Derivatives

Question 1

What is the difference between forwards and futures?

Answer 1

• Forward contracts are customised contracts in terms of size and delivery dates. Future contracts are standardised contracts in terms of size and delivery dates.
• Forward contracts are OTC contracts between two parties, and they are an obligation so difficult to reverse. Future contracts are contracts between a customer and a clearing house - often traded on an exchange, making future contracts more liquid and usually more suitable for investors.
• P/L on a forward contract is realised on delivery date, the price agreed is paid usually upon physical delivery. P/L of a futures contracts are realised immediately for they are market to market.
• For forward contracts margins are set on the day of the initial transaction. For future contracts margins must be maintained to reflect price movements.

Question 2

What are the main risks for derivatives?

Answer 2

• Counterparty risk:
  
  • Risk that one of the counterparties to the contract fails to meet their obligation and defaults.
  • This can be mitigated by trading through an exchange that are settled via a central counterparty who performs a process of contract novation where they break up the contract and become counterparty to both sides and require margin to ensure they are only exposed to one days loss.
  • For forward contracts which are OTC and bespoke the contract is between the two counterparties requiring only initial margin with P/L loss at the end of the day. This can be mitigated by monitoring the credit rating of the counterparty.
• Liquidity risk:
  
  • Risk that the investment company will not be able to realise their derivative contract to cash quickly.
  • Less likely to occur in heavily regulated futures market where contracts are standardised in terms of their size and delivery dates.
  • The investment company would be able to close out their position early by entering into equal and opposite position to realise gains of losses.
• Interest rate risk:
  
  • Could be a risk if using leverage and the cost of borrowing is impacted by the rate. If interest rates were to rise the cost of funds increases and may cost the investment company more to hold the position.
• Market risk:
  
  • Regulation impsed on derivative contracts.
  • FCA is cognisant of how derivative products can harm the stability of markets and therefore the possibility to increase regulation on the products.
  • The investment company shgould ensure sufficient liquidty to support any calls for margin.

Question 3

How do you hedge a gilt portfolio?

Answer 3

• Switch to short dated gilts to reduce duration risk
• switch to higher coupon gilts although these tend to be longer dated
• only hold gilt stock to remove currency risk
• buy a proportion of index linked gilts to reduce the inflation volatility component. If mark-to-market, current valuation is performed on real basis then short-dated ILGs may reduce volatility.
• Switch to a range of gilts with matching maturities.

Question 4

How do you hedge of FTSE100 Portfolio?

Answer 4

• Owns a FTSE 100 portfolio of £60,000 and you expect the share price to rise.
• You hedge by going short the future which is trading at 6000.
• You sell a contract of the FTSE100 where a 1-point movement in the index is worth £10 so 1 FTSE100 contract is 6000 x £10 = £60,000.
• By short selling the FTSE future at 6000 you have a short position of £60,000 which ties up with your portfolio value.
• The FTSE100 then drops 10% so you lose £6,000 on your portfolio
• FTSE moved 600 points x £10 = £6,000 so you have hedged.

Question 5

What are the considerations one should take when looking to use derivatives?

Answer 5

1. The trade-off between the cost of the put vs the protection it provides. The cost of the protection is the cost of acquiring the protective put, which reduces the expected return. Liquidity will play a part in how cost effective the put is likely to be to purchase.
2. What level to buy the put at, what are the cost points of the put at different levels, and whether there is a more cost-effective portfolio value to buy the put at.
3. When and how long to maintain. The cost of timing and duration of the put will mean cost could range from limited to moderate.
4. Is buying a put in line with the portfolio objectives. Is the client sufficiently loss averse to warrant putting in place a put. Do the objectives of the fund state that risk is approached asymmetrically.
5. What basket of securities, indexes or assets is the put designed around and are these proxies for the real portfolio held.