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CFA L3 > Derivatives and Risk Management (11.6.24) > Flashcards

Derivatives and Risk Management (11.6.24) Flashcards

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1
Q

Put Call Partiy

A

Stock price + put premiuxm = call premium + strike price/(1+r)^T

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2
Q

Synthetic long forward position

A

Long call + short put (same strike and maturity)

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3
Q

Synthetic short forward position

A

Short call + long put (same strike, maturity)

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4
Q

Delta

A

The relationship between option price and underlying price; shows how much an option price will change for a small change in the stock

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5
Q

Gamma

A

A numerical measure of how sensitive an option’s delta (the sensitivity of the derivative’s price) is to a change in the value of the underlying

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6
Q

Vega

A

The change in a given derivative instrument for a given small change in volatility, holding everything else constant

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7
Q

Theta

A

The change in a derivative instrument for a given small change in calendar time

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8
Q

Position delta

A

the overall/portfolio delta

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9
Q

cash secured delta

A

an option strategy involving the writing of a put option and simultaneously depositing an amount of money equal to the exercise price into a designated account (also called fiduciary put)

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10
Q

How are spreads classified

A

1) Market sentiment
2) Direction of the initial cash flows

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11
Q

Bull spread

A

An option strategy that becomes more valuable when the price of underlying asset rises; requires buying one option and writing another with a higher exercise price

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12
Q

bear spread

A

an option strategy that becomes more valuable when the price of the underlying asset declines;

long put + short put, on different strikes

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13
Q

Debit spread

A

when the spread requires a cash payment by the investor; effectively long because the long option value exceeds the short option value

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14
Q

credit spread

A

when the spread initially results in a cash inflow to the investor; effectively short because the short option value exceeds the long option value

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15
Q

Long straddle

A

option combination in which one buys both puts and calls with the same exercise price and same expiration date on the same underlying asset

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16
Q

Short straddle

A

short put + short call, both with same strike

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17
Q

When would you use a straddle

A

when you expect volatility but don’t know which direction

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18
Q

Collar

A

long stock + long put (exercise below current price) + long call (exercise above current price)

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19
Q

When would you use a collar

A

protect gains that has long-term potential but are concerned about short-term volatility; limits both potential gains and losses

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20
Q

Calendar spread

A

a strategy in which one sells an option and buys the same type of option but with different expiration dates, on the same underlying asset and with the same strike

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21
Q

Implied volatility

A

Standard deviation that causes an option pricing model (BSM) to give the current option price

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22
Q

Realized volaility

A

Historical volatility, the square root of the realized variance of returns, which is a measure of the range of past price outcomes for the underlying asset

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23
Q

Annual Standard deviation %

A

StD monthly % * sq (252/21)

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24
Q

Volatility smile

A

the u-shaped plot (of implied volatility (y axis) against strike (x axis) for options on the same underlying with the same expiration) that occurs when the implied volatilities priced into both OTM puts and calls trade at a premium to implied volatilities of ATM options

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25
Q

Volatility skew

A

The skewed plot (of implied volatility (y axis) against strike price (x axis) for options on the same underlying with the same expiration) that occurs when the implied volatility increases for OTM puts and decreases for OTM calls, as the strike price moves away from the current price

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26
Q

Risk reversal

A

a strategy used to profit from the existence of an implied volatility skew and from changes in its shape over time. A combination of long (short) calls and short (long) puts on the same underlying with the same expiration is a long (short) risk reversal

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27
Q

Term structure of volatility

A

The plot of implied volatility (y axis) against option maturity (x axis) for options with the same strike price on the same underlying. Typically, implied volatility is not constant across different maturities - rather, it is often in contango, long-term options implied volatilities are higher than near-term ones

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28
Q

Implied Volatility surface

A

a 3-dimensional plot, for put and call options on the same underlying asset, of days to expiration (x axis), option strike prices (y axis), and implied volatilities (z axis). It simultaneously shows the volatility skew (or smile) and the term structure of implied volatility

