Part 8 - Volatility And Complex Structures

Question 1

Three Limitations of Realised Volatility

Answer 1

• Realised volatility does not define the return distribution’s shape
• When assets have identical realised volatility the could differ
• Realised volatility does not indicate whether the dispersion of returns occurred near an underlying asset price or during a specific period in the sample

Question 2

Six properties of realised volatility with regards to volatility arbitrage strategies and portfolio risk management

Answer 2

• Is non-constant and exhibits slow mean reversion and clustering
• Is normally low until a market shock and then vol rises for an extended period
• Can be large in the short term but will be near long term averages in the long term
• Higher R Vol is negatively correlated with risky asset returns
• Higher in bear, lower in bull. Negatively correlated between equity value and volatility
• Realised Equity Vol rises faster in bear markets and falls slower in bull markets

Question 3

Four principles of vega equation

Answer 3

• Vega is positive for long calls and puts
• Vega must be equal for a call and put with the same time to maturity, strike price and implied volatility
• As time to expiration nears zero option vega approaches zero
• As value of underlying asset gets closer to zero or infinity the vega of the option gets closer to zero

Question 4

Degrees of curvature measured by gamma result in

Answer 4

• increasing rates of return for call options as the underlying increases in value
• Decreasing rates of losses as underlying decreases in value
• Increasing returns for puts as the underlying decreases in value

Question 5

Volatility smiles and smirks most likely occur due to

Answer 5

• negatively skewed return distributions
• Institutional investor demand for downside risk protection associated with long put options in the equity market
• Negative return correlation between returns and volatility changes

Question 6

Short Iron Butterfly

Answer 6

Sell bull spread and bear spread with same middle strike price

Question 7

Short Iron Condor

Answer 7

Sell OTM Bull spread and OTM bear spread

Question 8

Performance Drivers of delta-neutral hedged portfolio

Answer 8

• Price variation

- Rehedging strategy

Question 9

Impact of rebalancing delta hedge portfolios

Answer 9

Frequent rebalancing will increase expected returns if asset in mean reverting

Question 10

Four criteria for complexity risk premium

Answer 10

1. Asset must have a return history of unfavourable periods
2. Complexity factor should be implementable
3. Any risk premium needs to be confirmed empirically
4. Any risk premium should be persistent over time

Question 11

Characteristics of an Asset Based Borrower

Answer 11

• Small to medium sized firms
• Loans tend to be $10 - $50
• Retail, distribution, wholesale, manufacturing and service firms are common borrowers
• Usually have asset rich balance sheet, 50% of assets in working capital
• A proven management team capable of dealing with complex securities
• Usually have strong controls for financial accounting and IT systems
• Loans are typically not rated by credit agencies

Question 12

Internal Credit Enhancements for CCRs

Answer 12

• Senior / subordinated structure
• Spread accounts
• Excess finance charges
• Overcollateralisation

Question 13

External credit enhancements for CCRs

Answer 13

• Cash collateral accounts
• Letters of credit
• Collateral invested accounts