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2021 CFA Level III > Derivative and currency mgmt 15-17 > Flashcards

Derivative and currency mgmt 15-17 Flashcards

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1
Q

put-call parity

A

so+po = x + xe^(-rt)

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2
Q

synthetic long forward

A

long call +short put with same strike

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3
Q

synthetic short forward

A

long put + short call

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4
Q

synthetic call

A

long call = asset + put

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5
Q

synthetic put

A

long put = call - asset

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6
Q

covered call

A

stock + short call

max profit = (x-so)+co
breakeven= So-Co
Max loss = unlimited

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7
Q

protective put
buying insurance

upside potential with limited downside risk

A

stock + long put

max profit = unlimited
breakeven So+Po
Max loss = S0-x +P0

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8
Q

Implied volatility

A

value of unobservable volatility variable that equities the result of adoption pricing model

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9
Q

Delta

change in option price/change in underlying

A

call +

put -

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10
Q

Gamma
change in delta/change in underlying value
largest at the money near S0

A

call/put +

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11
Q

Vega

change in value of option / change in volatility of underlying

A

call/put +

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12
Q

Theta

time decay, sensitivity of option’s price o passage of time

A

call/put -

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13
Q

benefit of covered call

A

a. yield enhancement
writing covered calls is cash generating in anticipation of limited upside moves in the underlying

b. reducing a position at a favorable price
call premium = time value + intrinsic value
= time value + max(0, s-x)
sell ITM call option

c. target price realization (hybrid of a+b)
write OTM calls with K near the target price for the stock

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14
Q

Collar

acquire downside protection through protective put but reduce cash outlay by writing a covered call

A

protective put + covered call

Long stock + long put Xl - call XH

buy int rate floor + selling int rate cap

zero - cost collar 
buy put + sale call with same premium net cost=0
BEI=S0
max gain = St-So
max loss = S-x

sacrifice the position part of the return distribution in exchange for the removal of the adverse position

  • narrow the distribution of possible investment outcomes, risk is reduced return is limited
  • economically intermediate b/w pure equity and FI exposure
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15
Q

cash secure put
for bullish view
acquire shares at a particular price

A

write a call and simultaneously deposit same amount of money equal to the exercise price in a designated account

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16
Q

bull spread

buy XL, short XH
when price increase spread increase more value

A

bull call

long call L + short call H (less expensive) debt spread

profit = max(0, St-XL) - max(0, St-Xh) -CL + CH
Max profit = XH-XL +CH-CL
Max loss = CH-CL
BEI = XL-net premium

bull puts

long put L + short put H (more expensive) credit spread
profit = max (0, XL-S) - max(0, XH-S)
BEI between two strike

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17
Q

bear spread

Short XL, buy XH
when price decrease spread increase more value

A

bear call

short call L + long call h

bear put

short put L + long put H

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18
Q

spread are classified in 2 ways

A

market sentiment

by direction of the initial cash flow

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19
Q

debt spread

A

long

long option value > short option value

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20
Q

credit spred

A

short

the short option value > long option value

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21
Q

Tactical adj. for option trader

A

adding a short leg to a long position (bull call)

spread and dealt (change in market view)

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22
Q

Long straddle

short

A

long put + long call with same x and exp. date

short put + short call

two BEI X+/- (C+P)

MAX LOSS = -P-C

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23
Q

calendar spread
sensitive to implied volatility
take advantage of the time decay
time decay is more prominent for a short term option

A

long (stable market/increase in implied volatility)
long more distant call and sell near call

short (decrease implied volatility)
long near term call and sell the long-daed call
credit spread implied volatility decrease

Themat for ITM call may provide motivation for a short calendar spread.

