Chapter 5: Derivatives and Structured Products

Question 1

List seven reasons why an investor may use derivatives as part of an investment strategy.

Answer 1

Reasons to use derivatives from an investor’s perspective

1. asset transactions (transition management) whereby exposure can be gained quickly through derivatives while a physical portfolio is built up more slowly
2. hedging, whereby exposure to an asset category is reduced through the use of derivatives. One of the main uses here is to manage currency exposure in institutional investment portfolios.
3. leverage transactions, whereby more exposure is gained to an underlying asset (such as long-term bonds) than can be easily achieved through the physical markets
4. long/short (market neutral) portfolios, whereby managers aim to achieve absolute returns and hedge market exposure
5. non-linear strategies which can be achieved through options, which give a more sophisticated payoff than traditional cash instruments
6. speculation can be carried out easily using derivatives 7. arbitrage to generate risk-free profits.

Question 2

List eight things that would be specified about a futures contract prior to trading.

Answer 2

Specifying a futures contract

1. the size of each contract
2. the units of price quotation
3. minimum price fluctuations
4. the ‘grade’
5. place for delivery (if the underlying asset is a physical asset such as a commodity)
6. any daily price limits
7. margin requirements
8. opening hours for trading

Question 3

List the four main advantages of using the CDS market to manage credit rather than using the corporate bond market itself.

Answer 3

Four main advantages of using the CDS market:

1. A greater range of durations is often available in CDS markets
2. Liquidity is typically greater
3. CDS’s are unfunded, enabling geared positions to be taken
4. CDS markets are more standardised.

Question 4

List the four main disadvantages of using the CDS market to manage credit rather than the corporate bond market itself.

Answer 4

The four main disadvantages of the CDS market:

1. Liquidity is dependent on the market makers making good markets, which can be problematic during times of market stress
2. The correlation between the prices of each is not stable during times of market stress – creating a basis risk
3. Collateral arrangements need to be made
4. Counterparty risk is introduced – though clearing houses are typically being used to remove this risk, eg using the London Clearing House.

Question 5

List the four main advantages of investing in a structured products such as a guaranteed equity fund, from the perspective of the investor.

Answer 5

Four main advantages of structured products such as guaranteed equity funds

1. Principal protection can be very attractive to some investors
2. Investors can obtain a very tailored investment return
3. They can be more tax-efficient than the underlying investments in some cases
4. Structured products typically have lower volatility than the underlying asset (eg equities), but with scope to participate in rising equity markets

Other advantages from earlier courses include:

1. practical for certain types of investor as an alternative to engaging in derivatives directly
2. requires no intervention or derivative rebalancing
3. may avoid complex legal or accounting issues

Question 6

List the four main disadvantages of investing in structured products such as guaranteed equity funds from the perspective of the investor.

Answer 6

Four main disadvantages of structured products such as guaranteed equity funds

1. Counterparty or credit risk (particularly if issued as an uncollateralised note)
2. Low liquidity – may need to unwind exposures pre-expiry, at investor’s cost
3. Complex underlying structure, with opaque pricing 4. Embedded fees can be high.

Other disadvantages included in earlier courses include:

1. pricing issues may cause problems
2. legal, accounting and tax issues still remain in many cases.

Question 7

List five roles of a clearing house (from Subject SP5).

Answer 7

Roles of a clearing house

1. counterparty to all trades
2. guarantor of all deals (removing credit risk)
3. registrar of deals
4. holder of deposited margin
5. facilitator of the marking to market process.

Question 8

Describe the term credit derivative

List the two most common types of credit derivatives.

Answer 8

Credit derivatives

Contracts where the payoff depends partly upon the creditworthiness of one (or more) commercial (or sovereign) bond issuers.

Two most common types:
1. credit default swaps (CDS)
2. credit spread options (CSO).

Question 9

Explain how a credit default swap (CDS) works.