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29
Q

Interest rate Swap

A

OTC contract between two parties that agree to exchange cash flows on specified payment dates - one based on a variable interest rate and the other based on a fixed rate - determined at the time the swap is initiated

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30
Q

Swap tenor

A

when the swap is agreed to expire

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31
Q

Basis risk

A

Spread risk, or the difference between the market performance of the asset and the derivative instrument used to hedge it

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32
Q

Forward rate agreement

A

OTC derivative instrument that is used mainly to hedge a loan expected to be taken out in the near future or to hedge against changes in the level of interest rates in the future

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33
Q

The preferred instrument to hedge bond positions

A

Fixed income futures, given that their liquidity is high

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34
Q

Principal invoice amount

A

(futures settlement price/100) * CF * Contract Size

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35
Q

If the basis is negative how would a trader make profit

A

Buying the basis - purchasing the bond and shorting the futures

36
Q

If the basis is positive, how would a trade make profit

A

Selling the basis - sell the bond and buy the futures

37
Q

Hedge Ratio (HR)

A

Number of fixed-income futures contracts to be sold or purchased

Change in value of the bond portfolio (Delta P) = HR * change in value of the fixed income futures (Delta F)

HR = (Delta P / Delta CTD) * CF

38
Q

Portfolio’s target basis point value

A

BPV = MDUR * 0.01% * MV

39
Q

Basis point value hedge ratio (BPVHR)

A
  • BPV (P) / BPV (CTD) * CF
40
Q

Cross-currency basis swap

A

A swap in which notional principals are exchanged because the goal of the transaction is to issue a more favorable funding rate and swap the amount back to the currency of choice

41
Q

Equity Swap

A

Derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by a single stock, a basket of stocks, or an equity index and the other party pays either a variable series determined by a different equity or rate or a fixed series

42
Q

Disadvantages to equity swaps

A

1) Require putting up collaterals
2) Relatively illiquid contracts
3) Do not confer voting rights

43
Q

Advantages of equity swaps

A

1) When access to a specific market is limited
2) Taxes are levied for owning physical stocks (stamp duty) but not on swaps
3) Custodian fees are high
4) Cost of monitoring the stock position is elevated (corporate actions)

44
Q

Number of equity futures contracts to buy or sell

A

NF = ((BT - BS) / BF) * (S/F)

45
Q

Cash securitization (equitization/cash overlay)

A

Strategy designed to boost returns by finding ways to “equitize” unintended cash holdings

46
Q

VIX

A

“fear index”, measure of investor’s expectations of volatility in the S&P500 over the next 30 days

47
Q

Payoff at settlement of a variance swap

A

(variance notional) * (realized variance - variance strike)

variance notional = vega notional / 2 * strike price

48
Q

Vega Notional

A

The trade size for a variance swap, which represents the average profit and loss of the variance swap for a 1% change in volatility from the strike

49
Q

What two things do variance swap traders typically agree on

A

1) A variance swap trade size expressed in vega notional (not in variance notional)
2) The strike (x), which represents the expected future variance of the underlying, expressed as volatility (not variance)

50
Q

Variance notional

A

The notional amount of a variance swap; it equals vega notional divided by two times the volatility strike price

(vega notional) / (2 * strike price)

51
Q

Rule of thumb for strike of a variance swap

A

Typically corresponds to the implied volatility of the put that has 90% moneyness (calculated as the option’s strike divided by the current level of the underlying)

52
Q

Effective federal funds rate (FFE)

A

The fed funds rate actually transacted between depository institutions, not the Fed’s target federal funds rate

53
Q

Probability of a change in the federal funds rate

A

(Effective federal funds rate implied by futures contracts - current federal funds rate) / (federal funds rate assuming a rate hike - current federal funds rate)

54
Q

How much of the foreign exchange market do spot markets account for

A

less than 40%

55
Q

FX Quoting Hierarchy

A

1) Currency pairs using EUR, EUR base
2) Currency pairs using GBP, other than EUR, GBP base
3) Currency pairs using AUD or NZD, other than EUR and GBP, AUD/NZD base
4) All other currency quotes using USD, USD base