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24
Q

implied volatility BSM

A

Std(month%) = std(annual %) / sir(252/21)

if an investor buy an ATM one-month (21)day straddle using puts and call, in order to be profitable, price must move up/down by at least by the implied volatility

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25
Q

volatility smile

A

when the implied volatility priced into both OTM puts and calls trade at a premium to implied volatility of ATM options, the curve is U-shaped

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26
Q

volatility skew

A

implied volatility increase for OTM put
decrease for OTM calls as the strike price move away

OTM put typically command higher implied volatility than ATM or OTM calls due to “fat tail”

skew depend on investor sentiment

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27
Q

when implied volatility is significantly higher for put

with X below S

A

an imbalance in the supply and demand for option

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28
Q

a sharpe increase in the level of skew, accompanied with a surge in the absolute level of implied volatility

A

an indicator market sentiment is turning bearish

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29
Q

higher implied volatility for call with X > s

A

indicate investor are bullish

demand for OTM calls to take an upside exposure is strong

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30
Q

Delta hedge

delta-neutral position of 0

price lead to implied volatility change

std increase, long straddle/strangle buy ATM CALL/PUT

std decrease, short straddle/strangle sell ATM call/put

A

take a long or short position in a risk reversal

when Std PUT >std call

long risk reversal by selling the OTM put
buy the same exp. OTM call

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31
Q

term structure of volatility

A

often in contango F near term

when in stress/de-risk, demand ST option to push up the prices
term structure of volatility to invert

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32
Q

implied volatility surface (3-dimensional plot)

A

joint influence of maturity (x) and strike (y)

the shape of the volatility skew reflects varying degrees of market participants’ fear about future market stress

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33
Q

advantage of derivatives

A
  1. cheaper
  2. leverage
  3. liquidity
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34
Q

outlook on the trend of underlying asset

bearish

A

implied volatility decrease
write calls

unchanged
write call and buy puts

increase
buy puts

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35
Q

outlook on the trend of underlying asset

unchanged

A

implied volatility decrease
write straddle

unchanged
calendar spread

increase
buy straddle

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36
Q

outlook on the trend of underlying asset

bullish

A

implied volatility decrease
write puts

unchanged
buy calls and write puts

increase
buy calls

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37
Q

bullish view not sure treading up/down

A

call bull spread

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38
Q

bearish view not sure treading up/down

A

put bear spread

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39
Q

interest rate swap

A
  1. convert b/w floating and fixed exposure

2. alter the duration of a fixed-income portfolio

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40
Q

buyer swap

A

makes a series of fixed-rate pmt and receive a series of floating rate ptm

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41
Q

basis risk/spread risk

basis point value BPV = mv * md *0.01%

A

price discrepancy b/w price of cash and FI futures

= spot cash price - futures price * CF

<0 BUY BASIS BUY BOND, SHORT FUTURES
>0 short basis buy futures, short bond

assumption:
change in value of bond p portfolio can be approx. by using the concept of modified duration, old curve inflation, and it is affect only by parallel shift

portfolio and derivative contract used to hedge are prefect substitute

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42
Q

MPp(MDVRp) + Ns(MDVRs) = MVp(MDVRt)

A

MDVRs MD of swap

measure change in value of swap

mdvrt md of combined portfolio

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43
Q

change in p

A

= Ns*change in S

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44
Q

Ns

A

(MDVRt - MDVRp)
/ MDVRs

MDVRt - MDVRp <0 fixed rate payer
MDVRt - MDVRp >0 fixed rate receiver, floating rate payer

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45
Q

interest rate forward & futures

FRN

A

FRA will settle only the discounted difference between the rate agreed and the actual rate prevailing at the time of settlement, applied on the NP

HEDGE Future ST borrowing/lending rate

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46
Q

FRA borrower long FRA

A

FRA lender

short fRA

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47
Q

Interest rate future borrower

short futures

A

interest rate futures lender

long futures

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48
Q

fixed income futures

hedge duration risk for longer maturities

A

Duration of a future contract is usually consistent with the forward behavior of the cheapest to deliverable bond
will reflect the duration of the CTD bond

price sensitivity of bond future will reflect the duration of the CTD bond

49
Q

low coupon, long maturity

A

long duration CTD bond

if market yld > notional yld of FI futures

50
Q

high coupon, short maturity

A

short duration CTD bond

if market yld < notional yld of FI futures

51
Q

hedge ratio change of value of FI futures=

A

change in p/change in CTD * conversion factor

52
Q

BPVHR=

A
  • BPVP/BPVctc * CF

=bpvt-bpvp/bpvctd * cf

53
Q

np=

A

$change in duration /2

54
Q

hedging result are imperfect because:

A

the hedge is done with the cheapest to deliver bond
duration of futures contract can change