Answer 9

Credit default swap (CDS): How it works

1. Contract that provides payment if particular credit event (usually default) occurs.
2. Party buying protection pays regular premium to party selling protection.
3. If credit event occurs within term of contract, payment made from seller to buyer.
4. If credit event doesn’t occur within term of contract, buyer receives no payment but has benefited from protection.
5. Settled via cash payment equal to fall in market price of defaulted security (cash settlement) or exchange of cash and security (physical settlement).
6. In either case, if value of defaulted bond is equal to recovery R, then net payment on default equals 100 - R .

Question 10

State what is meant by a credit-linked note (CLN).

Answer 10

Credit-linked note

1. Consists of basic security plus embedded credit default swap.
2. For example, long position in risk-free security plus short position in credit default swap.
3. Provides payments linked to credit experience of reference bond underlying the credit default swap.
4. Can be used to transfer credit risk from holder of risky reference bond to holder of credit-linked note.

Question 11

Explain with the aid of a simple example how a credit spread option works (CSO).

Answer 11

Credit spread option

1. An option on spread between yields earned on two assets, which provides payoff when spread exceeds some level (the strike spread).
2. The payoff is calculated as difference between value of bond with strike spread and market value of bond.
3. For example, a credit spread option might give holder the right, but not the obligation, to sell corporate bond on strike date and at price corresponding to strike spread of 1% above corresponding government bond yield.
4. It offers protection against widening of credit spread beyond strike spread.

Question 12

State how the following types of swap are structured:

1. zero-coupon swap
2. amortising swap
3. step-up swap
4. deferred or forward swap
5. constant maturity swap
6. extendable swap
7. puttable swap.

Answer 12

Types of swap strucutes
* * * * * *
1. Zero-coupon swap – each individual payment is traded separately.

2. Amortising swap – principal reduces in predetermined way.
3. Step-up swap – principal increases in predetermined way.
4. Deferred or forward swap – swap agreed now but doesn’t start until some future date.
5. Constant maturity swap – where the floating leg of the swap is for a longer maturity than the frequency of payments.
6. Extendable swap – one party has option to extend life of swap beyond specified period.
7. Puttable swap – one party has option to terminate swap early.

Question 13

Explain the difference between puttable and callable bonds.

Answer 13

Puttable and callable bonds

1. Puttable bonds give holder option to redeem them early (ie sell them back to issuer) at predetermined price on specified dates in future.
2. Callable bonds give issuer option to redeem them early (ie buy them back from holder) at predetermined price on specified dates in future.

Question 14

In the context of options, define:

1. delta
2. the hedge ratio.

Answer 14

Delta of an option (D):

D = ∂f / ∂S , where f is option price and S price of underlying asset.

Measures sensitivity of option price to small changes in price of underlying asset.

Hedge ratio:

Number of options needed to hedge each share. *
= 1/ D

NB! As delta changes through time, continual rebalancing required to remain delta-hedged.

Question 15

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

Answer 15

Five items to included when reporting on use of derivatives (#SLAVE)

1. Sensitivity analysis of portfolio to different factors, perhaps including value at risk calculations
2. List of individual derivatives used, each included within the relevant asset class
3. any Additional explanations needed to ensure that fund’s exposure properly understood
4. Valuation of derivatives (at market value)
5. resulting net Exposure of portfolio to different asset classes (& currencies), what it is and how it has been changed through use of derivatives.

Question 16

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

Answer 16

Four main problems when making large changes to the asset allocation (#MTCC)

1. possibility of shifting Market prices
2. Time needed to effect change and difficulty of making sure timing of deals is advantageous
3. Costs involved (research, transaction, administration, changing managers?)
4. possible Crystallisation of capital gains leading to tax liability

Remember MTCC.

Question 17

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 17

Four costs when making change to portfolio asset allocation

1. research costs
2. transaction costs (bid-offer spread, commissions, stamp duty) 3. administration costs (recording, settling, accounting)
3. costs of changing investment managers

Four ways transaction costs may be reduced in cash market

1. implementing transition in stages
2. share exchanges between old and new managers
3. crossing, whereby investment bank looks among its clients for buyers and sellers of stock
4. using investment of net cashflows as way of rebalancing portfolio