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CISI: Derivatives > Chapter 8: Trading, Hedging and Investment Strategies > Flashcards

Chapter 8: Trading, Hedging and Investment Strategies Flashcards

1
Q

What is a structured product?

A

Investment strategy that is based on derivatives

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2
Q

What is a futures spread?

A

Simultaneously buying and selling futures contracts

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3
Q

What are Intra-Market Spreads?

A

Buying and selling of futures with different expiry dates but the same underlying asset

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4
Q

Why would a trader enter an intra-market spread? (4)

A

Anticipating changes in the basis
Reducing risk
Arbitrage (buy one exchange and sell another)
Roll over existing hedge to a new expiry date

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5
Q

What is an inter-market spread?

A

Buying and selling futures on different (but correlated) assets

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6
Q

Why would a trader enter a inter-market spread? (3)

A

If the price relationship between the two assets has broken down and the trader expects a return to baseline
Hedging
Changing asset allocation in portfolio

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7
Q

Where are Inter-Market spreads popular and why?

A

Interest rate markets, allows traders to bet on relationship between short and long term interest rates (yield curve)

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8
Q

How could a fund manager look to reduce their long equities exposure by selling some shares and use the sale proceeds to buy bonds - without trading the actual securities?

A

By using the futures market (eg, selling FTSE 100 futures and buying long gilt futures), it is possible to produce the same effect without the need to trade the actual securities.

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9
Q

What is the difference between intra and inter market spreads?

A

Intra - Same asset different expiry
Inter - Different asset

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10
Q

What do intra and inter mean and how to they represent the difference in spread?

A
  • Intra (‘within’) = underlying assets are the same.
  • Inter (‘between’) = underlying assets are different.
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11
Q

How do hedgers offset price risk?

A

By taking an opposite position in the futures market

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12
Q

What will affect the performance of a hedge?

A

Basis changes

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13
Q

What is the cheapest to deliver (CTD)?

A

A long bond futures contract contains a basket of deliverable bonds
The cheapest one to deliver is know as the CTD bond

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14
Q

What is the implied repo rate?

A

Measure of the funding cost implied in futures prices
Reflects difference between cash price and price of futures contract

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15
Q

What will be the implied repo rate of the CTD bond?

A

The highest in the basket of bonds in the futures contract

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16
Q

Which bond do they use in the portfolio to calculate the number of contracts needed to hedge?

A

The CTD, cheapest to deliver

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17
Q

What is the formula for number of contracts to hedge for bonds?

A

price factor * (nominal value of the CTD portfolio) / (nominal value of the contract)

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18
Q

What hedging method is used if you do not have a portfolio of CTD bonds?

A

duration based hedge ratios

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19
Q

What is the formula to calculate the hedge ratio for CTD bonds?

A

Number of contracts = (P* DP) / (FC * DF)
Where P = Nominal value of portfolio
DP = Duration of portfolio
FC = Interest-rate futures price
DF = Duration of the underlying asset in the interest rate future

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20
Q

What is a stock or portfolios beta?

A

Its volatility relative to the entire market

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21
Q

What is the calculation for beta?

A

Beta = Covariance (Rp, Rm) / Variance (Rm)
Where
Rp = Return of stock / portfolio
Rm - Return of overall market, usually index

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22
Q

What if the beta is?
More than 1
Equal to 1
Between 1 and 0
Equal to 0
Less than 0

A

More than 1 = the stock or portfolio is more volatile than the market
Equal to 1 = in line with the market
Between 0 and 1 = less volatile than the market
Equal to 0 = no relationship
Less than 0 = inverse relationship

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23
Q

What is the calculation for beta in simple word terms

A

Covariance of return of stock and market
over
Variance of return of market

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24
Q

Why is beta useful when using futures to hedge an equity porfolio?

A

Calculate how many contracts you need for the portfolio to be fully hedged

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25
Q

Why is the formula different for STIR (short-term interest rate) futures?

A

It’s dependent on the relative change in portfolio and STIR prices given one basis-point change in yields

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26
Q

What is the hedge ratio for STIR futures calculation?

A

Price change in portfolio given one basis point change in yields /
Price change in STIR futures given one basis point change in yields

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27
Q

What is basis?

A

The difference between the cash and the futures price

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28
Q

What is basis risk?

A

That the change in future prices will be different to the changes in the cash price

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29
Q

What is basis trading?

A

Strategies to profit from anticipated basis changes

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30
Q

Who has the biggest disadvantage in basis changes?

A

Hedgers
If futures are used to hedge cash positions, basis changes mean that the hedge will become less efficient

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31
Q

Who has the biggest advantage in basis changes?

A

Speculators and arbitrageurs

32
Q

What is the efficiency of hedging using options based on?

A

Whether the delta of the option position mirrors the delta of the position, creating a delta neutral portfolio
E.g. +0.5 delta pos, and -0.5 options is good

33
Q

What are the deltas? (long only)
Long underlying
Long future
Long call (deep ITM)
Long call (ATM)
Long put (deep ITM)
Long put (ATM)

A

Long underlying = +1
Long future = +1
Long call (deep ITM) = +1
Long call (ATM) = +0.5
Long put (deep ITM) = -1
Long put (ATM) = -0.5

34
Q

What is the delta of an option ATM?

A

+- 0.5

35
Q

How does a futures hedge performance differ to a options hedge?

A

Futures will always outperform as options have premium paid

36
Q

What does an options hedge provide that a futures does not?

