Derives Flashcards
Formula to add/reduce duration to a portfolio
(Duration Target - Duration Portfolio / Duration Index) * Value Portfolio / Future Price*multipler
Formula to add/reduce beta to a portfolio
(Beta Target - Beta Portfolio / Duration Index) * Value Portfolio / Future Price*multipler
What may cause basis risk
Difference in asset price and future price if contract needs to be retired early
Rounding
Betas/durations cannot be measured accuratley
Future is not a good hedge for the portfolio
Effective Beta portfolio
%deltaportfolio / %deltaindex
Why would you want to hedge a portfolio?
To reduce market risk given you anticipate a certain market to increase/decrease
How to reduce allocation to a portfolio without straight selling out
Use derivates. Use the PCP formula (the beta changing one) with a target beta of 0 ,and the difference in allocations as the portfolio value
What is pre-investing?
Investing in a derivative before you actually have the cash avalaible to take advantage of market moves/anticipated market moves
Explain synthetic positions
Converting Cash to a risky asset or viseversa - pretty much investing in a risky asset without actually investing in it
Equitised, what does it mean
Turing into an equity exposure
What are the 3 steps in establishing a synthetic position? How should you invest your cash reserves?
Work out how much money you need at the expiry of the contract
Invest in the risk free rate so you have the money at expiration
Invest in the contract on margin
What is transactional currency exposure
It is when you buy something from overseas, cash due in x months - the market movements of that currency is the risk
You have bought a bag from Colombia (paying in cop), your payment is due in 3 months - how do you hedge this position
So, you dont want the value of the COP to go up, then you would have to pay more - so lock in a price today - BUY a long future contract and lock in the 200 pesos to 1 AUD today
You are going to recieve 500 Swiss Franc in 20 days time - how do you hedge this position?
You’re going to recieve 500 Swiss - you dont want that to go down, but if it does, you wanna be prepared - short it and lock in a price today
What is economic risk in currency management
That an econmic acitivity will effect currency translation
Why would someone create a synthetic position with some of thier CASH reserves
Reduce cash drag and tracking error
Explain the end to end situation, 1 I got 100m in equity, 20m in Cash. I want to reduce my tracking error - what do i do
Bang. First. You’re going to want to buy x future contracts on the index. Lets say each is worth 1,000$ with a 10x multiplier
20m/(1000*10) = 2000 contracts.
Then she invests the 20m in a TD at whatever, 3%?
Then after a year, the index is up, the future price has increased from 1000 to 1050. 50 points * 2000 contracts * 10 multiplier = 1m
I get the return from my TD of 600,000.
So i have made an extra 1,600,000$ plus my cash back and the return on my equity.
What is a covered call strategy, explain it
Covered call strategy is SELLING a call while owning the underlying. The call option will be above the current stock price. It makes money in a non volatile market to get cash off the premo recieved
If you have a stock at 50$, and sell a call option at 55$ for $2 - What is the profit loss in 1 year if the stock is now $60
You get the $2. Then the appreciation from the stock price to the exercise price. Then you’re done, you’re exposure is over.
$7
Protective put - explain it
It is when you own the underlying, but you BUY a put option - limits your downside. It may be when you expect vol in the market.
If you expect vol in the market, would you use a protective put or coverred call? And why
Put - the call is used in a non volatile environment to collect premium off writing options. Protective puts are used to limit downside in a volatile market
Which has unlimited gain, protective put or covered call and why
PUT - if the price goes up, it could continue to infinity. You own the underlying in both these strategies, but the call only has exposure up to the exercise price
What is the breakeven price on a protective put (think premium and stock)
The stock price + the premium (you have to recoup that premium you paid
Bull Spread - explain
It is when you BUY a call option at a low strike, then SELL a call at a higher strike price.
This sort of puts your profits in a band or collar.
You do NOT own the underlying, so you get profit when you hit your strike, but lose the difference between your strike and that which you sold is hit by the market.
Bear spread, explain
Similar to a bull spread, it is selling a LOW LOW price Put option, and Buying a higher Put option - this allows you to profit when the price decreases
What is a straddle and why use it
You’d want to use it in high vol situations and because it has higher upside than things like collars or spreads.
Buy same priced calls and puts. Max losses are your premiums paid. You lose if the price doesnt move
Collar strategy, explain
Buying put and selling call. Putting a collar around your gains and losses - limiting the upside and downside - potentially in times of serious market distress or uncertainty
What is the Delta Hedge formula and what does it mean
It is# shares to buy = - (delta) * #options you own
It is the formula that gives you the # of stocks you need to buy/sell to earn the risk free rate (neutralise) your position
If i write a call option, is my delta going to be positive or negative
negative
How many stocks do i buy to delta hedge my portfolio if the portfolio has a delta of .5 and i own 10,000 options
5000
If the delta of my portfolio changes, and i end up having to sell some of my positions to maintain a delta neutral portfolio, what do i do with the extra cash
Invest in the risk free rate
When would a delta hedge be most difficult to do? (think greeks)
When the gamma is at its highest, which would be when the position of the options is close to at the money.
What is gamma
The rate of change in delta
What is vega
Volatility
How to create synthetic long forward?
Buy call, sell put
How do i reduce my duration exposure using a swap
You enter into a RECIEVE FLOATING pay fixed swap
Cash flow risk and market value risk. How is a floating note effected by these risks (IF AT ALL)
It is subject to cash flow risk because you dont know what your cash flows will be in n months.
