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CAIA II > Topic 9: Volatility and Complex Strategies > Flashcards

Topic 9: Volatility and Complex Strategies Flashcards

1
Q

Define VEGA

A

VEGA: sensitivity of option value to change in volatility of underlying asset

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2
Q

Define GAMMA

A

GAMMA: second-order derivative wrt underlying asset value

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3
Q

Define THETA

A

Time

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4
Q

Differences between Vega and Volatility

A
  1. VEGA: holds all variable OTHER THAN VOLATILITY constant while correlation In volatility do not hold other variables constant
  2. Long equity = ZERO Vega but short vol since higher vol means lower return. Therefore delta is one.
  3. Deep in the money equity calls have positive Vega, but negative vol
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5
Q

Examples of asset classes with short volatility

A

Since VIX futures are positively correlated with equity market vol and tend to decline in value due to negative risk premium, if you long VIX contracts, you enjoy the hedging benefit of negative equity betas but pay for protection.

EXPECTED returns less than riskless rate

  • write option
  • long traditional equity
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6
Q

Key reasons Implied Vol differ for options with same underlying but different strikes or tenors:

A
  1. Skewness and Kurtosis
  2. Time varying vol
  3. Autocorrelation
  4. Time varying risk premiume
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7
Q

Implied Vol of OUT OF THE MONEY put is ____ than the implied vol of AT THE MONEY put

A

Implied Vol of OUT OF THE MONEY put is HIGHER than the implied vol of AT THE MONEY put

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8
Q

According to Nossman and Wilhelmsson, the positive risk premium of short volatility products compensates sellers for ___

A

The compensation (i.e., positive risk premium or expected return) associated with short volatility positions is for two volatility risk premiums:

  1. volatility diffusion (continuous accrual of small changes in volatility)
  2. volatility jump (large, sudden increase in volatility) risk.
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9
Q

What pattern does realised return volatility follow

A

Discrete

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10
Q

For convertible bonds, what is gamma a measure of?

A

Gamma is the second partial derivative of the convertible bond price with respect to the stock price and, therefore, is a measure of the curvature of the relationship between the convertible bond price and its underlying stock price.

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11
Q

Which options have the highest implied vol?

A

Deep out of the money

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12
Q

Reasons why volatility strategies have recovered from drawdowns quickly (i.e., in less than one year)

A
  1. Periods of high volatility are short due to the high degree of mean reversion in realized volatility.
  2. After a crisis, there is a greater demand for long volatility products by investors in traditional assets.
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13
Q

What is the economic rationale proving that implied vol of SPY options exceed realised volatility over the long term?

A

Investors with short volatility positions should earn a consistent profit (i.e., returns greater than the riskless rate) from exposure to the volatility factor.

The consistent profit to short option positions comes from implied volatility consistently exceeding realized volatility.

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14
Q

Volatility derivatives are:
1. ___ vol
2. ___ market risk
3. carry ___ risk premium

A

Volatility derivatives are:
1. long vol
2. short market risk
3. carry negative risk premium

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15
Q

In a volatility skew, which types of options have higher IVs

A

ATM puts have lower IVs than Out of The Money and In The Money options

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16
Q

Which has higher IV? Out of the money PUTS or CALLS?

A

Puts

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17
Q

Rank the ones with highest to lowest IVs
ATM
ITM
OTM puts

A

OTM put –> ATM put –> ITM put

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18
Q

When is GAMMA the highest and lowest?

A

Highest: near the money option
Lowest: in/out of the money option

19
Q

How to execute dispersion trade?

A

Sell index options
Buy options on the index components

Option positions all hedged to be delta neutral

20
Q

When does delta portfolio make money?

