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CFA Level 3 > Derivatives and Currency Management > Flashcards

Derivatives and Currency Management Flashcards

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1
Q

What is put-call parity?

A

Spot + Put = Call + X/(1+r)^T

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2
Q

What is put-call-forward parity?

A

Forward/(1+r)^T + put = Call + X/(1+r)^T

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3
Q

How do you create a synthetic long forward position? Short?

A

Using at the money, same expiration long calls and short puts. To be short, use short calls and long puts.

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4
Q

What are the common uses of synthetic forward positions?

A

For market makers and investment banks to hedge risk

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5
Q

How do you create a synthetic long put position?

A

If you are short the stock but purchase a call option to minimize downside

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6
Q

How do you create a synthetic short put position?

A

Long the stock and sell a call option and invest proceeds at risk free rate

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7
Q

What is the purpose of a covered call strategy?

A

This is when you are long a stock and sell calls to cap upside, but you receive the option premium instead

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8
Q

What is the purpose of a protective put strategy?

A

This is when you are long a stock and buy puts to limit downside

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9
Q

What does delta measure?

A

Change in option price with respect to underlying price

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10
Q

What does gamma measure?

A

Change in delta with respect to underlying price

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11
Q

What does vega measure?

A

Change in option price with respect to volatility

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12
Q

What does theta measure?

A

Option price with respect to time

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13
Q

How do you find the maximum gain on a covered call strategy?

A

Max gain = Strike Price - Initial Price + Option Premium

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14
Q

How do you find the breakeven price on a covered call?

A

BE = Initial stock price - option premium

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15
Q

How do you find the maximum loss on a covered call position?

A

Max loss = inverse of BE

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16
Q

What is the maximum loss on a protective put?

A

The max loss is the stock price - strike price + option cost

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17
Q

What is the purpose of writing cash secured puts?

A

This is when you want to acquire shares at a particular price

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18
Q

How do you create a call bull spread?

A

You would sell a call at a higher price and purchase a call at a lower price. You’re effectively selling off the probability of it being above a certain price. This will cost money as lower strike priced calls are more valuable.

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19
Q

How do you create a put bear spread?

A

You sell lower priced put and purchase higher priced puts. The lower priced calls are less expensive, so there is an initial cash outflow.

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20
Q

How do you create a long straddle? Short Straddle? Why would you do this?

A

Long straddle is when you purchase put and call options at the same strike, short straddle is when you write them both. The long straddle bets on higher than implied vol, short the opposite.

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21
Q

What is a collar? Why would you do this?

A

A collar is when you’re long a stock, buy a put below below the current price and writes a call above the current price. This is a combination of protective put and covered call. You do this to limit volatility

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22
Q

What are the risks of a collar?

A

It takes on the risks of protective puts and covered calls but offsets them with each other. You essentially narrow the distribution of outcomes. You’re in between equity and FI.

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23
Q

What is a long calendar spread? A short? Why would you do this?

A

A long calendar spread is when you sell an option in the short term and buy the same option at a longer date. A short calendar spread is the opposite. The purpose is to take advantage of the time value of an option. You have a directional opinion but do not believe that it is imminent

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24
Q

How do you calculate the one month expected/implied volatility?

A

Vol = Annualized / (sqrt (252/21))

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25
Q

What is the volatility smile? Volatility skew?

A

Vol smile indicates higher implied volatility for OTM options vs ATM options. Skew is when implied vol for OTM puts is higher and vol for OTM calls is lower. This reflects higher demand for OTM puts. Higher implied vol for puts is bearish, for calls is bullish

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26
Q

What is the risk reversal strategy for a volatility skew?

A

This is when you use a combination of OTM long calls and short puts at same expiration. This is when you think implied volatility on puts is too high. The opposite can be done to be a short risk reversal.

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27
Q

What does it say about the term structure of voliatility when it is in contango?

A

TS of vol being upward sloping is normal. If it goes to backwardation, that means demand for short term options is up and can signal vol.

28
Q

What are the various options strategies when you are bearish on an underlying?

A
  1. If you expect implied vol to decrease, write calls now
    Your payoff has unlimited losses as the underlying goes up, and you earn just the option premium if the underlying goes down. You write now because options are overpriced
  2. If you have no view on implied vol, write calls and buy puts (short collar). You have limited up and down side
  3. If you believe vol will increase, buy puts. You are purchasing cheap insurance
29
Q

What are the various options strategies when you are bullish on the underlying?

A
  1. if you expect vol to decrease, sell a put. You have low probability of exercising plus are selling the put high
  2. if you have no view on vol, write puts and buy calls. Your implementing a bullish view but subsidizing costs
  3. If you expect vol to go up, buy calls
30
Q

What are the various strategies for options when you are neutral on the underlying in the mid term?

A
  1. If you expect vol to go down, short straddle
  2. If you are neutral on vol, you can use a calendar spread
  3. If you expect vol to go up, you have use a long straddle.
31
Q

How do you create a put bull spread?