  1. the relationship b/w interest rate & bond prices is not linear, owing to convexity
  2. the term structure of interest rates often changes via non-parallel moves
55
Q

currency swaps

A

hedge against the risk of exchange rate fluctuation to achieve better rate outcomes

56
Q

cross currency basis swap

A

exchange NP because the goal of the transaction is to issue at a more favorable funding rate and swap the amount back to the currency of choice

57
Q

advantage equity swap vs. physical stock

pay equity return
and get index return

A

gain exposure to equity when participation in physical market is restricted or equity is liquid

avoid tax in physical ownership

avoid custody fees on physical ownership

avoid the cost of monitoring physical positions, which may increase due to corp. actions

equity swap required collateral
swap are iliquid
swap doesn’t convey voting rights

58
Q

equity futures

A

exchange traded, standardized, require margin
have low transaction cost, and are available on indexes and single stocks

enable:
1. implement tactical allocation decision
selling futures decrease equity exposure

  1. achieve portfolio allocation
  2. gain exposure to international markets
  3. make directional bets on the direction of the market
59
Q

Nf =

A

Bt-Bs/bf *(s/f)

60
Q

beta of portflio

A

% change in portfolio /% change in index

61
Q

cash equalization/cash overlay

cash = security - future

A

boost returns by finding ways to equities uninvested cash holdings

beta s=0 with cash holding

62
Q

volatility and stock index negative correlated

A

variances spread has a valuable convesity feature as realized volatility increase

63
Q

contago

negative yield curve

A

S>F

64
Q

backwardation

positive yield curve

A

s>f

65
Q

Variance swap

A

used for taking directional bets on implied vs. realized volatility for speculative or hedging purpose

realized variance > swap’s variance X
long payoff >0 swap seller pays buyer

settlement amount = variance N (realized variance - variance strike)

is convex

66
Q

variance notional

A

vega notional / 2* strike price

settlement about = N variance * ( variance - x^2)

67
Q

probability of a Fed rate hike of short-term US interest rates.

A

implied fed fund effect rate - current target rate
/ size of rate change

2.825% (= 100 – 97.175).

avg(2.50%– 2.75% ) = 2.625%
2.75-2.5=0.25%

prob: (2.825-2.625)
/0.25 =80%

68
Q

federal fund rate

A

int rate the deposit institution charge others for loans in overnight interbank market

69
Q

federal funds effective rate

A

weighted avg of interest rate charged on overnight interbank loans

70
Q

federal fund target rate

A

rate set by FOMC meeting 8times/yr

71
Q

base currency hierachy

A 
EUR
GDP
AUD
NZD
USD
72
Q

return decomposition Rdc =

A

(1+Rfc)(1+Rfx)-1

73
Q

volatility decomposition Variance (Rdc) =

A

variance (rfx) + variane (rdc) + 2std* std * correlation

variance rfx = (1+rfc)*rfx

74
Q

hedge/not hedge

A

not hedge

  • fx rates revert to historical means to their fundamental value
  • No LT gains after netting out mgmt and transition costs
  • negative correlation help portfolio diversification

hedge in ST only
-FX rates to international trade and capital inflows
central banks, gove’t agencies and retail traders can have a larger impact on fx
-fx and FI move with interest rates, currency exposure provides little diversification benefit to FI portfolios and currency risk should be hedged
- optimal hedge ratio seems to depend o market conditions and LT trends in foreign currency bond portflio

75
Q

forms trading expenses/cost with currency management

A

bid-ask spread
currency option premiums
overhead costs

76
Q

opportunity cost

A

100% hedge forgo any possible favorable currency rate moves

<100% ex-ante dilemma

77
Q

passive hedging

A

rule based and typically matches the portfolios currency exposure to that of the bak used to evaluate the portfolio’s performance.

require period rebalancing to maintain this match

goal is to eliminate currency risk relative to the benchmark

The following will shift the portfolio towards more passive currency management:

A short time horizon for portfolio objectives
High risk aversion
Lack of concern with regret at missing opportunities to add value through discretionary currency management
High short-term income and liquidity needs
Significant foreign currency bond exposure
Low hedging costs
Clients who doubt the benefits of discretionary management

78
Q

discretionary hedging

A

allow the manager to deviate modestly from passive hedging by a specific percentage
goal to decrease currency risk while allowing the manager to pursue modest incremental currency returns relative to the bak.

