Derivatives and Currency Management

Question 1

What is a synthetic long forward position?

Answer 1

The combination of a long call and short put that have identical strike prices and expirations.

Question 2

What motivates the creation of a synthetic long forward position?

Answer 2

The motivation to create a synthetic long forward position could be to exploit an arbitrage opportunity or if an investor needs an alternative to the outright purchase of a long forward position.

Question 3

What investment objectives are possible for using a covered call?

Answer 3

The possible investment objectives for using a covered call include:
* Yield enhancement
* Reducing a position at a favorable price
* Target price realization

Question 4

What is the value of a covered call position at option expiration?

Answer 4

At option expiration, the value of a covered call position is the stock price minus the exercise value of the call. Any price increases beyond the strike price of the covered call belong only to the buyer of the call.

Question 5

What risk is there to a covered call strategy?

Answer 5

A covered call strategy is stock price depreciation. Covered calls do not protect against downside, although the receipt of the call premium offsets losses.

If a stock rises beyond the strike price. If this occurs, the investor has lost the opportunity to profit from price appreciation (opportunity loss).

Question 6

What are the similarities between the profit and loss diagram for protective puts and holding a long call?

Answer 6

The profit and loss diagram for protective puts is similar to holding a long call.

This similarity is the result of put–call parity—being long the asset and long the put is equivalent to being long a call plus long a risk-free bond.

Question 7

What are the risks to protective puts?

Answer 7

The real risk to protective puts is that they have a finite term and must be rolled over periodically to maintain the insurance (expensive over time).

Another minor risk is that purchasing a put before a stock rises will reduce total return.

Question 8

What is delta (Δ)?

Answer 8

Delta (Δ) ≈ Change in value of option/Change in value of underlying security.

Because a long call/put increases/decreases in value as the underlying security price rises:
* call deltas are always positive (0 to 1)
* put deltas are always negative (0 to –1)

Question 9

What is a straddle, including long and short straddles?

Answer 9

The objective of a straddle is to profit from a directional play on volatility.

Long Straddle: seeks to profit from above-consensus volatility and involves a long put and call with the same strike price and expiration.

Short Straddle: seeks to profit from below-consensus volatility.

Question 10

What is a call bear spread.

Answer 10

A call bear spread seeks to profit from falling prices, but offsets the price of a long call at a high exercise price with a short call at a low exercise price, generating negative options cost (credit spread).

Question 11

What is implied volatility?

Answer 11

Implied volatility not observed directly, but is derived by using the sigma value.

In a Black–Scholes–Merton (BSM) model’s cumulative distribution function that equates the theoretical price to the market price.

Question 12

What are the uses of calendar spreads?

Answer 12

A long calendar spread is long the far option, which has slowly declining time decay and vega, and short the near option. It will profit from stable or increasing volatility.

The opposite applies to short.

Question 13

What is volatility skew, smirk, and smile?

Answer 13

Volatility Skew: results from the price impact of increasing put and decreasing call volatility as the strike price diverges from the current price.

Smirk: occurs when volatility increases more for OTM puts than OTM calls reflecting greater demand for protective puts than calls.

Smile: results from increasing volatility for both puts and calls.

Question 14

What are some common strategies for options?

Answer 14

Common strategies for options include:
* A long call can be used to increase risk exposure to implement a bullish outlook.
* A protective put can be used to reduce equity risk exposure in that it serves as insurance against falling prices.
* Investors can hedge against increasing or decreasing market volatility through the use of call and put options on the the VIX.

Question 15

What are some option strategies for implementing a market view or investment objective?

Answer 15

• Bearish investors use collars on a long position to hedge risk and smooth volatility.
• Investors will buy/sell a call/put if implied volatility is expected to increase/decrease.
• Investors wanting to buy stock when implied volatility is high sell puts to offset the price of the stock.
• A bullish or bearish investor can use a bull or bear spread if markets are not clearly trending.

Question 16

What is a hedge ratio (HR)?

Answer 16

The hedge ratio (HR) is the number of futures contracts required to fully or partially hedge the portfolio.