A

This mirrors the call bull spread. You write a put option at the higher strike price, generating an initial premium. This position loses money (infinite) as prices decrease. You also buy a put option at a lower strike price. This costs money. It gains (infinite) when prices go down, offsetting the short put position. The max gain is the net premium credit, the max loss is the the difference between strike prices plus net credit received.

32
Q

Give a practical example of when selling covered calls makes sense

A

If you are considering selling a stock due to unfavourable views, you can write a covered call. This reduces your delta position over the time frame and raises some income. You have to consider the trade off between higher call premiums (ATM or near). If the stock goes up, you will have to sell it at the strike and take a loss. The higher the strike, the less likely this happens, but the lower the premium. If the stock goes down, you have mitigates losses through the income generated. You have unlimited losses.

33
Q

Give a practical example of when writing puts would make sense

A

Writing puts is a bullish position. If the underlying goes down in value, you must buy it for higher. If it goes up, you keep the premium. You can “get paid” to buy into the stock. Lets say you want to initiate a position, but it is a bit too expensive right now. Writing puts could force you to purchase the shares when they go down (obligated when put is exercises), and you keep the premium if the shares keep going up. You have unlimited losses.

34
Q

Give a practical example of when you would use a long straddle

A

a straddle will benefit from volatility being higher than implied by options pricing. If you expect volatility to increase around an event, you can be compensated for such. Losses are limited to option premiums, gains are unlimited on both sides.

35
Q

Give a practical example of when you would use a collar?

A

The purpose of a collar is to sell off the tails of the distribution. This could be the case if you have a position you don’t want to sell but want to limit volatility. A long collar would involve being long the underlying, buying a put with a strike below the spot, and selling a call above the spot.

36
Q

Give a practical example of when you would use a calendar spread?

A

A calendar spread seeks to benefit based off of future price movement/volatility. Lets say you expect little movement now, but are bearish long term, you could use a long calendar put spread where you sell short term put options to fund longer term put options. There is a net cash outflow. The hope is that the short term option never hits the money, so you’ve effectively subsidized your long term short position. Even if you end up losing on the short term written put, this could be offset by an increase in the long term put value.

37
Q

How can you use VIX options to hedge short term volatility?

A

You can collar your equity position using VIX call and put options. You can sell out of the money put options (bullish bet) and buy call options ATM. If VIX increases, you make money on the call and the put becomes worthless (keep premium). If the VIX decreases, you have unlimited losses on the short put. This position will typically have a net cash outflow. The hedge ratio is dependent on your expectation of how volatility effects your long portfolio.

38
Q

How can you use calls to modify your existing long only portfolio?

A
  1. Buy calls to gain cheap exposure

2. Sell covered calls to reduce risk

39
Q

How can you use interest rate swaps to convert floaters into fixed?

A

If you have a floating rate note to hedge, you want to then agree to pay fixed for floating.

40
Q

What is the duration of a floating rate bond?

A

Near zero, because coupon payments reset and bond sells at par after each interest rate period.

41
Q

Why will the duration of an interest rate swap (from fixed perspective) be negative?

A

The Modduration is the duration of fixed bond equivalent less floater - floater is always near zero.

42
Q

How do you find the notional swap principal when using an interest rate swap to hedge your fixed income portfolio to its target duration?

A

Ns = (target duration - portfolio duration)/Swap Duration) * MV

43
Q

Give an example of how you could use an interest rate future to hedge rate exposure:

A

You are expecting a deposit in three months, but expect rates to go down by then. You want to lock in the existing rate. You could use a Eurodollar futures. If the rate goes down, you would still deposit at that rate, but would be able to sell the futures contract at a gain.

44
Q

How does an interest rate future work?

A

As interest rates rise, the price of the interest rate future goes down. This means if you expect rates to rise, you should sell futures. This is because you can sell for a high price, have rates rise, and then close out at a lower price. The opposite is true if you want to benefit from declining rates. If you want to lock in a rate for a deposit, you would buy a future. If you want to convert to a floating rate, you would sell the future.

45
Q

How does a currency swap work?

A
  1. You need money in a foreign currency
  2. You can obtain cheaper financing in hoem country
  3. Take home country loan
  4. Ask for a cross currency basis swap
  5. The contact says you will exchange your home currency for the FX you need, both parties will pay a reference, and there will be a basis depending on whether covered interest parity holds.
  6. You will pay CAD interest on the loan, but receive CAD interest from teh swap, offsetting the position. You will pay USD reference rate.
46
Q

How do you calculate the hedge ratio/notional amount for an equity portfolio using index futures?

A

N = Beta Target - Portfolio Beta/Beta of Future * MV

47
Q

What market expectations can you infer from the Fed funds futures?

A

The fed fund futures are tied to the effective fed funds rate used between institutions. You can infer the probability of a change in the fed funds rate by using:
EFF implied by futures - Current Rate/(Fed funds rate assuming hike - Current rate)

48
Q

How do you find the implied fed funds rate using fed funds futures?

