Chapter 23: Portfolio Management (3)

Question 1

List the six main uses of futures and options in portfolio management

Answer 1

Hedging to reduce the market risk
Speculate to increase returns
Arbitrage profits based on mis-pricing
Portfolio management (in particular, transition management)
Synthetically tracking an index
Income enchantment - writing options only

Question 2

Outline the two risks that remain when using futures to hedge

Answer 2

Basis risk, which arises because basis of future (difference between spot and future price) cannot be predicted with certainty

Cross hedging risk, which arises because asset underlying future differs from portfolio to be hedge

Question 3

List 5 possible advantages of using futures and options to speculate, rather than dealing in the cash markets

Answer 3

Lower transaction costs

ability to implement larger deals due to greater liquidity

ability to gear up investment returns

ability to speculate on market fails if unable to sell short, eg by buying puts

options can be used to speculate on volatility, ie extent as well as direction of price movement

Question 4

n the context of options, define:

Delta
the hedging ratio

Answer 4

Delta of an option

Measures the sensitivity of option price to small changes in price of underlying asset
Hedge ratio

Number of options needed to hedge each share

Question 5

LIst 3 main uses of swaps

state the two risks to which each party to a swap is exposed

Answer 5

Three main uses of swaps

Matching assets and liabilities eg fixed to floating and or currencies

reducing cost of borrowing - based on principle of comparative advantage

transition management, ie swapping exposure between different asset classes without distrubing underlying assets

Two risks to which each party to swap is exposed

Credit risk - risk that counterparty to swap defaults

Markets risk - risk that market conditions change so that present value of net outgo under swap increases

Question 6

Explain how an equity swap could be used to swap exposure from equities to bonds

Answer 6

Investor long in euqities agrees to pay stream of variable size cash payments based on return on agreed stock market index

in return, counterparty agrees to pay stream of fixed size cash payments based on current bond yields

investor has, in essence, sold shares and brought bonds, while counterparty has sold bonds and bought shares

Question 7

List seven potential difficulties with using currency swaps to hedge currency movements

Answer 7

Extra cost of bid offer spread compared with spot currency transaction

removes possibility of favourable currency movements

counterpary credit risk

mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials

difficulty of hedging unknown future income

can only be easily hedge level income stream

available only on fairly large principal amounts

Question 8

Describe how an institution can use an inflation swap to hedge risk

Answer 8

An institution which hold 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 -linked payments this can be 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 receive inflation and thereby hedge the market risk from uncertain future inflation within their liabilities

Question 9

List 5 items that should be included when reporting to senior management on the use of derivatives

Answer 9

Sensitivity analysis of portfolio to different factors, perhaps including value at risk calculations

List of individual derivatives used, each included within the relevant asset class

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

valuation of derivatives (at market value)

resulting net exposure of portfolio to different asset classes (and currencies), what it is and how it has been changed through use of derivatives

Question 10

List the four main problems when making large changes to the asset allocation

Answer 10

Possibility of shirting market prices

time needed to effect change and difficulty of making sure timing of deals is advantageous

costs involved
possible of crystallisation of capital gains leading to tax liability

Question 11

Four different costs that may be incurred when making a change to the portfolio asset allocation

Four ways in which transaction costs may be reduced in the cash market

Answer 11

Four costs when making change to portfolio asset allocation​

Research costs
transaction costs (bid offer spread, commissions, stamp duty)

administration costs

costs of changing investment managers

Four ways transaction costs may be reduced in cash market

Implementing transition in stages

share exchanges between old and new managers

crossing, whereby investment bank looks among its clients for buyers and sellers of stock

using investment of net cashflows as way of re balancing portfolio