HR = (ΔP/ΔCTD) × CF

Question 17

What are cross-currency basis swaps?

Answer 17

Cross-currency basis swaps: exchange notional principal, which allows firms to use a local currency loan to create a foreign currency loan without bearing any foreign exchange risk.

Question 18

What are currency forwards and futures?

Answer 18

Currency forwards and futures: are used to manage currency risk, as these instruments can hedge against exchange rate risk by periodically buying/selling foreign currency at a fixed price agreed upon at contract initiation.

Question 19

What is cash equitization/securitization/overlay of unintended cash holdings?

Answer 19

Cash equitization/securitization/overlay: of unintended cash holdings is when futures are purchased to replicate underlying market returns where cash holdings would have otherwise been invested; puts and calls with the same strike price and expiration can also be used.

Question 20

What is variance swap payoff?

Answer 20

Variance swap payoff is convex and the profit/loss for changes in realized volatility is not linear.

Question 21

What is a mark-to-market valuation of a variance swap?

Answer 21

The mark-to-market valuation for a variance swap at time t (VarSwap_t) depends on realized volatility from initiation to t (RealizedVol (0,t)) and implied volatility at time t (ImpliedVol (t,T)) for the remaining life of the swap (T − t).

Question 22

How does a payment at settlement of variance swaps settle?

Answer 22

Variance swaps only exchange cash at expiration, not inception or periodically in between, and payment at settlement.

Question 23

What aree the implications of flat backwardation and contango volatility.

Answer 23

A flat shape shows that volatility is expected to remain stable over the near to long term.

A downward slope (backwardation): shows decreasing volatility expectations over time; prices are higher for short-term contracts.

An upward slope (contango): shows increasing volatility expectations over time; prices are lower for short-term contracts.

Question 24

What is the VIX correlation and the appeal to investors of VIX call options and VIX put options?

Answer 24

Increases in VIX are negatively correlated with equity prices.

Investors would purchase VIX call options if they expect increasing volatility due to a sell-off.

Investors would purchase VIX put options if they expect decreasing volatility due to stable markets.

Question 25

What are implied probabilities?

Answer 25

Implied probabilities: are the “priced in” market view and can easily diverge from guidance provided by central banks and inferred probabilities over long time horizons do not have strong predictive power. Also, activity by large financial institutions can influence future pricing such that the probabilities will be off.

Question 26

What are the strategic choices in currency management?

Answer 26

Choices involve remaining unhedged (zero hedge), partial hedging through full hedging, or actively seeking gains from FX movement.

Hedging and active currency trading both involve portfolio costs that may, in the long run, outpace hedging or active returns.

Question 27

What is an appropriate currency management program given financial market conditions?

Answer 27

Bond portfolios should hedge currency risks because interest rates affect both asset returns.

During times of global market stress, however, foreign investors should underhedge USD exposure, and USD investors should overhedge foreign exposures as the herd stampedes to USD investments.

Question 28

What is an appropriate currency management program given portfolio objectives and constraints?

Answer 28

Strategy should be biased toward full hedging as allocation to fixed income increases:
* liquidity needs increase or time horizon decreases
* risk aversion increases
* FX volatility increases
* governing board skepticism about FX returns increases

Lower hedging costs improve the outlook for hedging activity and should be considered.

Question 29

How is active currency trading based on economic fundamentals?

Answer 29

Increase exposure to currencies expected to appreciate based on expected long-run equilibrium rate and fluctuations around that path resulting from:
* foreign capital interest
* inflation
* changes in the country risk premium

These factors depend to some extent on fiscal and monetary policy.

Question 30

How is active currency trading based on technical analysis (TA)?

Answer 30

TA seeks to exploit market inefficiency that can be spotted from repeating historical data and short-term supply and demand conditions.

Technicians believe that stop loss orders triggered as prices approach important support levels can reverse a downtrend and sell orders at resistance levels can reverse an uptrend.

Question 31

How is active currency trading based on carry trade opportunities?

Answer 31

Carry trades are those that involve borrowing in currencies with low interest rates and investing in higher-yielding currencies.

