Chapter 16 - Managing your client's investment risk Flashcards
Who developed the idea of systematic risk and unsystematic risk?
William Sharpe when he published a paper in 1964 about Capital Asset Prices, which later became the Capital Asset Pricing Model, which broke down risk into 2 parts.
What is market risk better known as for debt securities?
Interest rate risk.
What is the measure of systematic risk?
Beta
Why is a stock portfolio the best defense against inflation risk, despite stocks doing poorly in inflationary environments?
Even if stocks are impacted on a short-term basis by inflation, equities will outperform the long-term inflation rate.
What can often be interpreted as an indicator of an investment’s liquidity risk?
The bid/ask spread. A narrow spread indicates high liquidity, a wide spread represents greater risk.
How can clients be indirectly exposed to currency risk?
If they’re heavily invested in shares of companies valued in CDN dollars that do a significant volume of business in a foreign currency. This can have adverse effects on the business, which then has adverse effects on the client.
What is the difference between realized risk and expected risk?
Realized risk is historical risk. Expected risk is an estimate of what the risk of an investment will be over a future time period. It may be a guess based on some fundamental analysis of the investment and/or determined by various scenarios for the investment and the economy.
What do beta and standard deviation measure?
Beta measures an investment’s systematic risk relative to the return of a benchmark index. Standard deviation measures an investment’s total risk.
How do you calculate standard deviation?
Each return has the average return subtracted from it, then square that number. Do that for each return period. Sum up all those numbers then divide by the number of periods. Find the square root of that figure.
How does a normal distribution for standard deviation work?
68% of returns lie within 1 stdev of the avg/expected return.
95% fall within 2.
99% within 3.
How are historical betas calculated?
Using simple regression analysis. This is often done using a statistical software package or a spreadsheet application. It determines the linear relationship between two variables from historical data. The independent variable (market’s return) is assumed to influence the dependent variable (security’s return).
What is the semi-deviation?
A measure of standard deviation that only includes returns below the average return in the calculation. This is done to ensure upside volatility isn’t penalized.
What is the correlation coefficient of two securities?
A measure of the strength of the relationship between their returns.
What does it mean when two securities have a correlation of 0?
Their returns are independent and a positive return in one may or may not coincide with either a positive or negative return on the other.
What is naive diversification and how does it differ from efficient diversification?
Naive diversification occurs when someone chooses securities randomly. Efficient diversification occurs when you select securities with the goal of obtaining the highest expected return for a given level of risk.
How can equity securities can be diversified?
Geography, market capitalization, style.
How can debt securities be diversified?
Geography, term to maturity, and credit risk (different credit ratings).
What is “diworsification”?
Adding securities to the point where the risk/return trade-off is worsened.
What are the most common types of derivatives available to the average retail investor?
Options and futures.
What is a call option? What is a put option?
Long call is the right to buy a stock. Long put is the right to sell a stock.
Short call is the obligation to sell the stock. Short put is the obligation to buy the stock.
What is an option premium?
The price that an option buyer pays to the writer (seller) for the right to buy or sell the underlying asset. Quoted on a per-unit basis.
What is the difference between an American-style and European-style option?
An American-style option can be exercised at any time up to the expiration date (this is standard in North America). A European-style option can only be exercised on the expiration date.
What is offsetting options?
Offsetting transactions are known as closing transactions. A long option is offset by the sale of an equivalent option. A short option is offset by the purchase of one. This effectively cancels the effects of the first option.
What are the 3 things that can happen with an option?
- They may be offset through a closing transaction
- They may be exercised
- They may expire worthless
When would a call option be considered in or out of the money?
Out of the money if the strike price is higher than the market price. In the money if the strike price is lower.
When is a put option considered in or out of the money?
In the money if the strike price is higher than the market price. Out of the money if the strike price is lower.
When is a call/put considered at-the-money?
When the strike price is equal to the market price.
What is an option cash settlement feature?
