Chapter 23: Portfolio management (3)

Question 1

Derivatives can be used to:

Answer 1

• manage and/or mitigate some of the risks an investor faces
• generate additional investment returns, typically by taking on additional risks
• carry out switches between different assets, whilst avoiding some of the costs and difficulties associated with buying and selling the underlying asset

Question 2

Main uses of swaps

Answer 2

• risk management - i.e. matching assets and liabilities
• reducing the cost of borrowing
• swapping exposure between different asset classes without disturbing the underlying assets (aka transition management)

Question 3

Disadvantages of using currency swaps

Answer 3

• extra cost of the bid-offer spread compared with a straight spot currency transaction
• removing the possibility of favourable currency movements
• introduction of 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 a level income stream
• are only available on large principal amounts

Question 4

Measure of interest rate risk

Answer 4

PV01 which represents the change in value of fixed payments under a 1 bps move in interest rates at all maturities

DV01 is equivalent UD$ measure

Question 5

How do swaps reduce the cost of borrowing?

Answer 5

• Based on the principal of comparative advantage (one company advantage in borrowing at fixed and other at floating)
• Comparative advantage implies companies’ relative credit ratings are different in the long and short-term debt markets

Similar situation may exist when borrowing in different currencies

Question 6

Risks faced by both counterparties of a swap

Answer 6

• Market risk – market conditions change so that the PV of the net outgo under the agreement increases
• Credit risk – the other counterparty will default on its payments

Question 7

Real rate swap

Answer 7

Invest assets in portfolio of fixed-rate corporate bonds and swap the fixed cashflows from the corporate bond in return for cashflows that match timing & inflation characteristics of liabilities

Question 8

Synthetic index-linked bonds

Answer 8

Variation of real interest rate swap but asset flows are chosen to mirror proceeds from notional portfolio of index-linked gilts rather than actual liabilities

Question 9

Exchange-traded derivatives

Answer 9

Focus on standardised derivatives where there are high levels of supply and demand = high levels of liquidity

Question 10

Over the counter (OTC) derivatives

Answer 10

• Bilateral transaction between two parties with each party exposed to credit risk in respect of their counterparty to the trade
• Generally mitigated through collateralisation – party who is out of the money required to provide collateral in respect of their loss-making position
• Collateral typically in form of cash or high-quality bonds which are subject to haircuts
• Significantly less liquid and transparent than exchange-traded derivatives

Question 11

Main uses of futures

Answer 11

• hedging
• speculation
• arbitrage
• transition management
• synthetic index tracking

Question 12

Using financial futures to hedge

Answer 12

• Involves taking a position in the future (long/short) which is opposite to the position held in the cash market = reducing risk.
• Loss/profit made in the cash market offset by profit/loss in futures market

Protecting against a fall in the equity market
- Protect against market fall by selling index futures with contract size equal to the size of the portfolio. The equities have effectively been sold in the future at a fixed price
- Useful fund going to disinvest large sum of money in few months and wants to avoid future risk
- Used when manager feels market is looking overpriced and vulnerable to a fall

Protecting against rises in bond yields (Similar approach can be used with bonds)

• Complication – bond future may be based on a relatively long and hence volatile bond => hedge ratio needs to be reduced in proportion to the volatility of the bond to the volatility of the portfolio to be hedged

Protecting against a rise in the market

• Investor expecting large cash inflow in future – wish to protect against rise in market by buying futures

Question 13

Risks when hedging

Answer 13

Basis risk – although the price of the future follows the cash price closely, the basis may not move exactly as expected

Cross hedging risk – unless the portfolio to be hedged behaves exactly the same as the underlying index, hedge will not be perfect

• Hedge ratio has been calculated to allow for the different volatility of a bond portfolio & the notional bond, there is a danger that the yield curve changes shape so the bond prices don’t move in proportion to their volatility

Question 14

Transition management and asset allocation techniques

Answer 14

• Transition management using standardised/simple derivatives
• Transition management using swaps

Question 15

Transition management using standardised/simple derivatives

Answer 15

• Economically more attractive to revise portfolios by transacting in entire asset classes instead of individual securities
• Take long futures position in index = ‘synthetic’ holding of the market portfolio

Question 16

Transition management using swaps

Answer 16

• More flexible strategy.
• Example: Entering an equity swap – one party agrees to pay variable payments based on return on an agreed stock market index and other party agrees to pay stream of fixed size cash payments based on current interest rates. Essentially, first part has sold stocks & bought bonds and the other has sold bonds & bought stocks
• Can be modified to provide international diversification or move between market sectors
• Swap deals can be reversed (mutually acceptable cash settlement) or closed out by arranging further offsetting deal.
• Temporary measure to alter nature of portfolio while appropriate stock sales and purchases researched, and suitable trades arranged

Question 17

What can ‘overlay’ strategies be used for?