Any profits generated with this strategy violate the uncovered interest rate parity condition, which suggests that any yield advantage in one currency will be exactly offset by depreciation of the higher-yielding currency.

Question 32

How is the forward rate bias allows a carry trade opportunity to develop.

Answer 32

Uncovered interest rate parity implies that the forward rate should be a perfect predictor of the future spot rate given interest rate differentials. However, forward premiums (FP/B – SP/B) overstate base currency appreciation, and discounts overstate base currency depreciation.

This implies that traders can profit from selling forward premiums and purchasing forward discounts; low volatility environments are preferred.

Question 33

How is active currency trading based on volatility?

Answer 33

Traders can buy at-the-money puts and calls to straddle a position, effectively hedging volatility, or sell out of the money puts and calls to strangle a position, effectively selling volatility unlikely to occur.

Straddle: is more profitable in volatile markets when the value of either the puts or calls goes into the money enough to pay for both positions.

Strangle: profitability requires the puts or calls to go past the OTM strike and will likely be less profitable than a straddle.

Question 34

How are forward contracts and FX swaps are used to adjust hedge ratios?

Answer 34

Increase the hedge ratio (short P/B forward) to take advantage of an appreciating foreign currency asset value. Also increase the hedge ratio if the base currency for that asset is expected to depreciate.

Question 35

How can out-of-the-money put options as a method to reduce hedging costs and modify the risk-return characteristics of a foreign-currency portfolio?

Answer 35

One way to protect against large currency losses is to purchase deep OTM put options with low deltas and, therefore, low probabilities of expiring in-the-money. These options are relatively cheap and protect against a currency meltdown.

Question 36

How is a risk-reversal strategy can reduce hedging costs and modify the risk-return characteristics of a foreign-currency portfolio?

Answer 36

Risk reversal involves purchasing a put option on the base currency to protect against downside risk and selling a call option to partially offset the cost of the long put.

Question 37

How is a put spread can reduce hedging costs and modify the risk-return characteristics of a foreign-currency portfolio?

Answer 37

A portfolio manager can buy and write out-of-the-money put currency options with identical expiry dates but different exercise rates to protect against a modest expected weakening of the currency. To be cost efficient, the short put should be deeper out-of-the-money (10-delta) than the long put (25-delta), which means it will not be a zero-cost hedge.

Question 38

How is a short seagull spread can reduce hedging costs and modify the risk-return characteristics of a foreign-currency portfolio?

Answer 38

It involves buying a protective put and selling deep out-of-the-money put and call options. Exercise rates are selected so the strategy is a cost-free one.

An investor in a short seagull spread realizes profits when the options expire within a tight range around the current spot price (i.e., volatility declined).

Question 39

What are exotic options?

Answer 39

Exotic options require the lowest-cost investment to achieve a specific outcome. These options are quite helpful for clients with unique IPS constraints or who have specific income needs that cannot be produced by traditional financial securities.

Question 40

How is the use of cross hedges in portfolios exposed to multiple foreign currencies?

Answer 40

In cases where no derivatives exist or contracts have low liquidity, an investor may cross hedge by using an asset highly correlated with the asset underlying a desired hedge. This does not provide a perfect match, but may reduce exposure in a useful way.

Question 41

How are the use of macro hedges in portfolios exposed to multiple foreign currencies?

Answer 41

A macro hedge uses index derivatives to offset a portfolio’s factor sensitivities. This protects the investor against general recessions, inflationary concerns, and other financial stresses between and among economies.

Question 42

What is the use of a minimum variance hedge in portfolios exposed to multiple foreign currencies?

Answer 42

A minimum variance hedge employs regression analysis to determine the sensitivity of the hedging instrument to changes in the underlying (i.e., the beta). That sensitivity becomes a ratio used to determine the amount of hedge instrument necessary to offset the desired risk.

Question 43

What is the challenges for managing emerging market currency exposures.

Answer 43

Emerging markets typically have higher trading costs but are also subject to wild swings in currency and financial asset values under stressed conditions.

Some assets are thinly traded and may not result in normally distributed returns, making regression analysis problematic. Historical conditions may not repeat, making derivatives strategies risky.