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FCA Paper 2: Derivatives > Chapter 8: Trading, Hedging and Investment Stratergies > Flashcards

Chapter 8: Trading, Hedging and Investment Stratergies Flashcards

16/100 Qs

1
Q

Intra-Market Spreads - what deriv, what is the same, what is different, anticipates changes in…

A
  • Trades with simulataneous buy/sell of futures with different expiry dates for the same UA.
    Reasons to enter into these trades
  • Anticipating changes in basis - (strengthen/weaken)
  • Reducing risk - less risky than outright positions but yeild less profit
  • Arbitrage - if the price is different for the same contract in different mkts
  • To roll over an existing hedge into the future - close the old future and buy a longer dated one
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2
Q

Inter-market spreads - type of deriv, what is same/different, why use

A
  • simultaneously buy/sell futures of DIFFERENT UAs.
  • These are traded when the relationship between the 2 different UAs has degreaded and there is an expectation that it willl become stronger again soon
  • Very common in IR products to speculate on IRs going up/down
  • Used to anticipate changes in financing costs from IR mvmts or to quickly change the asset allocation of a portfolio
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3
Q

Cheapest to deliver bonds hedging

A
  • long bond futures are used to hedge bond portfolios. In those futures the basket of underlying deliverable bonds will have 1 bond that is cheaper to deliver than the others (CTD).
  • Cheapest to deliver bond = bond with highest repo rate and the CTD is used to measure funding costs for futures contracts as the futures contract price will be closley linked to the CTD bond
  • When hedging bonds the CTD value has to be taken into account when working out home many futures are needed to hedge a position
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4
Q

No. fwds required to hedge a bond portfolio based on the cheapest to deliver bond calculation

A

No. contracts= price factor X (nominal value of CTD portfolio / nominal vale of the contract)

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5
Q

Calculation for number of contracts required to hedge a position with IR futures

A
  • Used when there is not a portfolio of CTD bonds

No. contracts = (nominal value of non-CTD portfolio X duration of portfolio) / (IR futures prices X Duration of the UA in the IR future)

Sometimes a minus sign is out infront of the no. contracts to indicate that it is a hedge

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6
Q

Hedge ratio calculation - beta
What is beta used to work out

A

Beta = Covariance (Rp, Rm) / Variance (Rm)
* Rp= return on stock portfolio
* Rm= return on overall stock mkt
* Beta is a stock’s volatility relative to the whole mkt

  • Beta is useful to calc how many contracts are needed to hedge a portfolio fully
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7
Q

Beta value meanings

A
  • Greater than 1 = more volatile than the mkt
  • 1 = in line with the mkt
  • Between 0 and 1 = less volatile than the mkt
  • 0 = no relationship
  • less than 0 = inverse relationship
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8
Q

STIR futures hedge ration - basis point

A

hedge ratio= price change in portfolio given a 1 basis point change in yield / price change in STIR futures given a 1 basis point change in yields

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9
Q

Basis, basis trading and basis risk - +/-s

A
  • Basis=difference between cash and futures prices
  • Basis risk = risk futures price will be different to the change in cash prices
  • Basis trading = using stratergies to profit from basis changes
  • disadvantages of changes in basis for hedgers are that auditors require an analysis of the hedge and it’s related cash position. If basis is volatile the auditor may require the hedge to be listed as a speculative deriv on the balance sheet
  • Advantages of changes in basis are for speculators and abrbitrage as volatility creates opportunity for profit. Also, basis trading has less price risk than outright trading.
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10
Q

Hedging Underlying long positions with options - and calc

A
  • Buy a put option to protect agianst price of the security being heddge from causing loss. Worked out by:
  • Value of underlying position/ (exercise price of option x price multiplier)
  • Sell a call option to protect against downward mvmt of a portfolio.
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11
Q

Hedging an underlying short position using options

A
  • buy a call option - make profit if the underlying price rises which will cancel out the loss from the short position
  • Sell a put option.
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12
Q

Key notes for hedging with options

A
  • Options hedges usually underperform due to the premium paid
  • more flexible than hedging with futures
  • Losses can be limited to the premium paid on the option
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13
Q

