Chapter 16 - Managing your client's investment risk

Question 1

Who developed the idea of systematic risk and unsystematic risk?

Answer 1

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.

Question 2

What is market risk better known as for debt securities?

Answer 2

Interest rate risk.

Question 3

What is the measure of systematic risk?

Answer 3

Beta

Question 4

Why is a stock portfolio the best defense against inflation risk, despite stocks doing poorly in inflationary environments?

Answer 4

Even if stocks are impacted on a short-term basis by inflation, equities will outperform the long-term inflation rate.

Question 5

What can often be interpreted as an indicator of an investment’s liquidity risk?

Answer 5

The bid/ask spread. A narrow spread indicates high liquidity, a wide spread represents greater risk.

Question 6

How can clients be indirectly exposed to currency risk?

Answer 6

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.

Question 7

What is the difference between realized risk and expected risk?

Answer 7

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.

Question 8

What do beta and standard deviation measure?

Answer 8

Beta measures an investment’s systematic risk relative to the return of a benchmark index. Standard deviation measures an investment’s total risk.

Question 9

How do you calculate standard deviation?

Answer 9

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.

Question 10

How does a normal distribution for standard deviation work?

Answer 10

68% of returns lie within 1 stdev of the avg/expected return.
95% fall within 2.
99% within 3.

Question 11

How are historical betas calculated?

Answer 11

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).

Question 12

What is the semi-deviation?

Answer 12

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.

Question 13

What is the correlation coefficient of two securities?

Answer 13

A measure of the strength of the relationship between their returns.

Question 14

What does it mean when two securities have a correlation of 0?

Answer 14

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.

Question 15

What is naive diversification and how does it differ from efficient diversification?

Answer 15

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.

Question 16

How can equity securities can be diversified?

Answer 16

Geography, market capitalization, style.

Question 17

How can debt securities be diversified?

Answer 17

Geography, term to maturity, and credit risk (different credit ratings).

Question 18

What is “diworsification”?

Answer 18

Adding securities to the point where the risk/return trade-off is worsened.

Question 19

What are the most common types of derivatives available to the average retail investor?

Answer 19

Options and futures.

Question 20

What is a call option? What is a put option?

Answer 20

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.

Question 21

What is an option premium?

Answer 21

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.

Question 22

What is the difference between an American-style and European-style option?

Answer 22

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.

Question 23

What is offsetting options?

Answer 23

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.

Question 24

What are the 3 things that can happen with an option?

Answer 24

1. They may be offset through a closing transaction
2. They may be exercised
3. They may expire worthless

Question 25

When would a call option be considered in or out of the money?

Answer 25

Out of the money if the strike price is higher than the market price. In the money if the strike price is lower.

Question 26

When is a put option considered in or out of the money?

Answer 26

In the money if the strike price is higher than the market price. Out of the money if the strike price is lower.

Question 27

When is a call/put considered at-the-money?

Answer 27

When the strike price is equal to the market price.

Question 28

What is an option cash settlement feature?

Answer 28

If an option is cash settled when exercised, the short position holder delivers to the long position holder an equivalent amount of cash.

Question 29

Where do options trade?

Answer 29

On both exchanges and OTC

Question 30

Who typically accesses the OTC market?

Answer 30

Large financial institutions, institutional investors, and large corporations.

Question 31

What is a protective put?

Answer 31

A long position in an asset is offset by a long put option on the asset.

Question 32

What is considered the net sale price if you buy a protective put?

Answer 32

The strike price minus the price of the option.

Question 33

What are option deductibles?

Answer 33

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.

Question 34

What are the 3 ways index options differ from stock options?

Answer 34

1. European-style 2. Cash settled (intrinsic value of option x multiplier (usually 100) x # of contracts) 3. Cannot provide perfect hedge

Question 35

How can you protect a stock portfolio?

Answer 35

By buying index put options. While not a perfect hedge, they can provide some protection.

Question 36

What are the advantages to buying a protective put instead of liquidating a stock and then repurchasing when the market warrants it?

