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CFA Exam Level 3 > Derivatives and Currency Exchange > Flashcards

Derivatives and Currency Exchange Flashcards

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1
Q

Forward Contracts

A
  • Are customizable and can be tailored
  • Counterparty risk - Higher default risk
  • Lower Liquidity
  • Forward prices will rise when interest rate rise.

Currency Forward Contracts:
* Less Expensive: Are more suitable as they are more flexible
* More Liquid: Trade OTC which dwarfs those for engage traded.

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2
Q

Futures

A
  • Traded on an exchange – Requires margin deposit (mark to market daily)
  • Standardized, not customizable
  • Futures prices will rise when interest rates/prices go down.
  • Low default/counterparty risk
  • Higher Liquidity
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3
Q

In Order for a Hedge to Work

A

3 Critical Areas that have to Prevail:
* The portfolio has to perform in line with the market as adjusted by Beta
* The stocks return price has to move in tandem in-line with the market
* Hedge reformulated each day as futures contracts have to post and adjusted.

Hedging Rarely Perfect due to results of the risk adjustments each day and basis risk.

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4
Q

Basis Risk Issues - Typical Reasons

A
  1. Basis Risk: The numerator (stock portfolio) and the denominator (hedging vehicle) are not based on the same item
  2. When Beta and Duration are not accurate.
  3. Hedge results are measured prior to or lifted before maturity (closed before expiration)
  4. When the amounts and the contracts are rounded as they need to be whole numbers
  5. Future and spot price are not fairly priced based on the cash and carry arbitrate model.
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5
Q

Effective Beta

A

Ex-Post or after the fact
* Percentage change in the value of the portfolio ÷ Percentage change in the value of the index
* Beta of the portfolio/stock’s covariance with the market place ÷ Variance of the market place

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6
Q

Pre-Investing

A
  • Buying contracts in advance of received cash in the future.
  • It’s a form of “synthetic positioning”.
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7
Q

Synthetic Forward Position

A

Synthetic Long Forward Position: Combination of a long call and short put that have identical strike prices and expirations.

Synthetic Short Forward Position: Combination of a short call and long put that have identical strike prices and expirations.

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8
Q

Types of Foreign Exchange Risk

A
  1. Transaction Exposure
  2. Translation Exposure: When your financial statement needs to be translated from one currency into your reporting currency
  3. Economic Exposure
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9
Q

Transaction Exposure

A

When there is a transaction of a payment in the future and have a risk of depreciation of the payment
* Asset Risk: If receiving a foreign currency (long position) sell the foreign currency forward. If the concern of foreign currency to depreciate short sell a future/forward contract (s) on the currency.
* Liability Risk: If making a payment of foreign currency (short position) buy the foreign currency forward. If the concern of foreign currency to appreciate buy a future/forward contract(s).

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10
Q

Choices for Hedging a Currency

A
  1. Hedge the foreign market risk and accept foreign currency risk
  2. Hedge foreign currency risk and accept foreign market risk
  3. Hedge Both
  4. Do Nothing
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11
Q

Currency Risk of Hedging

A

Manager will use different strategies
1. Hedge the initial principle
2. Hedge the future value of the portfolio
3. Hedge a minimum factor value bellow which you don’t want the portfolio to fall
4. Do nothing

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12
Q

Option Strategies How to Calculate

A

3 Things to Keep in Mind:
1. Cash Flow: Premium
2. Underling Position: Calculate the gain/loss on the underlying
3. Exercise Price: Calculate the gain/loss on the option

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13
Q

Covered Calls

A

Combination of a long underlying security position and a short call position.
* Yield Enhancement
* Reducing an Overweight Position
* Target Price Allocation

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14
Q

Protective Put

A
  • Combination of a long underlying security position and a long-put position on the security.
  • Used to hedge a portfolio or “portfolio insurance”

Risks of a Protective Put:
* Finite term, must be rolled over periodically
* Reduces total return

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15
Q

Delta

A
  • Is a first order measure
  • It is the change in an option’s price due to a price change in the underlying.
  • Positive for long calls and negative for long puts

Delta of a Call Option:
* Buyer between 0 and 1
* Seller between 0 and -1

Delta of a Put Option:
* Buyer between 0 and -1
* Seller between 0 and 1

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16
Q

Delta Hedging

A
  • A delta neutral hedge portfolio effectively earns the risk-free rate.
  • Assumes normal market conditions.
  • For holding the position only for a short period of time

Delta Is:
* Out-of-the-Money = 0
* At-the-Money = 0.5 or -0.5
* In-the-Money = 1 or -1

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17
Q

Delta Issues

A
  • It is only an approximation of the change of the underlying and the option.
  • Much less accurate if there is a large movement in the market.
  • Adjustment of the hedge over change in the market and passage of time.
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18
Q

Money Spreads

A

Are where the 2 options only differ by their exercise price

Debit Spread: Option strategy that requires a cash outflow.