When underlying stock’s ____ volatility is less than the PUT’s ____ volatility

A

When underlying stock’s REALISED volatility is less than the PUT’s IMPLIED volatility

21
Q

Define Knighting uncertainty

A

cannot form reasonable quantified estimates of either outcomes or possibilities

22
Q

Name the 5 mortality rate factors according to Krutov (2010)

A
  1. Cat events
  2. Fluctations
  3. incorrect estimations of trends
  4. Miscalculations of claims
  5. Data issues
23
Q

Is complexity a return factor

A

No, evidence is not conclusive

24
Q

What are lock boxes?

A

Bank accounts for asset backed lenders to receive account receivables

25
Q

Name the 4 internal credit enhancements

A
  1. senior/sub certs
  2. overcollateralisation
  3. excess spread
  4. spread accounts (if performance indicators fall below threshold, any excess spread is put into account to benefit note holders)
26
Q

Name the 3 external credit enhancements

A
  1. cash collateral accounts
  2. third party letters of credit
  3. collateral invested amounts
27
Q
A
28
Q

What is a ticking fee

A

Fee paid to lenders by borrowers to compensate for time lag between loan commitment and disbursement

29
Q

Differences between warrants and equity options

A
  1. Warrant maturities are longer
  2. Warrants issued by unlisted firms
  3. Not standardised securitites
  4. Dilutive then issued by firm
30
Q

What does it mean by price is sticky?

A

Price stickiness refers to prices being slow to respond to changes in economic conditions.

The law of one price implies that prices denominated in different currencies should quickly adjust to changes in exchange rates.

If the law of one price holds (which requires perfect markets with no arbitrage costs), then hedging currency risk is not necessary.

31
Q

Define a quanto option

A

An option whose payoff is determined in a different currency based on pre-determined exchange rate

32
Q

Investment Property forum study found that median transaction times fro sale of real estate properties are affected by:

A
  1. State of market
  2. Building location and quality
  3. Method of sale
  4. Type of real estate
  5. Type of buyer and seller

NOT important
1. Asset price
2. Brokerage

33
Q

Observations about realised volatility (Sinclair 2013)

A
  1. mean reverts
  2. typically low, then increases and remains at higher for some time
  3. ST can be high; LR reverts to mean
  4. high vol = increased risk aversion = negatively related to risky asset return
  5. high vol = bad price
  6. vol faster in bear market than bull
34
Q

what is volatility clustering

A

large changes tend to be followed by large changes, small then small

35
Q

key differences between long vol and tail risk funds

A
  • long vol uses less aggressive strategies
  • vary vol exposure and hold more asset spread position than tail risk funds (do not need to provide protection at all times)
36
Q

Advantages of complex products

A
  1. Complete the market
  2. Enable investors to earn postive complexity risk premium
37
Q

Define recourse loan

A

Allows lenders to seize borrowers’ assets beyond loan collateral to collect amount owed

38
Q

Define indemnity based longevity swap

A

Pension plan making periodic fixed payments to the swap CP (e.g. insurer) in exchange for periodic floating payments based on the pension plan’s actual mortalities

39
Q

Define cat bond

A

Insurance-linked debt instrument designed to transfer cat risks from issuers to investors

40
Q

Why are agency relationships more important in managing private real estate than public?

A
  1. Inefficient market = cannot be certain they will receive added value
  2. Private access requires greater diligence
  3. Alpha
41
Q

What is the premium of a 9 month at the money option compared to 12 months?

A

Value of ATM option is proportional to the square root of maturity time T, thus square root of 0.75 = 86.6%

42
Q

Determine the conditions under which sale of policy is beneficial to both policy holder and entity that purchases the policy

A

Surrender value < Purchase price < NPV of non-surrender cash flows

43
Q

Implied vs Realised Volatility

A

Implied: inferred under risk-neutrality, assumes:
1. Constant variance
2. Normally distributed
3. Uncorrelated

Realised: SD
1. Discrete, not continuous like Brownian motion
2. IV - Expected Realised = Vol related risk premiums
3. Same realised vol can give you different returns

CAIA II (9 decks)

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