Covered short calls - what underlying positions, AKA, why use

A
  • combiines a long underlying (U) position with a short call position(you own the UA, and write the option on it). AKA buy-write stratergy
  • used to enhance returns in a stagnant market and partly hedge long U positions.
    Can make money with the follow
    1. the mkt remains stagnant = the option will not be exercised and the writer/asset holder gains the premium
    2. In a falling mkt = premium reduces the loss but ddoesn’t provide a true hedge as the gain is limited to the premium
    3. Rising mkt = overall gains are limited since the call will be exercised and gains over the strike will not be realised as the investor will now own the UA.,m
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14
Q

Covered short put- construction, why use

A

Constructed by
* Writing the put and holding the funds to buy the UA if required and
* Already having a short position (like being short the futures contract) then writting a put on the futures contract

  • Motivation to hold one is enhance returns in a stagnant mkt and partially hedge a short underlying position.
  • Does limit gains however as once exercised the writer no longer holds the asset and cannot benefit fron further price falls
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15
Q

Options spreads - what is an option spread and 3 types

A
  • Simultaneous purchase/sale of options o th same class (put/call) and of the same UA#
  • Vertical spread - buying/selling puts/calls with different strikesbut the same expiry date.
  • Horizontal (calendar) spread - buy/sell options with the same strike but different expiry month.
  • Diagonal (diagonal calendar) spread - buy/sell options with different strike and expiry month
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16
Q

Vertical spreads (options) - bull/bear spreads

A
  • attempt to profit from directional mvmt in U price.
  • Spreads are only either moderately bullish/bearish so can be split into bull spreads and bear spreads
  • Bull spread - inv. buys lower strike option and sells the higher strike.
  • Bear spread - sells lower strike option and buys the higher strike
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17
Q

Vertical spreads - bull call

A
  • Motivation - Moderately bullish
  • Construction - buy low strike, sell high strike option
  • Net premium - paid out
  • max risk - premium cost
  • max reward - difference between strike prices of the 2 options subtract the premium paid
  • break-even point - lower strike price + net premium paid

Bull call graph is a reverse Z shape and goes from low to high

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18
Q

Vertical spreads - bear call

A
  • Motivation - Moderately bearish
  • Construction - sell at low strike, buy at high strike
  • Net premium - recievd
  • max risk - difference in strike - net premium
  • max reward - net premium recieved
  • break-even point - lower strike price + net premium

Bear call graph slopes downwards in teh reverse Z shape

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19
Q

Vertical spread - bull put

A
  • Motivation - Moderately bullish
  • Construction - buy at a lower strike, sell higher strike
  • Net premium - recieved
  • max risk - difference in strike price - net premium recieved
  • max reward - net premium
  • break-even point - higher strike price - net premium

Bull put graph the same shape as bull call graph

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20
Q

Vertical spread - bear put

A
  • Motivation - moderately bearish
  • Construction - sell at lower strike and buy at higher strike
  • Net premium - paid out
  • max risk - net premium paid
  • max reward - difference in strike prices - premium paid
  • break-even point - higher strike price - net premum paid

Bear put graph same as the bear call graph

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21
Q

Horizontal spreads - 2 types

A
  • Motivated by expected moves in volatility
    2 types
  • View that volatility will rise = sell shorter term options and buying longer maturity options of the same UA with the same strike. Takes advantage of the fact short dated options lose their time value faster and therefore react moe quickly to falls in volatility than the longer dated option
  • View that volatility (short term) will rise - buy a shorter dated option and sell the long dated with the same UA and strike price. Used regularly before key announcements like earnings to take advanatge of any short term high volatility
22
Q

Diagonal spreads - take advantage of what

A
  • Directional depending on the market view. Constructed with call options (if bullish) or puts (if bearish) by selling short dated options and buying long dated and OTM options. Use options with different expiry months
  • Bullish and bearish stratergies take advantage of the rate of time decayfor options with different expiries, so the trades are desgined to take advantage of the change in volatility as the option approaches expriy
23
Q