Credit Spread: Option strategy that requires a cash inflow.

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19
Q

Bull Spread Strategy

A

Bull Call Spread:
* Buy a call option with a lower strike price and write a call with a higher strike price, same expiration.
* You subsidize the lower option with the higher option. This is a debit spread.
* Used when you think that the stock has “limited appreciation”.

Bull Put Spread:
* Write a put with a higher strike price and buy a put with a lower strike price, same expiration date.
* This is a credit spread.

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20
Q

Risks with a Bull Spread

A
  • The underlying asset price needs to rise above the lower strike price to offset the initial costs.
  • For bull put spreads, if the stock price falls below the higher strike price, the investor will begin to lose the initial cash inflow.
  • Selling American-style options is riskier than European options, as they can be exercised at anytime.
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21
Q

Bear Spread Strategy

A

Bear Put Spread:
* Buy a put option with a higher strike price and write a put with a lower strike price, same expiration.
* You subsidize the higher option with the lower option. This is a debit spread.
* Used when you think that the stock has “limited depreciation”.

Bear Call Spread:
* Write a call with a lower strike price and buy a call with a higher strike price, same expiration date.
* This is a credit spread.

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22
Q

Risks with a Bear Spread

A
  • The underlying asset price does not fall below the higher strike price they will lose their initial cash outflow.
  • For bear call spreads, if the stock price rises above the lower strike price leading the investor to lose the difference between the call premiums
  • Selling American-style options is riskier than European options, as they can be exercised at anytime.
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23
Q

Straddle

A
  • You don’t own the underlying stock and you believe that the market will have high volatility.
  • You buy a call and put, at-the money (ATM), with the same exercise price.
  • You will have 2 breakeven points.
  • Vega will be positive for both puts and calls
  • Delta neutral positions will not lose value

Short Straddle:
* When you believe that the market will have low volatility.
* You sell a call and a put at-the money (ATM) with the same exercise price.

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24
Q

Strangle

A

Same as a Straddle, but buy/sell the options out of-the-money (OTM), same exercise price.

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25
Q

Collars

A
  • You own the underlying stock
  • Buy a put and sell call to net the premiums to zero “Zero Cost Collar” this is the goal.
  • The strike price of the put is less than or equal to the price of the call.
  • There is limited downside risk and upside potential.
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26
Q

Calendar Spread

A
  • Sells and buys the same type of option, but with different expiration dates.
  • Takes advantage of time decay “Theta trade”

Long calendar spread:
* The short-term option is sold, and the long-term option is purchased.
* Expecting positive news in the long-dated futures, but not in the short term.

Short calendar spread:
* The Long-term option is sold, and the short-term option is purchased.
* Going to lose time value quickly for a gain, will be put at risks with the stock (underlying)

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27
Q

Implied Volatility

A
  • Calculated for trading options on a stock and the different strike prices, and exercise dates
  • All items will imply the different levels of volatility.
  • You cannot directly observe implied volatility, but you can derive it from an option pricing model
  • Implied volatility often differs due to the ‘moneyness’ of the option.
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28
Q

Volatility Smile

A
  • Occurs when OTM puts and calls exhibit greater implied volatility than ATM options.
  • Can be used to trace a U-shape against the strike prices
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29
Q

Volatility Skew

A
  • When the implied volatility decreases for OTM calls relative to ATM calls and
  • When the implied volatility increases for OTM puts relative to ATM puts.
  • Put options are used as insurance and are more in demand.
  • The degree is based on expectations of supply and demand
  • A sharp increase in skew due to surging existing and implied levels of volatility indicates market sentiment is becoming bearish.
  • The opposite is true for markets becoming more bullish.
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30
Q

Gamma

A
  • Is a second order derivative, it measures the rate of change of delta of the option
  • When the option is ATM the delta would be the greatest (most change in delta occurs).
  • When the option is deep ITM or OTM the delta will be near zero (delta has not changed)
  • Positive for long calls and positive for long puts
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31
Q

