Chapter 23: Portfolio management (3)

Question 1

Main uses of swaps

Answer 1

• 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 2

Disadvantages of using currency swaps

Answer 2

• 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 3

Measure of interest rate risk

Answer 3

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 4

Real rate swap

Answer 4

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 5

Synthetic index-linked bonds

Answer 5

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

Question 6

Exchange-traded derivatives

Answer 6

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

Question 7

Over the counter (OTC) derivatives

Answer 7

• 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 8

Main uses of futures

Answer 8

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

Question 9

Risks when hedging

Answer 9

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

Hedging via options, you need to know the hedge ratio which is equal to the reciprocal of the delta of the option

• 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 10

Overlay strategy

Answer 10

An overlay strategy is an investment strategy that uses derivative investment vehicles to change a portfolio’s exposure

Question 11

What can ‘overlay’ strategies be used for?

Transition management using swaps

Answer 11

• 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 12

Main uses of options

Answer 12

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

Question 13

Covered call

Answer 13

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 14

Naked call

Answer 14

Write calls on assets you don’t own

• Extremely risky because max loss is unlimited

Question 15

Naked put

Answer 15

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

Question 16

Covered put

Answer 16

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

Question 17

Spread

Answer 17

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

Question 18

Straddles

Answer 18

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 19

Put on the interest rate futures

Answer 19

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

Question 20

Selling a call on interest rate futures

Answer 20

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 21

Interest rate collar

Answer 21

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 22

Forward currency contract

Answer 22

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

Question 23

Main problems hedging with currency forwards

Answer 23

• it is possible only to hedge expected returns
• 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
• it may be relatively expensive to hedge small cashflows (e.g. dividends)

Question 24

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

Answer 24

• 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

Question 25

Main problems with making large changes to the asset allocation

Answer 25

• 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

Question 26

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

Answer 26

• 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 27

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

Answer 27

• 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