If an option is cash settled when exercised, the short position holder delivers to the long position holder an equivalent amount of cash.
Where do options trade?
On both exchanges and OTC
Who typically accesses the OTC market?
Large financial institutions, institutional investors, and large corporations.
What is a protective put?
A long position in an asset is offset by a long put option on the asset.
What is considered the net sale price if you buy a protective put?
The strike price minus the price of the option.
What are option deductibles?
The deductible is the portion that is the out-of-the-money as the unrealized profit would be reduced by that amount if exercising the option. In-the-money options have a negative deductible.
What are the 3 ways index options differ from stock options?
- European-style
- Cash settled (intrinsic value of option x multiplier (usually 100) x # of contracts)
- Cannot provide perfect hedge
How can you protect a stock portfolio?
By buying index put options. While not a perfect hedge, they can provide some protection.
What are the advantages to buying a protective put instead of liquidating a stock and then repurchasing when the market warrants it?
Liquidating involves numerous transactions, is costly, and means having to forgo dividends, it also can have tax implications and requires accurate market timing.
What are the steps to implementing a protective put strategy on a portfolio?
Determine which index has the greatest correlation. Decide how many contracts to use in the hedge and what strike price.
How can you calculate the number of contracts to use for a protective put on a stock portfolio?
Number of contracts = value of portfolio x portfolio beta / current index contract multiplier
How do you determine the degree of protection of a protective put on a portfolio?
The higher the strike price, the greater the protection. (And the higher the cost)
How can covered calls be used a hedge?
Selling (writing) calls. If someone holds a stock, believes there will be a correction and wants to take advantage of it but also doesn’t want to sell.
How does buying protective puts differ from writing calls as a hedging strategy?
The only protection offered by the calls is limited to the premium received, unlike with puts where there is complete protection. If the stock price remains unchanged, the put strategy sees a loss, whereas the written call strategy sees a profit due to the call sold.
What are collars?
Provide all the cash protection of a protective put but usually without requiring any cash outlay by forgoing some of the stock’s upside potential. Purchase an out-of-the-money put while simultaneously write an out-of-the-money call. The premium received for the call option offsets the premium paid for the put. But if the stock price increases, you may need to sell the stock (if the call option is used).
What happens to the risk/reward ratio of collared hedges as the expiration dates of the options are pushed back (and why)?
Because of option pricing dynamics, a 1-year put will cost a lot more than a 1-month put, while an equivalent amount of money will write a call for a much higher value.
What are LEAPS?
Long-term Equity AnticiPation Securities. These are options with expiration dates that are originally listed for 3 years away (whereas normal options are originally listed for 9 months).
What are the tax implications of a collared hedge?
The gross premium of the short call options (before subtracting the premium of the long put option) is recognized as a capital gain.
What is the difference between options contracts and futures contracts?
With options contracts, buyers are allowed to walk away when it is not in their best interest to exercise them. With futures, neither the buyer nor the seller may get out of their contracts (except through an offsetting transaction) which is why it does not cost anything to get into one.
What is a futures contract?
Legally binding agreement traded on a regulated futures exchange. The buyer promises to take delivery of a specified underlying asset on a certain future date at an agreed-upon price, the seller promises to make delivery of the asset.
What is the name of the agreed upon price for a futures contract?
The entry price or delivery price
How can one get out of a futures contract?
By offsetting their positions by entering into an offsetting transaction in the same futures contract. This could result in a profit or a loss depending on the original entry price and the new entry price.
How are futures contracts settled?
Either by a cash payment or physical delivery of the asset
Why is there no cost to enter into a futures contract?
Because there is no value at initiation and the contract only gains value as the futures price changes.
What are futures margins?
An amount of money a customer must deposit with a broker for assurance that the financial obligations will be met (good faith deposit). There is an original margin and a maintenance margin.
478 - REDUCING PORTFOLIO RISK WITH STOCK INDEX FUTURES.