Theta

A
  • Daily change in the option price, considers time.
  • Negative for long calls and negative for long puts.
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32
Q

Vega

A
  • Change in option price for a 1% change in volatility.
  • An increase in volatility will make put or call more valuable.
  • Positive for long calls and positive for long puts
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33
Q

Risk Reversal

A
  • Long Risk Reversal: Long OTM call options and short OTM put options consensus market is moving up.
  • Short Risk Reversal: Long OTM put options and short OTM call options consensus market is moving down.
  • Strategy is to profit on implied volatility, not by the stock price moving
  • Delta hedge: You would sell the stock short or buy the stock to remove the position/exposure
  • The position will change as the time changes, due to dynamics
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34
Q

Swaptions

A
  • Option with a swap as an underlying asset
  • Buyer pays the premium and seller gets the premium.
  • Used to convert payments on floating rate obligations to a fixed rate
  • You want the option as not to lock into an interest rate.
  • Potentially terminate a particular swap early
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35
Q

Interest Rate Swaption

A

Payer Swaption:
* Enter into if you expect interest rate to go up.
* If interest rates continue are rising the buyer would exercise the option
* If interest rates are falling you would let the swaption to expire worthless

Receiver Swaption:
* Enter into if you expect interest rate to go down.
* If interest rates are falling the buyer would exercise the option
* If interest rates are rising you would let the swaption to expire worthless

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36
Q

Plain Vanilla Swaps

A
  • One side pays a fixed and the other side pays a floating interest rate
  • OTC contracts, two parties agree to exchange cash flows on specified dates
  • Net interest payment: The party that owes more interest makes the payment
  • Interest payment can change each period.
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37
Q

Incentives of a Swap

A
  • Mitigate or eliminate interest rate risks
  • The lender will charge a type of fee for structuring the swap
  • Achieve a target duration
  • Immunize against parallel interest rate shifts by setting overall duration to zero.
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38
Q

Interest Rate Liablity Risks

A

Floating Rate Liability: Increases Cash Flow Risk; Reduces Market Value Risk

Fixed Rate Liability: Reduces Cash Flow Risk; Increases Market Value Risk

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39
Q

Forward Rate Agreements (FRAs)

A
  • Purpose: Lock in today’s interest rate over a future borrowing or lending period of time
  • You have a Buyer (Long FRA) who is fearful of rising interest rates and Seller (Short FRA).
  • OTC forward contracts that are customized by the counterparties
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40
Q

Short-Term Interest Rate Futures (STIRs)

A
  • Similar to FRAs, but uses Eurodollar futures based on notional amounts of $1 million discounted
  • They are priced using the international money market convention
  • 100% - annualized LIBOR rate/Forward rate
41
Q

Fixed-Income Futures

A
  • Used to adjust the duration of bond portfolios.
  • The contracts specify a notional sovereign bond as underlying (does not actually exist)
  • Due to the deliverable bonds are not the same each they are assigned a “conversion factor” (CF).
  • The short party chooses the deliverable bond cheapest to deliver (CTD)
42
Q

Cheapest to Deliver (CTD)

A

The deliverable bond that gives the most profits or least losses from buying the bond in the spot market.

43
Q

Cross-Currency Basis Swaps

A
  • Motivation: one party has a competitive advantage of borrowing money in their home currency.
  • Notional principal amounts in each currency change hands at the start and the end of the swap.
  • Actually borrow money from the companies’ respective individual banks
  • Interest payments every 6 months or so.
  • Each company pays the interest rates for the other currency
  • Principle is not subject to interest rate risk, but the interest rates are.
44
Q

Reasons for Currency Swaps

A
  • Deals with violations to CIRP, when it does not hold arbitrage can be possible.
  • CIRP normally holds due to the free flowing of international developed markets.
  • Failure is due to a level of demand for borrowing USD, capital adequacy requirements, and rules
  • Reflected in the interest rate leg of the non-USD currency being adjusted downward by a negative amount, referred to as the basis.
45
Q

Reasons for Cross-Currency Basis Swaps

A

Consequence of Negative Basis:
* Lend USD and buy a foreign currency, agreeing to receive the USD and pay the foreign currency interest rate minus some basis points
* Deposit the foreign currency proceeds to earn the foreign currency interest rate