56
Q

Two forms of hedging costs

A

Trading costs and opportunity costs

57
Q

Currency overlay program

A

Program to manage a portfolio’s currency exposures for the case in which those exposures are managed separately from the management of the portfolio itself

58
Q

All else equal, the base currency’s real exchange rate should appreciate if there is an upward movement in…

A

1) Long-run equilibrium real exchange rate
2) Real or nominal interest rates, which should attract foreign capital
3) Expected foreign inflation, which should cause the foreign currency to depreciate
4) Foreign risk premium, which should make foreign assets less attractive compared with the base currency nation’s domestic assets

59
Q

Carry trade

A

A trading strategy that involves buying a security and financing it at a rate that is lower than the yield on that security

60
Q

Forward rate bias

A

An empirically observed divergence from interest rate parity conditions that active investors seek to benefit from by borrowing in a lower-yield currency and investing in a higher-yield currency

61
Q

Return distribution of the carry trade

A

Pronounced negative skew

62
Q

Is higher/lower volatility better for the carry trade

A

lower

63
Q

Most important Greek traded

A

Vega

64
Q

Why do institutional investors prefer forwards over futures when hedging currency trades

A

1) Futures contracts are standardized, which may not be exactly what they need
2) Futures contracts may not always be available in the currency pair that the PM wants to hedge
3) futures contracts require up-front margin (initial margin), as well as have intra-period cash flow implications

65
Q

Static Hedge

A

A hedge that is not sensitive to changes in the price of the asset hedged

66
Q

Dynamic hedge

A

A hedge requiring adjustment as the price of the hedged asset changes

67
Q

Put spread

A

A type of short risk reversal position used to reduce the upfront cost of buying a protective put

Involves buying an OTM put option and writing another deeper OTM put option

68
Q

Seagull spread

A

An extension of the risk reversal foreign exchange option strategy that limits downside risk

Long a protective put and then write both a call and deep OTM put

69
Q

Knock-in/Knock-out

A

Features of a vanilla option that is created (or creases to exist) when the spot exchange rate touches a pre-specified level (barrier)

70
Q

Cross hedge

A

A hedge involving a hedging instrument that is imperfectly correlated with the asset being hedged; for example, hedging a bond with futures on a non-identical bond

71
Q

Proxy hedge vs. Cross hedge

A

Proxy hedge removes the foreign currency risk by hedging it back to the investor’s domestic currency, while a cross hedge moves the currency risk from one foreign currency to another foreign currency

72
Q

Minimum-variance hedge ratio

A

A mathematical approach to determining the optimal cross hedging ratio (running a regression)

73
Q

2 Considerations when managing emerging market currency exposures

A

1) Trading costs are higher (thinly traded)
2) Increased likelihood of shit hitting the fan

74
Q

Non-deliverable forwards

A

Forward contracts that are cash settled (in the non-controlled currency of the currency pair) rather than physically settled (the controlled currency is neither delivered nor received)

75
Q

synthetic long put

A

long call + short shares

76
Q

theta for short stock + put position

A

positive

77
Q

theta for short stock + long call

A

negative

78
Q

where does the largest gamma occur

A

at or near the money

79
Q

amount of cash exchanged at initiation of a variance swap

A

0

80
Q

what does it mean to sell the basis

A

sell the bond and buy the futures

81
Q

deriving the probability of a rate move by the FOMC

A

1) Calculate FFE from contract price: | 100-contract price |

2) (FFE - current contract price)

3) Federal funds rate assuming a rate cut (if contract price is below 100) - current FFE

4) step 2 / step 3

82
Q

Currency swap - cash flows at inception

A

two parties pay the notional of the contract they agreed to enter into

83
Q

Currency swap - periodic cash flows

A

payments based on floating rate

84
Q

Currency swap - cash flows at maturity

A

notional principal in respective currencies

85
Q

return of domestic currency

A

R(DC) = (1+R(FC))*(1+R(FX))-1

86
Q

difference between currency swaps and fx swaps

A

fx swaps don’t have intermediate cash flows and are typically shorter r

87
Q

types of trading costs in currency management

A

CFA L3 (7 decks)

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