Options combinations - straddles, strangles, longs etc

A
  • Simultaneous purchase/sale of calls and puts
  • Common stratergies are straddles and strangles which aim to profit from a change of volatility on the UA
  • Straddle = uses a put and a call with the same strike and expiry
  • Strangles = same as a straddle but each leg has a different strike price
  • Long positions expect and increase in volatility, short assume a decrease.
24
Q

Long Straddle

A
  • Buys a put and a call around a time of expected volatility (earning calls etc) so the investor profits if the price goes up or if it goes down.
  • The returns for the price movement must return more than the net premiums paid.
  • So if in the event of an earnings announcement the news is good or bad the investor will abandon 1 of the options and exercise the other.
  • Has 2 break even points, an upside and downside break even
    *
25
Q

Long straddle profile

A
  • motivation - expected increase in volatility
  • Construction - buy a call and a put with the same strike and expiry
  • Max. risk - total sum of premiums paid
  • Max. reward - unlimited
  • Break even:
    1. Downside - strike price - total premium
    2. upside - strike + total premium paid
26
Q

Short straddle

A
  • for an investor who is unsure which direction prices will move but are sure the price won’t differ much for the current price
  • Sells a call and a put = shortt straddle
  • If the price moves outside of the strike price+net premium for price going up or strike- premium for going down, the short seller will make a loss as the investor will exercise one of the options and the premium will not cover the cost of the asset so they will make a loss.
  • Low volatility is expected from the shoort seller here
27
Q

Short straddle - profile

A
  • motivation - expectation of a decrease in volatility
  • Construction - sell a call and a put with the same strike price and expiry
  • Max. risk - unlimited
  • Max. reward - limited to the sum of teh premiums recieved
  • Break even:
    1. Downside - exercise price -premiums
    2. upside - exercise price + premiums
28
Q

Long Strangle difference to a long straddle

A
  • Strangles purchase a put and a call with the same expiry and different strike price (put strike usually lower than the call strike)
  • Premium outlay is usually lower on a strangle
  • Strangles need more volatility to be successful as the net premium cost and the difference in strike prices both need to be exceeded to make profit
  • Max loss on a long strangle is crystalised over a range of the 2 strikes where neither option is worth exercising
29
Q

Long strangle profile

A
  • motivation - expected LARGE increase in volatility
  • Construction - buy a call and a put with the same expriy and different strike
  • Max. risk - total sum of premiums paid
  • Max. reward - unlimited
  • Break even:
    1. Downside - lower strike price - total premium
    2. upside - higher strike strike + total premium paid
30
Q

Short strangle features compareed to a short straddle

A
  • Strangle involves sale of a call and put with the same expiry but different strike
  • Lower premium recieved on the strangle
  • Strangles can withsatand more volatility before losses are incurred than straddles as to have a profit, returns must exceed the sum of premiums and difference in strike price
  • Max. Profits are crystalised in a certain range of strike prices where neither option is worht exercising and teh seller keeps the premium.
31
Q

Short strangle profile

A
  • motivation - expectation of a LARGE decrease in volatility
  • Construction - sell a call and a put with a different strike price and same expiry
  • Max. risk - unlimited
  • Max. reward - limited to the sum of teh premiums recieved
  • Break even:
    1. Downside - lower strike price -premiums
    2. upside - higher strike price + premiums
32
Q

6 basic Synthetics

A
  • synthetic positions are created when futures and options are combined
    1. Synthetic long future - buy call + sell put with same price and expiry - AKA reversal
    2. Synthetic short future - sell call + buy put with same price and expiry - AKA conversion
    3. Synthetic long call - buy future + buy put = synthetic hedged long position
    4. synthetic short call - sell future + sell put = basically short call
    5. Synthetic long put - buy a call + sell future = hedged short position
    6. Synthetic short put - sell call + buy future = short put position

synthetics are used to create positions that might not otherwise be available on the actual UA (for example no futures on crude oil so uses options to create a synthetic)