Positive Reasons:
* Able to lock in the fixed interest rate over the term of the swap.
* Represents a lower cost, instead borrowing directly, borrow synthetically.
* May be cheaper to raise money in home currency and then enter into a swap
* The foreign currency might be exhibiting a negative basis

45
Q

Currency Forwards and Futures

A

Used to manage currency risk:
* Long Exposure: In a foreign currency (or anticipate receipts) can use these contracts to lock in an exchange rate at which they will sell the foreign currency and buy their domestic currency.
* Short Exposure: To a foreign currency (or anticipate payments) can use these contracts to lock in an exchange rate at which they will buy the foreign currency and sell their domestic currency.

46
Q

Equity Swaps

A
  • Is an OTC customizable contract where one party makes a series of payments based on the returns of a single stock, a basket of stocks, or an equity index.
  • The other leg could be a fixed or floating interest rate, or linked to a different equity return.
  • Relatively illiquid, and do not confer voting rights
47
Q

The CBOE Volatility Index (VIX)

A
  • Measures expectations for S&P 500 volatility over the next 30 days based on S&P 500 Index options.
  • Investors cannot invest directly but can buy/sell VIX futures.
  • Treats volatility as a sperate asset class
  • VIX is mean reverting.
  • There is a negative correlation between the VIX and stock returns
  • Low VIX level means the market is bullish, high means the market is bearish
48
Q

VIX Term Structure

A
  • Basis = spot price – future price
  • Always assume spot prices will remain the same and futures prices will coverage to the spot prices
  • Backwardation: Spot prices above future prices, volatility is going to decrease
  • Contango: Future prices above spot prices, volatility is going to increase.
  • A flat shape shows that volatility is expected to remain stable.
49
Q

Roll Yield

A
  • If the market is in backwardation there are more hedgers then speculators
  • Speculators: Expect the underlying asset price to increase (long)
  • Hedgers: Own the asset and want to hedge their risk (short)
  • Positive Roll Yield: At maturity the market is in backwardation, speculators will profit as they push down the contacts lower and can roll their position over a lower price.
  • Negative Roll Yield: At maturity the market is in contango.
50
Q

Variance Swaps

A
  • Directional bets on implied vs realized volatility to speculate or hedge portfolios
  • Measure of volatility (VIX), a weighted average of implied volatility (S&P options of 30 days)
  • If the value of the VIX is below 20 it is a low-risk environment, above 30 is a high-risk environment.
  • Has a fixed “strike variance” known by both parties at the outset
  • Variance notional “N Variance” which is an agreed size, representing the gain to the long from a unit increase in variance.
51
Q

Variance swap payoffs

A
  • One party makes a fixed rate payment base on implied volatility known at initiation
  • One party makes a floating rate payment variable payment are only know at the end.
  • Realized variance: actual variance over the swap
  • Variance swap at initiation is zero
  • No interterm settlements cash flows they are only exchanged at maturity

Payoff at expiration of a long variance swap:
* positive when realized variance is greater than the strike variance
* negative when the variance realized is less than the strike variance.

52
Q

Vega Notional

A

The average profit or loss of a variance swap for a 1% change in volatility from strike, which corresponds to the implied volatility of the put that has 90% moneyness (strike divided by the current price).

53
Q

Convexity of the Variance Swaps

A
  • Payoff is convex and the profit/loss for changes in realized volatility is not linear.
  • Volatility is linear, variance is curved
  • When realized volatility is below the strike “implied” the loss on a variance swap will be less than that of a volatility derivative. (Negative feature)
  • When realized volatility is above the strike “implied” the gain on a variance swap will be greater than that of a volatility derivative. (Positive feature)
54
Q

Federal Fund Futures

A
  • Used to infer the change in the interest rates that the market has “priced in”
  • Reflects the market expectations of the federal fun target rate at contract maturity
  • Usually do not have strong predictive power.

Federal Fund Rate: The rate that the banks charge each other for overnight loans.

Federal Fund Effective Rate: The weighted average of overnight lending of those rates.

Target Rate: Set by the governors of the federal Reserve at the FOMC.

55
Q

Federal Open Market Committee (FOMC)

A

Cannot directly control the effective rate, but they can:
* Conduct open market operations such as buy and sell treasuries.
* Change interest rate that they pay on reserves at the Fed.

