Chapter 23 Flashcards
Portfolio management (3)
What are the objectives of this chapter? (just read you do need to memorise)
j) Describe the main types of derivative contract, including how they can be used by an investment manager.
o) Discuss the principal techniques in the pf management including risk control techniques.
iv) Discuss the use institutional investor of financial futures, options, forwards and over-the-counter contracts
v) Discuss the use institutional investor of financial interest rate, currency and inflation swaps
vi) Discuss the use institutional investor of financial forward foreign exchange contracts for currency hedging
viii) Discuss the problems of making significant changes to the investment allocation of substantial pf
ix) Transition management and asset allocation techniques (including overlay strategies)
Section 3 uses of futures and section 4 Using options - OBJ (iv)
List the six main uses of futures and options in portfolio management.
- Hedging to reduce market risk - both (3.1& 4.1)
- Speculation to increase returns by using highly geared nature of futures if have a strong view of movement of market - both (4.2)
- Arbitrage profits based on mispricing - both
- portfolio management (In particular, Transition management) - both
- Synthetically track an index - both
- Income enhancement - by writing options only
iv) Uses of futures (and/or options)
Describe HEDGE in the context of futures contracts.
Involves taking a position in the future which is opposite to the position held in the cash market –> loss or profit made in the cash market will be counterbalanced by a profit or loss on the future.
iv. uses of futures
Explain how a future can protect (HEDGE) against a:
- fall in the equity market
- rise in bond yields
- rise in the market
Fall in the equity market:
- Sell index futures with contract value equal to the size of pf –> equities have been sold in the future at a fixed price –> Any fall in equities will be offset by profits on futures –> useful if fund going to disinvest large sum of money in few months and want to avoid any future risk
- Also used when manager feels market is over-priced and vulnerable to a fall
Rise in bond yields
- similarly to the equity pf, sell interest rate (bond)) futures with contract value equal to the value of the pf
- If interest rates rise, bond portfolio decreases in value, the price of the futures contracts will likely increase. A profit on the futures contracts is made, which helps offset the losses in bond portfolio.
Protecting against risk in the market:
- An investor expecting a large cash inflow (and want to invest it) in the future may wish to protect against a rise in the market by buying futures
iv. uses of futures
outline two risks that remain when using futures to HEDGE
- Basis risk - even though over time the futures price closely tracks the value of the cash position, there is a risk of deviation due to supply and demand factors that affect the two markets differently, resulting in the basis not moving exactly as expected, because:
- delivery costs
- liquidity –> less liquid futures contracts have wide bid-offer spreads
- quality differences - Cross-hedge risk - arises because asse underlying futures contract differs from pf to be hedged this could be due to:
- imperfect correlation
- basis risk
iv. Uses of options
Explain how options can be used to protect (HEDGE) against:
1. fall in the market
2. rise in the market
3. change in interest rates
Fall in the market
- use a protective put (pf insurance)\
Rise in the market
- buying a call option (especially if expecting a large cashflow in a few month)
Rise in interest rates
- buy put option on interest rate futures
iv. uses of options
Define:
- delta
- the hedge ratio
Delta:
- d = change in option price/change in price of underlying asset
- measures the sensitivity of option price to small changes in the price of underlying asset
- it a function of T, price relatively to exercise price and volatility
- to maintain fully-hedge position requires continual adjustment of number of options held
Hedge ratio
- number of options needed to hedge each share
- Equal to 1/d (call) or -1/d (puts) - delta neutral position/delta of the option
iv. uses of futures (and options)
Five advantages of using futures and options to SPECULATE, rather than dealing in the cash market.
- Lower dealing costs
- Ability to implement large deals due to greater liquidity
- Ability to gear up investment returns.
- Ability to speculate on market falls if unable to sell short, e.g., by buying puts.
- Options can be used to speculate on volatility, ie, extent as well as direction of price movement.
- Buying Options During Low Volatility
- Selling Options During High Volatility
iv. uses of options
How can you use options to enhance returns?
By using a:
1. Covered call
- enhances performance in a falling or flat market
- sacrifice all potential gains above the exercise price of the options that would have been made if markets rose
2. Naked call (extremely risky)
3. Naked put
iv. Uses of options (futures)
Describe three ways in which options can be used to SPECULATE.
- Simple directional
- expect the market to rise (fall) buy call (put)
- Gives high level of gearing and low dealing costs - Spreads
- simultaneously buying and selling calls (or puts) on the same underlying asset where there is a difference in the exercise price or expiry date.
- gives profits and losses in line with movements in the share price around the exercise prices, but limits both upside and downside
- profitable even if underlying price movement is limited
- Believe stock price will moderately increase –> Bull call spread (lower strike call) - straddles
- buying a put and a call on asset with same strike price and date
- sensible if you are sure underlying asset is volatile but not sure which way it will move
iv. use of options and futures
Describe the basis idea behind transition management
- Time passes and currently pf suboptimal
- investor identifies new optimal pf and makes revisions to current pf
- but transaction costs (brokerage, price impacts, b/o spread and possibly tax liabilities) and management and administration costs.
- May take time to transition
- So use derivatives to transition
iv. Uses of futures
Explain how futures can be used in transition management.
- Buying or selling futures contracts on stock market indices or treasury bonds
- (how futures help)
- switch (removal of exposure) implemented immediately in a liquid market thus lower dealing costs
- purchase right number of futures to achieve same re-weighting of effective exposure as from actual switch - if switch is for the long-term –> underlying securities bought and hold over extended period giving opportunities to buy and sell at favorable prices and so careful analysis for which shares to buy
- Short-term - use futures contract for tactical derivative overlay and maintain for whole duration –> if equities unmarketable then they will not be included in index which the future is based –> so cross hedging
v. Uses swaps
- List three uses of swaps
- State the two risks which each party is exposed.
Uses:
1. Match assets and liabilities (risk management - interest swaps and currency swaps (forward))
2. Lower the cost of borrowing
3. Transition management
Risks
1. Credit risk - risk that counterparty defaults
2. Market risk - risk that market conditions change so that present value of net outgo under swap increases
v. uses of currency swaps
List seven potential difficulties with using currency swaps to hedge currency movements.
- Extra cost of bid-offer spread compared with spot transactions
- Removes possibility of favorable currency movements
- counterparty credit risk
- mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials
- difficulty of hedging unknown future income
- can only easily hedge income stream
- available on fairly large principle amounts
v. Uses of inflation swaps
Describe how an institution can use inflation swaps to HEDGE risk.
- An institution which holds an asset that has an income stream that is linked to an inflation index is exposed to variations in future expectations of the level of inflation
- for longer dated inflation payments this can be a source of significant market risk
- An inflation swap allows a receiver of inflation–linked payments to pay these to a counterparty in return for receiving a fixed payment
- institutional investors such as pension funds, with inflation-linked liabilities, can use inflation swaps to received inflation and thereby hedge the market risk from uncertain future inflation within their liabilities.