33
Q

Main reason to use synthetics

A
  • Arbitrage
  • If put/call parity is out of line on the UA investors can lock in riskless profit
  • Both OTC and exchanged traded derivs in the stratergy, typically both. usually the product is chosen on the use of the stratergy = if a hedge, OTCs would be better as they are more flexible.
34
Q

Indirect investment in derivatives mkts

A
  • most investors won’t deal directly with derivatives but some products indirectly use derivatives like:
  • Accounts where (UHNW/UHNW individuals) give money to fund managers who manage i on their behalf and have access to F&O products
  • Pooled funds - CISs can use derivatives
35
Q

Investment style of derivatives based funds - 3 types

A
  1. Speculative - highlly geared, high risk high return. Clients can’t lose more than invested
  2. Guaranteed - investors are locked in for a period but are guaranteed to recieve all of their funds back (or a specified amount at least). Usually use low risk securities like ZCBs and then options. Low liquidity due to lock up period and high fees due to active mgmt
  3. Synthetics - funds designed to replicate the the performance of an index. usually invest capital in risk free deposits and futures. No gearing as the futures positions are fully cash backed.
36
Q

Retail client investment/portfolios use of derivs

A
  • Provided the highest level of protection by regulators/fin. institutions (unless they get MiFID classifies an opt-up professional)
  • Usage can differ to none at all to limited hedging./speculation positions
  • KYC checks on retail clients are used to classify them and ensure they are marketed/have access to the right products
  • Certain speculative positons are restricted to retail clients
37
Q

Individual portfolios use of derivs

A
  • For high or ultra high NWIs - at least $1million wealth exclding their house or annual income of $200,000 in the US.
  • UK = Min income of £100K or net assets of £250.000
  • Due to higher capital the client is less restricted than normal retail clients an tend to have higher risk tolerance for speculative prods
  • Restrictions usually come from banks/brokers based on whether they have capital to meet margin calls etc
38
Q

Institutional asset managers

A
  • Fund mangers use derivs to speculate and hedge to increase returns for the fund
  • prospectus outlines the use of these prods
  • Can use derivtives more but they have tto report it and manage postions based on their guidelines
  • More conservative with derivs than hedge funds
  • Also used when clients want to leave the fund - managers liquidate the client’s positions and use teh cash as margin for derivs to track a benchmark
39
Q

Corporate treasurers

A
  • corp treasurers can use dervis as hedges to reduce risk like buying/selling futures to reduce risk of price mvmts
  • Mining companies might sell coal futures to lock in their price now
  • Options can be used to reduce currency risk
40
Q

Hedge funds

A
  • use of derivs will range for hedging to highly specullative geard positions
41
Q

Sovereign wealth funds

A
  • parameters of what prods SWFs can use vary depending on each fund.
  • Can often be tied up in private infrastructure and equity
  • Some countries use SWF to diversify their national income stream - Saudi Arabia has one to diversify away from oil
  • Norway Government pension fund global is the largest SWF at $1.338 trillion
42
Q

Robo advisors

A
  • Automate creating and managing portfolios with no direct human contact
  • Use algorithms and a set of data submitted by the client (risk, time scale amount of £) and creates a stratergy
    • provide professional advise for low cost
  • Increasing use of AI
  • Mostly serve the retail mkt with basic portfolios but complex derviatives are becoming more common.
43
Q

DONE!

A
44
Q

Synthetic long future

A

Buy call + sell put with the same price and expiry

AKA reversal

45
Q

Synthetic short future AKA

A

Sell call + buy put at the same price and expiry date

AKA conversion

46
Q

Synthetic long call

A
  • Buy future and buy a put = synthetic hedged long position
47
Q

Synthetic short call

A
  • sell future + sell put = synthetic short call
48
Q

Synthetic long put

A

Buy a call + sell future = hedged short position

49
Q

Synthetic short put

A

Sell call + buy future = short put

50
Q
A
51
Q

Hedging a long underling using bonds - calculation

A

Market price / (number of contracts X price per point or tick size) =no. Contracts

**NOTE - if beta is more than 1 MULTIPLY the answer by the beta

FCA Paper 2: Derivatives (9 decks)

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