Answer 36

Liquidating involves numerous transactions, is costly, and means having to forgo dividends, it also can have tax implications and requires accurate market timing.

Question 37

What are the steps to implementing a protective put strategy on a portfolio?

Answer 37

Determine which index has the greatest correlation. Decide how many contracts to use in the hedge and what strike price.

Question 38

How can you calculate the number of contracts to use for a protective put on a stock portfolio?

Answer 38

Number of contracts = value of portfolio x portfolio beta / current index contract multiplier

Question 39

How do you determine the degree of protection of a protective put on a portfolio?

Answer 39

The higher the strike price, the greater the protection. (And the higher the cost)

Question 40

How can covered calls be used a hedge?

Answer 40

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.

Question 41

How does buying protective puts differ from writing calls as a hedging strategy?

Answer 41

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.

Question 42

What are collars?

Answer 42

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).

Question 43

What happens to the risk/reward ratio of collared hedges as the expiration dates of the options are pushed back (and why)?

Answer 43

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.

Question 44

What are LEAPS?

Answer 44

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).

Question 45

What are the tax implications of a collared hedge?

Answer 45

The gross premium of the short call options (before subtracting the premium of the long put option) is recognized as a capital gain.

Question 46

What is the difference between options contracts and futures contracts?

Answer 46

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.

Question 47

What is a futures contract?

Answer 47

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.

Question 48

What is the name of the agreed upon price for a futures contract?

Answer 48

The entry price or delivery price

Question 49

How can one get out of a futures contract?

Answer 49

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.

Question 50

How are futures contracts settled?

Answer 50

Either by a cash payment or physical delivery of the asset

Question 51

Why is there no cost to enter into a futures contract?

Answer 51

Because there is no value at initiation and the contract only gains value as the futures price changes.

Question 52

What are futures margins?

Answer 52

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.

Question 53

What changed investors' ideas that a stock portfolio's systematic risk could not be eliminated?

Answer 53

The introduction of stock index derivatives, as the use of stock index futures contracts has allowed investors to eliminate a stock portfolio's systematic risk.

Question 54

What are the steps to reduce stock portfolio risk with stock index futures?

Answer 54

1. Determine the total dollar value at risk 2. Take the opposite position in the futures market using a quantity of stock index futures that best replicates the portfolio If the market declines, the investor hopes that gains in the index futures will offset the stock portfolio's losses

Question 55

Why must beta be taken into account when determining the number of contracts to use in a hedge of a stock portfolio?

Answer 55

If the portfolio's beta is > 1 the investor may find themselves under-hedged, or over-hedged if the beta is < 1.

Question 56

What is the formula to determine the number of futures contracts needed to fully hedge a stock portfolio?

Answer 56

H = (market value of portfolio x beta) / (stock index futures price x stock index futures multiplier)

Question 57

What are some advantages to hedging a stock portfolio when volatility is anticipated vs selling the at-risk stocks (and moving to T-bills)?

Answer 57

Selling shares can trigger tax liabilities and incurs commissions/costs. An investor will also often want to re-invest in equities following a period of weakness in the markets, so they may not want to sell their positions.

Question 58

How can a client use futures to lower their beta?

Answer 58

If, for example, an investor's portfolio has a beta of 1.25 and they would like their beta reduced to 0.5, they would use 0.75 in the formula for calculating the number of contracts needed for stock index futures instead of 1.25.

Question 59

What is a "contract for difference" (CFD)?

Answer 59

A type of cash-settled OTC derivative contract with pricing closely mirroring that of an underlying asset. These are potential hedging substitutes for single stock futures. Not permitted in the US.

Question 60

How can CFDs be used to hedge against long stock positions?

Answer 60

Short CFD positions can be used to eliminate the risk of a long stock position by selling the same number of CFDs as the long positions. The CFDs will appreciate in value if the share price declines, and will lose money if the share price appreciates. CFDs have no maturity date, the investor must be able to maintain the margin requirements and the investor can maintain the hedged position indefinitely.