
Reduced cost of borrowing
Transition management (i.e. tactical asset allocation)
Main uses of futures
Hedging Speculation Arbitrage Transition management Synthetic index tracking
Main uses of options
Hedging Speculation Arbitrage Income protection Transition management
To reduce the risk associated with derivatives, appropriate reporting of exposure is important. This should include:
Listing derivatives individually
Valuing the derivatives at market value (“marking-to-market”)
Including any additional explanations needed to ensure that the fund’s exposure is properly understood
Including any additional explanations needed to ensure that the fund’s exposure is properly understood
Should include the effective exposure to equities (total option exposure x delta of the options)
To show the other Greeks as well
Report should make clear where the exposure of the portfolio to different asset classes has been changed through the use of futures or swaps and what the associated economic exposure is
Written explanation of the strategy employed should be given
Could also give a subsidiary option sensitivity analysis, if options were used
The main problems when making large changes to the asset allocation are:
Shifting market prices
Time needed to effect the change and the difficulty of making sure that the timing of deals is advantageous
Dealing costs involved
Capital gains tax
Note: unmarketable assets make the above more difficult or where the normal market size for deals in the securities is small
How to reduce the problems associated with transition management (6)
Use derivatives!
Get the required exposure immediately and then can conduct a gradual sale of the portfolio
Can thus buy and sell at favourable prices
Pay capital gains tax over an extended period for fewer shares - so reduce and spread your tax liability
Can conduct careful analysis of which shares to sell and which bonds to buy (for example)
Normally the markets for the derivatives are well developed - dealing costs are lower
Investors can create large exposure through derivatives
For transactions in the cash market, transaction costs may be reduced by:
Implementing the transition in stages, rather than attempting it immediately
Investigating share exchanges between old and new investment managers
Investigating crossing
Using the investment of cashflows as a way of rebalancing the portfolio
Share exchanges
Involves transferring a holding between the fund management company that originally managed the fund and the fund management company that is taking over management of the fund
If the old company still likes the existing shares holdings, they may well be open to “buying” them from the new manager in exchange for some shares that they have elsewhere that they would be happy to sell at the current price
By avoiding the market, they both avoid bid/offer spreads and commissions
Crossing
Whereby an investment bank looks among its (fund manager) clients for buyers and sellers of stock
Often large holdings of stock can be disposed of more easily and cheaply
Disadvantage of crossing
Manager trying to sell has to disclose this to a number of companies
If he does not manage to get rid of the stock this can sometimes panic other large institutions with the result that the share price may sink
Main disadvantages with the use of forwards for currency hedging
CURB FEMinism
Counter-party credit risk
Unknown future income
Rollover
Bid-offer
Favourable currency movements (i.e. market risk)
Expensive for small cashflows
Mismatching real liabilities by eliminating PPP against unexpected inflation differentials
Reasons for (unhedged) overseas assets
Higher returns (4) Increased diversification (5 - see ARM notes) Match (overseas) liabilities Hedging domestic inflation
Reduced cost of borrowing is based on what principle
Principle of comparative advantage
Advantages of using swaps
Can be done in a large size
And over a long time period
Costs can be reduced relative to dealing in the futures market
Also the index can be specified precisely, whereas in the futures market only certain indices are available
Customisable contract as are OTC instruments
Disadvantages of swaps
Credit/counterparty risk
Lack of marketability (no secondary market)
Also, note they are faced with market risk (although this is standard for most financial instruments)
Hedge ratio for options
= 1/delta
Thus value of option will increase by the same amount as the decrease in the underlying asset price
Spreads
Simultaneously buying and selling calls (or puts) on the same underlying where there is a difference in the exercise price or the expiry date
Straddles
Buying a put and a call on the underling asset with the same exercise price and expiry date
Believe the share price could be volatile and go up or down, but is not sure which way
Covered call
Owns the underlying asset, while writing a call option
Naked put
Risky, but the maximum loss is limited to the exercise price less the premium
Can’t really have a covered put (except in the sense of holding cash equal to the exercise price) because you can’t be short of the underlying asset
Note: a short put and short shares is a synthetic short call
Naked call
Extremely risky as the maximum loss is unlimited
Put on the interest rate futures
Cap on the interest rate to be paid for future borrowing, while still benefiting from any fall in rates
Selling a call on interest rate futures
Loss on contract from a fall in interest rates is offset with the benefit of having lower interest rates on future borrowing
Thus, sets a minimum interest rate for borrowing
Interest rate collar
Set a max and min interest rate by buying puts and selling calls - to borrow at
Do the opposite if you are the one lending money (see Question 22.19)
Alternative ways to have exposure to index-linked bonds
Real rate swaps
Synthetic index-linked bonds
Difference between real rate swaps and synthetic ILBs
The asset flows with a real rate swap are chosen to match the actual liabilities rather than the proceeds from a notional portfolio of index-linked bonds