56
Q

Currency Options Basics

A

Foreign Currency Key:
* DC = Domestic Currency, Price Currency, or Counter Currency
* FC = Foreign Currency, Base Currency
* Direct Quote = DC ÷ FC
* Indirect Quote = FC ÷ DC

Points to Remember:
* Unless otherwise stated the options are from the perspective of the base currency (denominator)
* Everything is based on this quote. 99% of the time CFAI uses a direct quote

57
Q

Spot and Forward Bid Ask Quote

A
  • Dealers Margin: The difference between the Bid and Offer
  • Spot: Immediate delivery of the currency at the spot price
  • Forward Transaction: Price or exchange rate establish today on a transaction for a delayed settlement
  • Ask is usually higher than the bid
58
Q

Currencies Trading at Forward Premium/Discount

A

Forward Premium: If the forward exchange rate is higher than the spot exchange rate, the base currency it is expected to appreciate in the future.
* The price currency would be trading at a forward discount, it is expected to depreciate.

Forward Discount: If the forward rate is lower than the spot exchange rate, the base currency it is expected to depreciate in the future.
* The price currency would be trading at a forward premium and is expected to appreciate.

59
Q

Offsetting Transaction

A
  • Selling one currency and buying the other
  • The bank always gives less and you always give up more
  • If the original order was to sell the offsetting would be to buy (it’s the opposite position)
60
Q

Steps Involved in Marking to Market a Position on a Currency Forward

A
  1. Create an offsetting forward position equal to the initial forward position.
  2. Determine the all-in forward rate for the offsetting forward contract.
  3. Calculate the profit/loss on the net position as of the settlement date.
  4. Calculate the present value (offsetting contract) of the profit/loss. Use the LIBOR rate (deannualize)
61
Q

FX-Swap

A
  • It’s not a currency swap it’s a series of forward contracts that keep rolling over as they mature
  • Can adjust the portfolios hedge ratio.
  • Requires to close out a contract before entering into a newer one.
  • Can create a cash flow volatility creating gains or losses in the process
62
Q

Return Effect on Portfolio Based on Return and Risk

A
  • RDC: Return on the portfolio in domestic currency terms
  • RFC: Return on the foreign asset in foreign (local) currency terms
  • RFX: Return on the foreign currency percent exchange in value of foreign currency
63
Q

Concerns of Foreign Exchange

A
  • If you are investing multinationally you are concerned about the market and foreign exchange risk
  • When you have an Asset in a foreign currency you want the foreign currency to appreciate
  • When you have an Liability in a foreign currency you want the foreign currency to depreciate
64
Q

Calculate a Portfolio Return with Multiple Assets and Currencies

A
  • The return in domestic currency terms will be the weighted average of each foreign asset return
  • You can look at the variance of the portfolio in domestic currency terms
  • Same formula as the variance for 2-assets, you can use it with just one asset (no weighted averages)
65
Q

Risk to a Domestic Investment Depends on

A
  • The foreign currency overall
  • The standard deviation foreign asset in terms on foreign currency

Depends on the correlation of returns:
* Positive: it will increase the volatility of returns in domestic terms
* Negative: it will decrease the volatility of returns in domestic terms

66
Q

IPS Return Objective of Currencies

A

Details should include:
* The risk characteristics of specific global investments.
* Target levels of passive and active currency management (acceptable range levels).
* A hedge rebalancing strategy.
* Currency benchmark and a description of allowable hedging tools

67
Q

Types of Hedging

A

Passive Hedging: Goal is to eliminate currency risks relative to the benchmark you need to continuously rebalance the portfolio’s exposures to minimize tracking errors.

Discretionary Hedging: the portfolio manager can deviate modestly by a specified percentage (usually 5%). The goal is to reduce currency risk, but enjoy a modest incremental currency returns by appreciation.

Active Management: Allowing the portfolio manager to have a greater deviation from the benchmark currency exposure to hedge against currency risk while expecting to have incremental return (Alpha) not reduce risk.

