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 incrase returns
• Arbitrage profits based on mis-pricings
• Portfolio management (in particular, transition management)
• Synthetically tracking an index
• Income enchangement - 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 ccertainty
• Cross hedging risk, which arises because asset underlyiing future differs from portfolio to be hedged

Question 3

List 5 possible advantages of using futures nad 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

In the context of options, define:

• Delta
• the hedging ratio

Answer 4

Delta of an option

• Meaures 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

Expain how an equity swap coudl 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 currenccy 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 cann be source of significant market risk
• an inflation swap allows a reciever of inflation - linked payments this can be a source of significant market risk
• an inflation swap allows a reciever of inflation linked payments to pay these to a counterparty in return for recieving a fixed payment
• Institutional investors such as pension funds, with inflation linked liabilities, can use inflaiton swaps to recieve inflation and thereby hedge the market risk from uncertain future inflation within their liabilities

Question 9

Give three practical problems with using forwards for currency hedging

Answer 9

• Can only be used to hedge expected cashflow from foreign currency asset, so hedge unlikely to be exact
• many invesetments are of longer term than contracts available in market so forwards have to be rolled over on expiry at unknown rate
• costs associated with forward contracts may be significant when attempting to hedge smaller amounts

Question 10

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

Answer 10

• Sensitivity analysis of portfolio to different factors, perhaps including alue at risk calculations
• LIst of individual derivatives used, each included within the relevant asset class
• any additiona lexplanations needed to ensure that fund’s exposure properly understood
• valuation of deriatives (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 11

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

Answer 11

• Possibility of shirting market prices
• time nedded to effect chagne and difficulty of making sure timing of deals is advantageous
• costs involved
• possible of crystallisation of capital gains leading to tax liability

Question 12

• Four different costs that may be incurred 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

Question 13

Four costs when making change to portfolio asset allocation​

• Reseach costs
• transaction costs (bid offer spread, commissions, stamp duty)
• adminstration 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 rebalancing portfolio

Question 14

List

• 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 14

Four costs when making change to portfolio asset allocation

• Research costs
• transaction costs (bid off psread, 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 cashflow as way of rebalancing portfolio