Transition management using swaps

Answer 17

• obtain immediate re-allocation of funds between asset categories
• a means of altering the portfolio structure on a medium term basis
• change the nature (i.e. fixed/floating) and/or duration of a fixed interest portfolio
• obtain international diversification

Question 18

Matching long-term liabilities (immunisation)

Answer 18

• Dealt on margin, the return from holding futures is volatile.
• Bond futures can be used to match long-term liabilities thus overcoming major limitation of the bond cash market

Question 19

Consolidating stock selection profits

Answer 19

Can eliminate any profit/loss from market movements leaving only their stock selection profit/loss by selling index futures at same time as buying individual securities

Question 20

Main uses of options

Answer 20

• hedging
• income enhancement
• trading or speculating
• arbitrage
• portfolio (or transition) management

Question 21

Using options to hedge

Answer 21

Protecting against a fall in the market (protective put)

• Buying put options on asset the minimum value of the combined holding can be fixed at exercise price of the option
• Value of asset goes up – profit reduced by option premium = portfolio insurance
• Hedge ratio = reciprocal of delta of the option

Protecting against a rise in the market

• Buying a call = benefit if prices rise a lot
• Useful if expecting a cash inflow and don’t want to risk prices rising

Protecting against interest rate changes

• Buying a put on the interest rate future – cap can be put on the interest rate to be paid for future borrowing while still benefitting from falls in rates
• Establish interest rate collar = set a max and min interest rate by buying interest rate put and calls

Question 22

Using options for income enhancement

Answer 22

• Covered call
• Naked call
• Naked put

Question 23

Covered call

Answer 23

Increase income of fund by writing call options on assets.

• Flat/falling markets this enhances performance of fund relative to similar funds which haven’t executed this strategy.
• Cost of strategy = sacrifice potential gains above exercise price would’ve been made if market rose

Question 24

Naked call

Answer 24

Write calls on assets you don’t own

• Extremely risky because max loss is unlimited

Question 25

Naked put

Answer 25

• Risky, although maximum loss is limited to exercise price less premium

Question 26

Covered put

Answer 26

Covered put doesn’t really exist (except if holding cash equal to strike price) because can’t be short of the asset

Question 27

Spread

Answer 27

Simultaneously buying & selling calls (or puts) on same underlying asset with different exercise prices or maturity

Question 28

Straddles

Answer 28

Buying a put and a call on the underling asset with the same exercise price and expiry date

Believe the share price could be volatile and go up or down, but is not sure which way

Question 29

Put on the interest rate futures

Answer 29

Cap on the interest rate to be paid for future borrowing, while still benefiting from any fall in rates

Question 30

Selling a call on interest rate futures

Answer 30

Loss on contract from a fall in interest rates is offset with the benefit of having lower interest rates on future borrowing

Thus, sets a minimum interest rate for borrowing

Question 31

Interest rate collar

Answer 31

Set a max and min interest rate by buying puts and selling calls - to borrow at

Do the opposite if you are the one lending money

Question 32

Portfolio (or transition) management using options

Answer 32

• Call options = exposure to upside movement in price of underlying & put options remove exposure to downside risk
• Calls & puts on different assets can combine & change fund’s exposure across asset classes/ within asset categories

Question 33

Forward currency contract

Answer 33

Agreement to exchange currencies at specified date in future at a fixed rate now

Question 34

How is the forward currency market efficient?

