Chapter 22: Portfolio management (3)

Question 1

Uses of swaps (3)

Answer 1

1. reduce risk by matching assets and liabilities
2. reduce a company’s cost of borrowing, based on the principle of comparative advantage
3. swap exposure between different asset classes without disturbing the underlying assets

Question 2

Two kinds of risks each counterparty to a swap faces

Answer 2

1. the market risk that market conditions will change so that the present value of the net outgo under the agreement increases.
2. the credit risk that the other counterparty will default on its payments.

Question 3

Uses of financial futures and options (5)

Answer 3

H - Hedging to reduce market risk
A - Additional income from options
S - Synthesizing an index

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G - Generating arbitrage profits
P - Portfolio (or transition) management,
S - Speculation aimed at increasing returns

Question 4

Two risks involved in the use of futures for hedging: (2)

Answer 4

1. basis risk - as the basis of the future cannot be predicted with certainty
2. cross hedging risk - if he actual assets differ from those underlying the future.

Question 5

Main problems hedging with currency forwards

Answer 5

1. it is possible only to hedge expected returns
2. many investments are of a longer term than the contracts available in the market and so the forward contracts will have to be rolled over on expiry at an unknown rate
3. it may be relatively expensive to hedge small cashflows (e.g. from dividends)

Question 6

Derivative reporting should include: (3)

Answer 6

1. listing derivatives individually
2. valuing the derivatives at market value (“marking-to-market”)
3. including any additional explanations needed to ensure that the fund’s exposure is properly understood.

Question 7

Main problems when making large changes to the asset allocation (4)

Answer 7

1. the possibility of shifting market prices
2. the time needed to effect the change and the difficulty of making sure the timing of deals is advantageous
3. the dealing costs
4. the possibility of the crystallisation of capital gains leading to a tax liability

Question 8

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

Answer 8

1. implementing the transition in stages, rather than attempting it immediately.
2. investigating share exchanges between old and new investment managers
3. investigating crossing, whereby an investment bank looks among its clients for buyers and sellers of stock
4. using the investment of cashflows as a way of rebalancing the portfolio

Question 9

The disadvantages of using currency swaps include: (4)

Answer 9

1. the extra cost of the bid-offer spread compared with a straight spot currency transaction
2. removing the possibility of favourable currency movements, i.e. market risk
3. the introduction of counterparty credit risk
4. mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials.

Question 10

The main disadvantages of using forwards to hedge currencies include: (6)

Answer 10

1. the extra cost of bid-offer spread compared with a straight spot currency transaction
2. the need to rollover short-term forwards to remain hedged over longer periods
3. removing the possibility of favourable currency movements (i.e. market risk)
4. counterparty credit risk if the contract is not centrally cleared.
5. mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials
6. the difficulty of hedging unknown future income

Question 11

Options trading - directional speculation:

Answer 11

1. Directional strategies seek to benefit from the rise or fall in a security or market.
2. An investor who expects an increase in the price of the underlying security will purchase calls, while an investor who expects it to fall can buy puts.

Question 12

Options - Spreads

Answer 12

1. A spread means simultaneously buying and selling calls (or puts) on the same underlying asset where there is a difference in the exercise price on the expiry date.
2. It limit both upside and downside

Question 13

Options - Straddles

Answer 13

1. A straddle means buying a put and a call on an underlying asset with the same exercise price and expiry date.
2. Such a strategy might be sensible if you are sure that the underlying share price will be volatile.