79
Q

active currency mgmt

A

allow manager to have greater deviation from bmk currency exposures
goal: to create incremental return (alpha) not to reduce risk

80
Q

currency overlay

A

out sourcing of currency mgmt purely seeking currency alpha, not risk reduction

  • . use outsources currency overlay manager to passively hedge their fx position
  • for a active fund = separate the alpha and hedging mandate
  • engage multiple currency overlay manager if the manager’s use different active mgmt strategy
81
Q

factors shifts strategic decision formulation toward a benchmark neutral or fully hedged strategy are:

A
  • short term investment objective of the portfolio
  • high risk aversion
  • client who’s concerned with the opportunity cost os missing positive currency return
  • high st income and liquidity needs
  • significant foreign currency bond exposure
    • low hedging costs
  • -clients who doubt the benefits of directional mgmt
82
Q

active currency mgmt base on economic fundamentals

converge to fair value

A

real exchange rate = real ppp between 2 countries
LT equilibrium level for th real exchange rate is determined by PPP
ST: movement in real exchange rate reflect real int.rate diff

All else equal,
base currency’s real fx should appreciate if there’s an upward increase movement in :
1. long run equilibrium real fx
2. either its real/nominal int. rate which should attract foreign capital
3. expect foreign inflation, which should cause the foreign currency to depreciate
4. foreign risk premium, which should make foreign asset less attracted compare with the base currency nation’s domestics asset

83
Q

technical analysis

A

market reflect future expectation

historical data incorporate all relevant information on future price movements and that such movements have a tendency to repeat.

  1. in a liquid freely traded market the historical price data can be helpful in projecting future price movement
  2. historical patterns have a tendency to repeat and provide profitable opportunities
  3. technical analysis does not attempt to determine where mkt prices should take but we’re they will trade
84
Q

carry trade

= buying currencies selling at a forward discount
and sell currencies trading at a forward premium

A

currency with higher relative int rate tend to attract capital and appreciate in value

borrowing in low yield currencies and invest in high yield currencies

85
Q

strangle

A

ohm call/put similar to straddle but less payoff

86
Q

when relative currency increase

A

decrease the hedge (short position) or increase long position

87
Q

relative currency depreciate

A

increase hedge or decrease long position in the currency

88
Q

market condition stable

A

carry trade

89
Q

market condition crisis

A

discontinue the carry trade

90
Q

forward contract vs. futures

A
  1. futures are standardized, settlement dates and contract size may not be appropriate
  2. minor currency futures may not be available
  3. futures require initial margin and margin maintenance
  4. OCT forward are more liquid
91
Q

static hedge with forward contract

A

avoid transaction cost, but will also end to accumulate unwanted currency exposure as the value of foreign currency asset change because market value of foreign currency assets will change with market conditions, create a mismatch between market value of foreign currency asset and the nominal forward contract.

solution: use dynamic hedging

purely currency risk

92
Q

dynamic hedge with forward contract

A

require rebalancing periodically

increase transaction cost

93
Q

roll-yield/return

> 0 ibIp

A

F/S-1

negative roll yield, increase hedging cost
do no hedge if negative

positive roll yield, decrease hedging cost
encourage hedging

94
Q

reduce hedging cost

1. over-or under hedge with forward contract

A

base currency appreciate decrease hedge ratio

base currency depreciate increase hedge - positive convexity gain>loss low cost strategy

95
Q

reduce hedging cost
2. buy ATM put option

highest initial cost but no opportunity cost

A

eliminate downside risk and return all upside potential

ATM option is relative expensive and has only time value, no intrinsic value

96
Q

reduce hedging cost
3. buy oTM put option

reduce initial cost of hedging but does not eliminate all downside

A

offer loss downside protection limited to x of puts

reduce initial cost of hedging but does not eliminate all downside

97
Q

reduce hedging cost
4. collar
further reduce initial cost but limit upside potential

A

some downside protection while decrease cost than ATM put

sale of OTM call removes some upside potential but generate premium

98
Q

reduce hedging cost
5. put spread
decrease initial cost and reduce downside protection

A

buy OTM put in base currency
sell put that are further OTM

downside protection but if base currency fall below XL, protect is lost

decrease initial cost and reduce downside protection

99
Q

reduce hedging cost

6. seagull spread

A

= buy call spread + Short OTM PUT

= buy XL sell XH + short OTM put

100
Q

exotic option

knock-in-out feature

A

plan vanilla option that only comes into existence if underlying 1st reaches some prespecified level

disadv:
the stock price could rise to the level that causes the expiration of the knock-out, and then decline, resulting in unprotected losses.