Answer 34

Market is efficient in the sense that the cost of buying one currency directly with another is same as cost of buying currency indirectly via a third (ignoring dealing costs)

Question 35

Costs of using forwards to hedge currency risk

Answer 35

• Remove possibility of appreciation of foreign currency which would increase domestic value of investment/income
• Bid/offer spread on forward deals is normally a little more than spread on spot market transactions so there is a small additional cost of using forwards

Question 36

Limitations of using currency as an asset

Answer 36

Institutional investors with liabilities denominated in the domestic currency will:

• Invest majority of the fund in domestic assets
• Invest minority of fund in overseas assets with most of currency risk hedged
• Rarey invest in domestic assets and speculate using forward currency deals

Most overseas exposure by institutional investors goes unhedged

Question 37

Main reasons why institutional investors invest overseas and whether currency hedging helps in each case

Answer 37

1. Maximising returns - hedging has small cost, which should reduce expected returns
2. Diversification - exposure to overseas investments adds extra dimension to diversification which hedging removes
3. Overseas liabilities - hedging introduces a mismatch
4. Hedging domestic inflation - the argument is that currency movements will compensate for differential inflation rates. Hedging removes this benefit because the forward exchange rate is locked in and you no longer get protection from unexpected inflation

Question 38

Practical problems with forwards

Answer 38

• An investor who holds overseas investment which gives uncertain return can only hedge the amount of the expected return. Investor still exposed to some foreign exchange risk.
• Main problem: many investments are of a longer term than contracts available in the market. Forward contracts will need to be rolled over on expiry at unknown rate
• Costs associated with forward contracts: dealing costs are low, but may be significant when attempting to hedge smaller amounts, e.g. dividends

Question 39

Main disadvantages of using forwards to hedge currencies

Answer 39

• extra cost of the bid-offer spread compared with a straight spot currency transaction
• need to rollover short-term forwards to remain hedged over longer periods
• removing the possibility of favourable currency movements
• introduction of counterparty credit risk if contract not centrally cleared
• mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials
• difficulty of hedging unknown future income

Question 40

To reduce the risk associated with derivatives, appropriate reporting of exposure is important. This should include:

Answer 40

• Listing derivatives individually in intelligible way within portfolio valuations (and directly under other holdings in relevant asset or assets)
• Valuing the derivatives at market value (marking-to-market)
• Including any additional explanations needed to ensure fund’s exposure is properly understood

Made clear where fund’s exposure to different asset classes has been changed though use of futures/swaps and what associated economic exposure is

Reporting on options – written explanation of strategy employed should be given

• Where use of options is material – subsidiary option sensitivity analysis should be included.

Question 41

Main problems with making changes to the asset allocation

Answer 41

• Possibility of shifting market prices (On sale of existing portfolio & purchase of new assets)
• Time needed to effect the change and difficulty of ensuring the timing of deals is advantageous
• Dealing costs involved
• Possibility of crystallisation of capital gains leading to a tax liability

Problems particularly severe when unmarketable assets are involved or where normal market size for deals in the assets is small

• These problems need to be considered when asset allocation decision is made

Question 42

Why derivative contracts may be effective in enabling a more efficient change in asset allocation

Answer 42

• investors can create large exposure through derivatives
• the main derivatives markets are well-developed (i.e. efficient and very liquid)
• dealing expenses are usually much lower
• positions can be taken quickly, allowing more time to change the exposure in the underlying cash market

Question 43

How can transaction costs for transactions in the cash market be reduced?

Answer 43

• Implementing the transition in stages, rather than attempting it immediately
• Investigating share exchanges between old and new managers
• Investigating crossing, whereby an investment bank looks among its clients for buyers & sellers of stock
• Using investment of cashflows as a way of rebalancing the portfolio

Question 44

Share exchanges between old and new managers

Answer 44

Involves transferring a holding between the fund management company that originally managed the fund and the fund management company that is taking over management of the fund

If the old company still likes the existing shares holdings, they may well be open to “buying” them from the new manager in exchange for some shares that they have elsewhere that they would be happy to sell at the current price

By avoiding the market, they both avoid bid/offer spreads and commissions

Question 45

Crossing

Answer 45

Whereby an investment bank looks among its (fund manager) clients for buyers and sellers of stock

Often large holdings of stock can be disposed of more easily and cheaply

Question 46

Costs and benefits of a financial proposal

Answer 46

Need to be fully evaluated

Full analysis of proposal will consider:

• Immediate costs and benefits
• Changes in the risk profile
• Operational work involved in implementing the proposed solution

Different solutions to problem can be compared with each other and with simply accepting the risk