A

The price of fed fund futures is inversely related to the rate. Specifically, the price is 100 - expected rate.

49
Q

What are the steps in determining domestic currency return for unhedged foreign investments?

A 
R(dm) = (1+Rfc)*(1+Rfx) - 1
1. Find FC asset values before and after
2. Find price of FC before and after
3. Use equation
Note that pricing convention matters - domestic currency must be the price (numerator) when finding FX return.
50
Q

What factors would encourage more currency hedging?

A
  1. Short term objectives
  2. Risk aversion
  3. Income and liquidity needs
  4. Fixed income assets
  5. Hedging is cheap
  6. Risky markets
  7. Skeptical of active management
51
Q

What are the basic factors that should cause real exchange rates to appreciate?

A
  1. Upward movement in the long run exchange rate
  2. Upward movement in real or nominal interest rates which attracts capital
  3. Increases in expected foreign inflation
  4. Increases in the riskiness of foreign assets
52
Q

How is the carry trade related to uncovered interest rate parity?

A

Uncovered interest rate parity suggests that the yield advantage gained when holding a higher yield currency should be offset by depreciation.

53
Q

How is the carry trade related to forward rate bias?

A

Forward rate bias is the idea that the forward rate is actually biased. Whether it is premium or discount, the future FX rate volatility/change is overstated. A currency with a lower yield should be trading at a forward premium, but the premium is often not realized over time.

54
Q

What are the risks of the carry trade?

A

Low yielding (funding) currencies are often safe havens, so periods of market turmoil can erase gains very quickly

55
Q

What is delta hedging?

A

This is the act of hedging away any exposure to the underlying price movement. For example, if you had a call option with a delta of 0.5, you could enter a short forward for 50% of exposure to fully hedge delta. The purpose is to isolate exposure to the other greeks, specifically vega

56
Q

Why are forwards used more than futures for FX hedging?

A
  1. Futures are M2M are require collateral
  2. Not all cross currency pairs are available
  3. Less liquid for large orders
57
Q

When would you expect a negative roll yield on FX hedging?

A

If you are hedging a currency with a forward premium (the base currency), you are expected to pay more in the future than you would today in the spot market. if the spot price does not move, you’re essentially overpaying at the end. If you keep the hedge on, you need to roll over the position. This involves selling at a lower price than you paid via the foward position, losing you money. This is the opposite of the carry trade.

58
Q

What is negative roll yield?

A

If the futures curve is in contango, meaning that futures prices are higher than current spot prices, then buying the asset forward could result in paying a higher price and materializes. This is the negative roll yield. Conversely, if you were selling forward you could be realizing positive roll yield.

59
Q

What is the purpose of over or under hedging using forwards for FX exposure?

A

This will express opinion on currency movements. If you over hedge to the base, you expect the base to appreciate as you’ve increased exposure.

60
Q

What is a risk reversal trade in the FX markets?

A

This is when you have a long call and sell a short put (long) or the opposite for a short risk reversal. you are looking to benefit from volatility skew

61
Q

What is a put spread FX position?

A

This is normal protective put. However, to offset put costs you actually write a put option as well. The put you buy is OTM, but the put you write is deeper OTM. This has lower downside protection. Between current spot and first put, hedge exists, but hedge falls off any lower than the second put.

62
Q

What is a seagull spread?

A

This is a put spread with a covered call. It could also be seen as a short risk reversal combined with a put spread. The benefit of this is that you collect more option premium, allowing you to buy the put closer to the money (more downside protection).

63
Q

What is the difference between a long seagull and short seagull strategy?

A

A long seagull provides downside with upside. You would write a call option ATM and use the proceeds to purchase OTM puts and calls.

64
Q

What is the purpose of a cross hedge?

A

A cross hedge uses one asset to hedge against another in a portfolio. In the case of FX, this could mean going long/short FX exposures that are correlated.

65
Q

What is the minimum variance hedge ratio and why does it matter?

A

This is the OLS regression showing the optimal hedge ratio. This does not really matter for direct observations for one currency hedge using Spots and forwards, as the hedge ratio will be close to 1, but is optimal when considering cross hedges or macro hedges.

66
Q

What is basis risk when hedging FX and why is it relevant?

A

Using cross hedges relies on a historical relationship between two assets that may change over time. If you are a USD fund and are hedging AUD and NZL against each other based on correlation, that correlation may change. Because your hedge is not direct, you may not experience 1 to 1 gains or losses in the portfolio. You must constant monitor this.

67
Q

How is the risk of negative roll yield increased in EM currencies?

A

Hedging EM currencies involves selling them forward. However, when there is downward pressure on EM currencies, they may hike rates.
Based on covered interest rate parity, Selling DC/EMC forward will be at a higher discount as EMC will have a higher rate. This means you may be selling at a lower rate than spot at the time of transaction.

CFA Level 3 (28 decks)

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