68
Q

Currency Overlay Manager

A
  • Not a hedge
  • Very similar to active management.
  • 3rd party manager is going to have active management to generate alpha.
  • Treats currencies as a sperate asset class.
69
Q

Currency Strategic Diversification Issues

A
  • Currency volatility in the long run is lower than in the shorter-term
  • If there is a positive correlation between the foreign asset return and foreign currency return it will increase the volatility in domestic terms and increase the need for hedging.
  • If there is a negative correlation between the foreign asset return and foreign currency return it will decrease the volatility in domestic terms and decrease the need for hedging
  • Correlation tends to change depending on the time period.
  • In some periods diversification is provided while in other times its does not
  • Higher positive correlation in bond portfolios and foreign currencies than in equity portfolios
70
Q

Strategic Cost Issues with Hedging

A
  • Full Hedging: will lead to more frequent rebalancing this reducing returns
  • Purchase Options: used to hedge, if the contracts expire OTM it is a cost
  • Forward Currency Contracts: me need to be rolled over.
  • Overhead costs: Most companies will need a special division or entity
  • 100% Hedging: has an opportunity cost not able to enjoy favorable foreign currency movement.
  • Hedging Currencies: is very costly, managers might use a specific time frame to rehedge
71
Q

Complete Currency Hedging is Better than Unhedged When?

A
  1. Significant short-term objectives, especially income or liquidity requirements.
  2. Global fixed-income investments.
  3. Exposure to markets with high currency or asset volatility.
  4. High levels of risk aversion.
  5. Doubt about the value of currency return potential.
  6. Behavioral issues, such as the possibility of feelings of regret if the hedge is not profitable.
  7. Cheap costs to implement the hedging program.
72
Q

Carry Trades

A
  • This is a short-term tactical strategy for managing risk or exploiting opportunities
  • Works well under normal market conditions “not volatile”
  • If we allow a manager’s decision, they can take active and tactical decisions
  • An unhedged trade: must violate uncovered interest rate parity
  • Borrows in the lower interest rate currency (developed) and invest in the higher-yielding currencies (EM)
  • Will work if the foreign currency depreciates less than the market consensus based on the discount.
73
Q

Tactical Decision

A

Based On:
1. Economic Fundamental Analysis
2. Technical Analysis
3. Carry Trade
4. Volatility Trading

74
Q

Relative PPP

A
  • There is an exchange rate between 2 currencies that should hold over the long-term (15-20 years)
  • Doesn’t hold over the short-term
  • Has value by telling you what currency has appreciated in the short-term and will depreciate in the long-term
75
Q

Currencies that are Expected to Appreciate

A
  1. If a currency is more undervalued relative to their fundamental value or intrinsic value
  2. The long-run equilibrium exchange rate rises will increase in intrinsic value
  3. Have higher or rising real and nominal interest rates if expected inflation is the same in 2 countries, but one is higher than the other it will appreciate due to the higher the real rate
  4. Have a lower inflation rate compared with other countries (unexpected inflation equals depreciation)
  5. Lower or decreasing foreign risk premiums
76
Q

Cover Interest Rate Parity (CIRP)

A
  • The no arbitrage formula that equites the spot market with the futures.
  • If there is an arbitrage opportunity there are forward and futures contracts to eliminate the arbitrage.
77
Q

Uncovered Interest Rate Parity (UIRP)

A
  • It’s for the expected spot rate
  • A forward rate is an unbiased predicted a future spot rate
  • If there is an arbitrage opportunity in a market it could continue to exist
  • As there is no forward or future contract to remove the arbitrage
78
Q

Crash Risk

A
  • It’s the risks of the carry trade.
  • If your expectations are wrong (even if it’s in the right direction but more than expected) the losses can be extreme.
79
Q

Static Hedging

A
  • Undertake a hedge and keep it to expiration, the hedge ratio remains constant.
  • Likely to be ineffective over time because the market value will change
  • It will avoid transaction costs but also tend to accumulate unwanted exposures.
80
Q

Dynamic Hedge

A
  • Requires rebalancing the portfolio periodically.
  • Requires adjusting some combination of the size, number, and maturities.
  • It will keep the actual hedge ratio close to the target
  • Disadvantage: increased transaction costs.
  • Adds convexity which can add profits.
81
Q

Mixed-Matched FX-Swap

A

The near spot rate and the far forward rate are not of equal size

82
Q

Direct Hedge

A

Short a forward currency with protection on a foreign currency locks in a forward price will eliminate downside risk and upside return.

83
Q

Option Based Hedging Strategies

A
  • Use Forward Contracts: You can either over or underhedged
  • Instead of matching it can adjust the hedge ratio to be above or below 100%.
  • Increases the hedge ratio when the base currency weakens and decreasing the ratio when it strengthens.