Since the duration is so low for a floating rate swap, there is no real market value risk
Formula for notional principle (how much you have to invest) to reduce/increase duration exposure using a swap
it is:
Value Swap* (((Target D - Actual D)/ Swap D)
D = Duration
Explain what happens in a currency swap
Exchange notional at initiation, pay back interest payments in the currency you recieved then reexchange notional at expiration
What is a currency swap doing to your foreign currency exposure
Reducing it to just the interest payments - the risk is spread out over the life of the swap
Why would you enter into a currency swap
Reduce foreign currency exposure AND because you do NOT have preferable borrowing terms in foreign currencies/jurisdictions
How to make synethic put option
Short stock and buy call
Buying the call is the outflow from buying a put
Explain a synthetic long
Buying a call and put option at the same strike and exp - ONE OF THEM GOTTA BE EXERCISED RIGHT. Just like in a forward.
Has the same payoff as just buying the underlying
What does using a covered call do to your portfolio characteristics?
REDUCES DELTA
3 benefits of covered call
Yield (+ premium)
Locking in a future sales price (with an extra premium)
Reduce portfolio delta
When would you use a protective put
If you think the market gunna crash
Explain bull spread (legion)
So, stock is at 10, you BUY a call at 9$ and SELL a call at 11. You gotta pay for those options, but the one you bought will prob cost more.
You ride the rise all the way up to the exercise of the higher priced option, then you cash out net of premiums.
What is the max loss on a bear spread
Just the premiums
Explain why you might enter an equity swap?
Reduce or increase an exposure to a certain stock or index.
Eg equity swap paying apx recieiving sp500 if you have a huge allocation to apx
When could a payer swaption be beneficial , in whuch ir enviornment
Increasing IR
I have just issued a floating rate bond - how do i negate my payments so i am either paying less, or a fixed rate, in one year
Enter a payer swaption.
If ir increase, you exercise and recieve the floating rate which you pay to your bondholders, while transforming your payments into a fixed pmt yo the market maker
What is a main risk of entering into a swap or currency swap?
Counterparty risk.
or currency risk, if the amount a currency appreciates or depreciates, one party would have a loss
What is a eurodollar future?
A TD on USD outside the US - just like a bond
Explain the process of an FRA
So, you go to the bank, and lock in an interest rate for some point in the future for an amount you intend to borrow. This is because you think interest rates will go up and you dont wanna pay more than you have to
The day comes, and interest rates have increased. The bank pays you the discounted value of the loan amount multiplied by the difference in interest rates, then you carry out the loan on normal terms.
How to work out if a swap is better than just borrowing - what is the process of interest rates and swap interest rates?
I am asking, if you were to work out if its better to just borrow vs using a swap, how would you work it out using swap rates and interest rates
So, is the interest rate from a bank better than the NET amount of what you would pay if you went through the swap process.
E.g loan at 5.5% (which is -5.5%)
OR
loan in Colombia at 6% (-6%), plus the amount you recieve on the swap (5%) minus the amount you have on the swap (4%)
-6+5-4 = -5%.
The swap is better
Ignore which currency is which
This assumes interest rate parity and well integrated markets
Explain what a currency basis swap is
It is when there is a DISCOUNT on the swap rate of one of the currencies in a currency swap because the counterparty currency is in high demand (like the USD)
You subtract the negative basis points from the swap rate to determine the effective interest rate/cost of debt.
You convert everything into one currency and compare if the swap is cheaper than just borrowing direct from the currency you want
How do you go long volatility?
Buy vix future
In a vix future, what sort of environment has positive ROLL Return
Backwardation - spot higher future
Are OTC Swaps (like equity swaps) Liquid?
No way Jose
If i buy a call option, what does that do to my delta?
Increases
This one is important Guy.
How do you hedge tail risk using volatility VIX options? Why does this make sense?
What happens as vol increases? Prices decrease. So if you go LONG volatility, you are in fact reducing your tail risk. You can offset this position by also selling put options.
If vol gets gnarly, that is a tail event. Buying the call options on this volatility for a discount is an awesome idea.
If i sell a call option, what position do i have on theta
positive
Explain the process of a calendar spread (calls)
Sell short dated calls and BUY long dated calls
This is when you assume no vol in the short term, but perhaps some hectic upside after earnings or something in the future
Explain a volatility skew
It is when there is HUGE volatility on Out the money calls/puts, and lower vol for those options that are at or in the money.
This means that there are many hedgers/people buying insurance around
If there is an uptick in volatility in OTM puts - what sentiment is this sending?
This is inferring an upcoming bearish market - people think that prices will go down, so they are buying insurance
What if there is an uptick in OTM calls - what sentiment is this sending
Bullish market to come
Assume that there is an uptick in OTM put volatility, but you think it is overcooked - how might you take advantage of that?
Buy calls and sell puts. The puts are going to be selling at a premium because everyone is buying them, so sell some if you believe this reality will not be realised.
Formula for predicting the Federal Fund Rate change
Implied Fund Rate - Current Fund rate / change %
Notional Principal swap formula
NS=(MDURT−MDURP/MDURS)(MVP)
(Target Mod Duration - Mod duration Portfolio) / Mod Duration Swap * MV portfolio