101
Q

exotic option

digital option

A

pay fixed amount that does not vary with diff. in price b/w x and underlying price

102
Q

cross hedge - currency

A

occurs when a position in one asset is used to hedge the risk exposure of a different asset

moves the currency risk from one foreign currency to another foreign currency

likely most efficient for the emerging market currencies (to reduce transaction costs) but not necessary for widely traded currencies such as the USD, EUR, and GBP.

103
Q

proxy hedge

A

removes the foreign currency risk by hedging it back to the investor’s domestic currency

104
Q

macro hedge - for EM currencies

A

a type of cross hedge that address portfolio-wide risk factors rather than the risk of individual portfolio asset

uses a derivatives contract based on a fixed basket of currencies to modify currency exposure at a macro (portfolio) level.

105
Q

minimum-variane hedge ratio

from regressing foreign market return in domestic currency vs. foreign currency value

riskier

A

determine the optimal cross hedge ratio

cov(Y,x)/var(x) = correlation(y,x) * (std(y)/std(x))

does not applied to direct hedge

used to jointly optimize over changes in value of rfx and rfc to minimize the std of rdc

strong positive correlation between Rfx and Rfx increase the volatility of Rdc
hedge ratio >0 reduce vol of rDC

Strong negative correlation between Rfx and Rfc decrease volatility of rdc hedge ratio <0 volatility decrease

106
Q

BASIS RISK

Rdc=

A

a+b(%change in Sa/b)+ error

107
Q

other unique challenges EM currencies/foreign exchange hedging face

A
  1. EM currencies are thinly traded, causing higher transaction costs
  2. underlying foreign currency asset in EM can be illiquid and lack derivative products
  3. increase likelihood of extreme market event and severe liquidity under stressed mkt condition

Em currencies return distributes are non-normal with higher probabilities of extreme events, negative skew of returns
higher yield of em currencies will lead to large forward discount (negative roll yield)

tail risk, gov’t intervention

108
Q

non-deliverable forwards

A

cash settled “bet” on movement in the spot rate of these currencies

gov’t frequently restrict movement of their currency in/out of the control to settle normal derivative transaction

benefit:
lower credit risk only the gains to one party are paid at settlement

109
Q

full repricing method

A

use of spot rates (zero coupon cubes)
most accurate measure of price changes in securities.

-require more data than duration based approach.

110
Q

Risk involved in carry trade

A
  1. high yielding currencies are typically from high-risk countries
  2. in times of global financial crisis, there is a rapid movement from high-risk currencies to low-risk currencies, resulting in unwinding of carry trade.
  3. large-scale losses can be incurred quickly due to the large amount of leverage involved with a carry trade
111
Q

hedge return ~=

A

rf + (id-if)

id-if >0 domestic currency depredate

112
Q

cashless collar

A

buying a put and selling a call

buy low sell high

113
Q

forward conversion option

A

buy put and sale a call with same strike and expiration date.

= synthetic short position.

the riskless position can be used as collateral for a loan at favorable terms, generating liquidity.

114
Q

direct hedge

A

widely-traded currencies such as the USD, EUR, and GBP.

However, because the portfolio contains some emerging market currencies, those currencies are not likely to be efficiently hedged using direct hedges due to high transaction costs and the potential non-existence of an appropriate hedging contract.

115
Q

hedging cost

A

trading costs

opportunity cost

116
Q

speculative volatility trades

A

markets are stable:
net short volatility

when volatility increase
long volatility

117
Q

hedger of volatility

A

net long volatility, long option as if they are paying insurance premium

buy protection from unanticipated price volatility

118
Q

bear call

A

modest stock price decline is expected and there is very limited potential for a price increase.

119
Q

equity swap risk

A
  1. return paid on equity index maybe more than the return earned on the stocks held, making a loss
  2. counterpart risk

2021 CFA Level III (12 decks)

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