Depends on Opinion of Future Spot Rates.
* Underhedge: If you expect the currency appreciation and hold a long position
* Overhedge: If you expect the currency to depreciate and hold a short position

84
Q

Short Seagull Spread

A
  • Offers some downside protection with some possible upside potential.
  • Involves buying a protective put and combining it with short positions in a deep OTM put option and a call option (bear put spread + a call option).
  • Usually selects exercise rates so that the strategy is a cost-free one.
  • Benefits when volatility is expected to decline and the spot rate remains within some expected bounded range.
85
Q

How to Hedge Multiple Currencies

A
  • Forward Hedge
  • Proxy Hedge
  • Macro Hedge
  • Minimum Variance Hedge Ratio (MVHR)
  • Cross Hedge
86
Q

Proxy Hedge

A
  • If there is no forward contract on a foreign currency but there is one with a high correlation you enter in a forward contract with the higher correlated currency
  • Used when contacts on the other currency is not available or is very costs
  • Reduces but cannot not eliminate risks
  • Considered an indirect hedge.
87
Q

Cross Hedge

A
  • Transfer the risk by buying a forward contract in one currency, but get a different currency at expiration (not the domestic currency; Bonds Only)
  • For currencies there is no distinction proxy vs cross hedging as there is a forward contract on all currency pairs
  • Considered an indirect hedge.
88
Q

Macro Hedge

A
  • Same as a proxy or cross hedge but done on a portfolio-wide basis not just one asset.
  • Derivatives contract on a fixed basket of currencies to change on a macro level.
  • The currency basket might not matchup perfectly with the currencies in the portfolio
  • Lot less costly as it can reduces some risk but never eliminate all risks.
89
Q

Minimum Variance Hedge Ratio

A
  • Marco approach used for indirect hedges
  • Regress pass change in the portfolio returns with the hedging instruments
  • Direct hedge no minimum variance hedge ratio needed
  • Provides a hedge ratio that is expected to result in the least possible standard deviation
90
Q

Minimum Variance Hedge Ratio can be Used for

A
  • To optimize changes in the foreign currency return and foreign asset return
  • To minimize the volatility in domestic currency terms
  • If the return on the foreign asset and foreign currency are highly positively correlated it will increase the volatility of the domestic returns; need a hedge ratio > 1 to reduce the volatility.
  • If the return on the foreign asset and foreign currency are highly negatively correlated it will decrease the volatility of the domestic returns; you want a hedge ratio < 1.
  • When correlations move significantly away from 1, and when they change unexpectedly, basis risk can make the hedge inefficient.
91
Q

Challenges for Foreign Emerging Market Exposures

A
  • Lower trading volume large bid-ask spreads
  • Higher transaction cost
  • Lower Liquidity
  • Normally higher inflation
  • Return distribution are non-normal, skewed negatively
  • Currencies have higher yield, and a large forward discount (market in backwardation)
  • Roll yield positive long side negative for the short side
  • Higher minimal interest rates while real rates are the same. Equal inflation differential
  • Historical performance measures such as Sharpe ratio can look very attractive when market conditions are stable but disappear when they are not.
92
Q

Non-deliverable forwards (NDFs)

A
  • Forward contacts that are cash settled by netting instead of the underlying currencies.
  • Payments always netted and settled in the non-controlled (developed) currency of the pair.
  • Credit risk is typically lower because there is no delivery.
93
Q

Currency Alpha & Beta

A

Currency Alpha: The active currency management function, which can be managed externally

Currency Beta: The currency hedging function, which can be done effectively internally

94
Q

Roll Yield Premium Positions

A

Higher forward premium results in a higher roll yield
* If a currency is trading at a premium; sell a forward to earn a positive roll yield
* If a currency is trading at a discount; buy a forward to earn a negative roll yield

95
Q

Notional Value of the Swap

A

Should be set that the fixed rate payment receives will equal the fixed coupon payments that the company must pay on its fixed rate bond obligations.

96
Q

Basis Trade

A

If the Basis is:
* Positive: “selling the basis,” selling the bond and buying the futures.
* Negative: “buying the basis,” purchase the bond and short the futures.

97
Q

Box Spread

A

Is constructed by taking a synthetic long exposure (long call short put) at the low strike and a synthetic short exposure (short call long put) at the high strike.

98
Q

Butterfly Spread

A

Inverse volatility strategy that profits when volatility falls

CFA Exam Level 3 (13 decks)

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