Ch 22 - Portfolio Management (3) Flashcards

1
Q

Main uses of swaps

A

Risk management
Reduced cost of borrowing
Transition management (i.e. tactical asset allocation)

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2
Q

Main uses of futures

A
Hedging 
Speculation
Arbitrage
Transition management
Synthetic index tracking
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3
Q

Main uses of options

A
Hedging 
Speculation
Arbitrage
Income protection
Transition management
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4
Q

To reduce the risk associated with derivatives, appropriate reporting of exposure is important. This should include:

A

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

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5
Q

Including any additional explanations needed to ensure that the fund’s exposure is properly understood

A

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

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6
Q

The main problems when making large changes to the asset allocation are:

A

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

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7
Q

How to reduce the problems associated with transition management (6)

A

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

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8
Q

For transactions in the cash market, transaction costs may be reduced by:

A

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

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9
Q

Share exchanges

A

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

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10
Q

Crossing

A

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

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11
Q

Disadvantage of crossing

A

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

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12
Q

Main disadvantages with the use of forwards for currency hedging

A

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

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13
Q

Reasons for (unhedged) overseas assets

A
Higher returns (4)
Increased diversification (5 - see ARM notes)
Match (overseas) liabilities
Hedging domestic inflation
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14
Q

Reduced cost of borrowing is based on what principle

A

Principle of comparative advantage

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15
Q

Advantages of using swaps

A

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

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16
Q

Disadvantages of swaps

A

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)

17
Q

Hedge ratio for options

A

= 1/delta

Thus value of option will increase by the same amount as the decrease in the underlying asset price

18
Q

Spreads

A

Simultaneously buying and selling calls (or puts) on the same underlying where there is a difference in the exercise price or the expiry date

19
Q

Straddles

A

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

20
Q

Covered call

A

Owns the underlying asset, while writing a call option

21
Q

Naked put

A

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

22
Q

Naked call

A

Extremely risky as the maximum loss is unlimited

23
Q

Put on the interest rate futures

A

Cap on the interest rate to be paid for future borrowing, while still benefiting from any fall in rates

24
Q

Selling a call on interest rate futures

A

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

25
Q

Interest rate collar

A

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)

26
Q

Alternative ways to have exposure to index-linked bonds

A

Real rate swaps

Synthetic index-linked bonds

27
Q

Difference between real rate swaps and synthetic ILBs

A

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