A

Flexibility
Profits can still be made even if underlying moves in an investors favour as loss is limited to premium paid

37
Q

What is a buy-write strategy?

A

Covered option, own underlying

38
Q

What is the same class of options on an options spread?

A

Same contract type and underlying
E.g. buy put and sell put on AAPL

39
Q

How do you construct a covered short put?

A

Writing a put and having sufficient funds to buy the asset if necessary
Having a short position

40
Q

What is an options spread?

A

Simultaneous buying and selling of options in the same class

41
Q

What are the three different types of options spread?

A

Vertical spread
Horizontal or calendar spread
Diagonal spread

42
Q

What is a vertical spread?

A

Buying and selling calls (or puts) with different strikes but same expiry

43
Q

What is a horizontal spread?

A

Buying and selling calls (or puts) with same strike but different expiry

44
Q

What is a diagonal spread?

A

Buying and selling calls (or puts) with different strikes and different expiry

45
Q

How do you set up a bull and bear spread?

A

Bull spread - buys lower strike, sells the higher strike
Bear spread - sells lower strike, buys higher strike

46
Q

What are horizontal spreads motivated by?

A

Expected moves in volatility

47
Q

What horizontal spread will you do if volatility is expected to increase in the long term?

A

Sell shorter maturity, buy longer maturity on same asset / strike

48
Q

How does sell shorter maturity, buy longer maturity work for expecting volatility to increase?

A

Short dated options will lose their time value faster then longer dated options. This means they will react more quickly to a fall in volatility.
Basically isolating volatility as a factor
Longer dated options will increase more

49
Q

What horizontal spread will you do if volatility is expected to increase in the short term?

A

Buy shorter maturity, sell longer maturity on same asset / strike

50
Q

What are diagonal trades designed to take advantage of?

A

Changes in volatility

51
Q

How are diagonal spreads structured?

A

Puts or Calls
sell short dated, buy long dated
diff strikes and expiry

52
Q

What is the difference between a straddle and a strangle?

A

Straddles are put and call with same strike and expiry
Strangles are put and call with different strike and expiry

53
Q

What are the two different combination strategies?

A

Straddle and strangle

54
Q

What would would a trader want to happen if entering a short straddle or strangle strategy

A

Decrease in volatility

55
Q

Which combination strategy will usually have a higher premium outlay for?

A

Strangle

56
Q

Which combination strategy needs more volatility to succeed and why?

A

Strangle
higher premiums
difference in strike prices needs to be overcome

57
Q

What is the difference between the maximum loss (on a long) or gain (on a short) for a strangle versus a straddle

A

Straddle has a precipice, one price where you will have maximum gain/loss
Strangle has a range of price where you will have max gain/loss

58
Q

Which combination strategy will have a higher total premium received?

A

Straddle

59
Q

How do you create positions synthetically?

A

Combining futures and options

60
Q

How would you create a synthetic future, long and short?

A

Same strike and expiry for all
Long future - buy a call and sell a put
Short future - sell a call and buy a put

61
Q

How would you create a synthetic call, long and short?

A

Long call - buy a future and buy a put
Short call - sell a future and sell a put

62
Q

How would you create a synthetic put, long and short?

A

Long put - buy a call and sell a future
Short put - sell a call and buy a future

63
Q

What is the main reason for using synthetics?

A

Arbitrage

64
Q

How is arbitrage achieved with synthetics?

A

Put/call parity formula defines relationship of premiums and asset price
If call and put premiums are out of line you can lock in riskless profits using synthetics

65
Q

What are the advantages of OTCs over ETDs? (2)

A

Flexible contracts to fit exposure
No margin required

66
Q

What are the advantages of ETDs over OTCs? (3)

A

More liquid
Full price transparency
CP risk limited

67
Q

What are the disadvantages of ETDs? (2)

A

Margin payments
Standardised contracts

68
Q

What are the disadvantages of OTCs? (3)

A

CP risk
Limited price transparency
Higher costs

69
Q

What are the two main routes for investors waiting to invest in derivatives?

A

Accounts - client entrusts money to a regulated firm
Pooled funds - collective investment scheme managed by fund companies

70
Q

What are the three main type of derivative-based fund?

A

Speculative - max loss 100%
Guaranteed - structured funds (max loss 0 or preset amt like 5%)
Synthetics - designed to replicate performance of an index

71
Q

What are the two types of unit trust and how do they differ?

A

Authorised (AUT)
Unauthorised
Authorisation comes from FCA and allows marketability to all customers

72
Q

What is the benefit and risk off offshore funds?

A

Tax efficient and greater choice
Less regulation and higher charges
Luxembourg, the Cayman Islands, the British Virgin Islands or Mauritius

73
Q

Why would a private client use derivatives?

A

Hedging and moderate speculation
Some restrictions from banks, need KYC and risk appetite

74
Q

Why would a institutional asset manager use derivatives?

A

Hedge and speculate to increase returns
Client transition periods, where they want to change manager;
Derivatives can be used to track benchmark until full transition is made
Access to difficult assets, capital controls, difficult custody

75
Q

Why would a hedge fund use derivatives?

A

Hedging to highly geared speculation
Short exposure in markets where securities loans are not possible

76
Q

What derivative could a fund use to implement a ESG focused investment strategy?

A

Carbon emission derivatives

77
Q
A

CISI: Derivatives (10 decks)

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