Derivatives and Currency Management

Question 1

What is the objective of a active currency management approach?

Answer 1

Take currency risks and manage them for profit with the primary goal of adding alpha to the portfolio through successful trading.

Question 2

What is the objective of a discretionary hedging approach?

Answer 2

Primarily to protect the portfolio from currency risk. Also to seek alpha within limited bounds.

Question 3

What is the objective of a passive hedging approach?

Answer 3

Keep currency exposures close to those of a BM.

Question 4

The strategic currency positioning of a portfolio should be more biased toward a fully-hedged programme the more…

Answer 4

ST the investment objectives, risk averse the client, immediate the liquidity needs, fixed income assets held, cheaply a hedging programme can be implemented, and volatile markets are.

Question 5

What are two justifications for forwards over futures for currency hedging?

Answer 5

Less expensive and greater liquidity.

Question 6

What positions create a bull spread?

Answer 6

Buy one option and sell another with a higher strike price.

Question 7

What positions create a bear spread?

Answer 7

Buy one option and sell another with a lower strike price.

Question 8

What positions create a long calendar spread?

Answer 8

Buy a long dated option and sell a short dated option.

Question 9

What is the IV takeaway of a volatility smile?

Answer 9

OTM option IV is higher than ATM option IV.

Question 10

What is the IV takeaway of a volatility skew?

Answer 10

OTM call IV is lower than ATM and OTM put IV is higher than ATM.

Question 11

Why is OTM puts IV higher than ATM puts?

Answer 11

Cheaper OTM puts are used by investors to hedge downside risk. Higher demand leads to higher prices and higher IV.

Question 12

What is a long risk reversal trade?

Answer 12

Buy low IV option and sell high IV option. Net long position so delta hedge it out by selling underlying. Profit from IV correction.

Question 13

What is the equation to find the notional value of an interest rate swap?

Answer 13

portfolio value × target duration - portfolio duration/swap duration

Question 14

What is the BPV equation for the number of bond futures contracts required to duration hedge a bond portfolio?

Answer 14

(target BPV - portfolio BPV / CTD BPV) × CF.
where:
portfolio BPV = duration × 0.01% × MV
CTD MV = CTD price / 100 × 100,000

Question 15

Negative basis in a cross currency basis swap indicates a what for the non-USD lender/USD borrower?

Answer 15

A cost.

Question 15

What is the equation to find the number of equity futures for needed to hedge a portfolio?

Answer 15

(target β - portfolio β / futures β) × MV / F

Question 16

What is the equation for the value of a volatility swap at expiry?

Answer 16

variance notional × (realised variance – strike variance)
where:
if given realised and strike volatility, square to get variance.
variance notional = vega notional / 2 × strike volatility

Question 17

What is the equation for the value of a volatility swap before expiry?

Answer 17

variance notional × PV factor (time passed × realised variance + time remaining × implied variance - strike variance
where:
variance notional = vega notional / 2 × strike volatility

Question 18

What is the equation for the probability of a change in the Fed Funds Rate?

Answer 18

Effective FF rate implied by futured contract - current FF rate / FF assuming a rate hike - current FF
where:
FF futures contract price = 100 − effective FFE rate
current and expected are the midpoint of the range.

Question 19

What impact does end of month activity by large IIs have on predicted FF rates?

Answer 19

Increased demand leads to a higher fed futures price and a dip in expected FFE rate.

Question 20

What is a carry trade?

Answer 20

Borrowing a low yield currency and investing in a high yield currency. Want a stable market.

Question 21

What is trading the forward rate bias?

Answer 21

Borrowing a currency trading at a forward premium and investing in a currency trading at a forward discount.

Question 22

When rolling over a matched currency swap contract, what rates are used for the spot and the forward legs?

Answer 22

Spot uses mid-market rate and forward uses the all-in rate.

Question 23

When rolling over a mismatched currency swap contract, what rates are used for the spot and the forward legs?

Answer 23

Both use the all-in rate.

Question 24

What is a short seagull spread?

Answer 24

Write an OTM call and OTM put and buy an ATM put.

Question 25

What is the equation for the minimum variance hedge ratio?

Answer 25

correlation × σD/σFX

σFX is standard deviation of the exchange rate.

Question 26

What is a collar?

Answer 26

Protective put and a covered call i.e., buy put and underlying and sell call. Sell calls to fund the puts. Exposure is between the two strikes.

Question 27

What positions do you take in a bond arbitrage trade when the basis is positive?

Answer 27

Profit by selling the basis i.e., selling the bond and buying the futures.

Question 28

Why are variance swaps good for hedging equity tail risk?

Answer 28

Have a convexity feature where when realized variance increases the positive pay off increases. Vega notional should be equal to potential equity position loss.

Question 29

How do you replicate a long futures position?

Answer 29

Buy underlying stock and invest in risk-free bond.

Question 30

What is the equation to find the invoice amount that the short receives from the long in a settled bond futures?

Answer 30

futures settlement price / 100 x CF x contract size

contract size usually = 100,000

Question 31

What is the equation for the number of bond futures contracts required to duration hedge a bond portfolio that has the CTD as the underlying?

Answer 31

(ΔP / ΔCTD) × CF

Question 32

Under what condition would you exercise if you bought a payer swaption?

Answer 32

If SFR < new SFR

Question 33

Under what condition would you exercise if you bought a receiver swaption?

Answer 33

if SFR > new SFR

Question 34

When does a long FRA position win?

Answer 34

When rates rise.