Topics 31-38

Question 1

Types of banks

Answer 1

Commercial banks are those that take deposits and make loans. Commercial banks include retail banks, which primarily serve individuals and small businesses, and wholesale banks, which primarily serve corporate and institutional customers.

Investment banks are those that assist in raising capital for their customers (e.g., by managing the issuance of debt and equity securities) and advising them on corporate finance matters such as mergers and restructurings.

Question 2

Identify the major risks faced by a bank

Answer 2

The main risks faced by a bank include credit risk, market risk, and operational risk.

• Credit risk refers to the risk that borrowers may default on loans or that counterparties to contracts such as derivatives may default on their obligations. One measure of credit risk is a bank’s loan losses as a percentage of its assets.
• Market risk refers to the risk of losses from a bank’s trading activities, such as declines in the value of securities the bank owns. Later in this topic, we will distinguish between the “trading book” and the “banking book” of a bank.
• Operational risk refers to the possibility of losses arising from external events or failures of a bank’s internal controls.

Question 3

Economic capital

Answer 3

Economic capital refers to the amount of capital that a bank believes is adequate based on its own risk models. Even if economic capital is less than regulatory capital, as is often the case, a bank must maintain its capital at the regulatory minimum or greater.

Question 4

Explain how deposit insurance gives rise to a moral hazard problem

Answer 4

To increase public confidence in the banking system and prevent runs on banks, most countries have established systems of deposit insurance. Typically, a depositor’s funds are guaranteed up to some maximum amount if a bank fails. These systems are funded by insurance premiums paid by banks.

Moral hazard is the observed phenomenon that insured parties take greater risks than they would normally take if they were not insured. In the banking context, with deposit insurance in place, the moral hazard arises when depositors pay less attention to banks’ financial health than they otherwise would. This allows banks to offer higher interest rates on deposits and make higher-risk loans with the funds they attract.

One way of mitigating moral hazard is by making insurance premiums risk-based. For example, in recent years, poorly-capitalized banks have been required to pay higher deposit insurance premiums than well-capitalized banks.

Question 5

Describe investment banking financing arrangements including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches

Answer 5

In a private placement, securities are sold directly to qualified investors with substantial wealth and investment knowledge. The investment bank earns fee income for arranging a private placement.

If the securities are sold to the investing public at large, the issuance is referred to as a public offering. Investment banks have two methods of assisting with a public offering. With a firm commitment, the investment bank agrees to purchase the entire issue at a price that is negotiated between the issuer and bank. The investment bank earns income by selling the issue to the public at a spread above the price it paid the issuer. An investment bank can also agree to distribute an issue on a best efforts basis rather than agreeing to purchase the whole issue. If only part of the issue can be sold, the bank is not obligated to buy the unsold
portion. As with a private placement, the investment bank earns fee income for its services.

First-time issues of stock by firms whose shares are not currently publicly traded are called initial public offerings (IPOs). An investment bank can assist in determining an IPO price by analyzing the value o f the issuer. An IPO price may also be discovered through a Dutch auction process. A Dutch auction begins with a price greater than what any bidder will pay, and this price is reduced until a bidder agrees to pay it. Each bidder may specify how many units they will purchase when accepting a price. The price continues to be reduced until bidders have accepted all the shares. The price at which the last o f the shares can be sold becomes the price paid by all successful bidders

Question 6

Describe the potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to the conflict of interest problems

Answer 6

For example, an investment banking division that is trying to sell newly issued stocks or bonds might want the securities division to sell these to their clients. The investment bankers may press the securities division’s financial analysts to maintain “Buy” recommendations, or press its financial advisors to allocate these stocks and bonds to customer accounts.

Another clear conflict of interest among banking departments involves material nonpublic information. A commercial banking or investment banking division may acquire nonpublic information about a company when negotiating a loan or arranging a securities issuance. Other parts of the banking company, such as its trading desk, may benefit unfairly if they gain access to this information.

Where banking firms are permitted to have commercial banking, securities, and investment banking units, the firms must implement Chinese walls, which are internal controls to prevent information from being shared among these units.

Question 7

Describe the distinctions between the “banking book” and the “trading book” of a bank.

Answer 7

The banking book refers to loans made, which are the primary assets of a commercial bank. Normally, the balance sheet value of a loan includes the principal amount to be repaid and accrued interest on the loan. However, for a nonperforming loan the value does not include accrued interest. A loan is typically classified as nonperforming if payments are more than 90 days overdue.

The trading book refers to assets and liabilities related to a bank’s trading activities. Unlike other assets and liabilities, trading book items are marked to market daily. For items that lack a liquid market, do not trade frequently, or are complex or custom instruments, marking to market involves estimating a price. Such items are sometimes said to be “marked to model.”

Question 8

Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks

Answer 8

In contrast to a bank making loans and keeping them as assets, the originate-to-distribute model involves making loans and selling them to other parties.

• The benefit of the originate-to-distribute model is that it increases liquidity in the sectors of the lending market where it is used.
• A drawback of this model is that, in some cases, it has led banks to loosen lending standards.

Question 9

Term/whole life insurance

Answer 9

Term (temporary) life insurance provides a specified amount of insurance
coverage for a fixed period of time. No payments are made to the policyholder’s beneficiaries if the policyholder survives the term of the policy; therefore, payment is not certain.

Whole (permanent) life insurance provides a specified amount of insurance coverage for the life of the policyholder so payment will occur upon death, but there is uncertainty as to the timing. For both term and whole life insurance, it is most common for premiums and the amount of coverage to be fixed for the entire period in question.

Question 10

P&C insurance

Answer 10

P&C insurance companies usually provide annual and renewable coverage against loss events. The premiums may increase or decrease based on any changes in estimates of expected payout.

Property insurance covers property losses such as fire and theft.

Casualty (liability) insurance covers third-party liability for injuries sustained while on a policyholder’s premises or caused by the policyholder’s use of a vehicle, for example. Liability insurance is subject to long-tail risk, which is the risk of legitimate claims being submitted years after the insurance coverage has ended.

Question 11

Major risks facing insurance companies

Answer 11

Major risks facing insurance companies include the following:

1. Insufficient funds to satisfy policyholders’ claims. The liability computations often provide a significant cushion, but it is always possible to have a sudden surge of payouts in a short period of time.
2. Poor return on investments. Insurance companies often invest in fixed-income securities and if defaults suddenly increase, insurance companies will incur losses. Diversification of investments by industry sector and geography can help mitigate such losses.
3. Liquidity risk of investments. Purchasing privately placed fixed-income securities, or publicly traded securities with a thinner market, may result in the inability to easily convert them to cash when most needed to satisfy a surge of claims.
4. Credit risk. By transacting with banks and reinsurance companies, insurance companies face credit risk if the counterparty defaults on its obligations.
5. Operational risk. Similar to banks, an insurance company faces losses due to failure of its systems and procedures or from external events outside the company’s control (e.g., computer failure, human error).

Question 12

Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a property-casualty insurance company

Answer 12

Property and casualty insurance companies compute the following ratios:

• The loss ratio for a given year is the percentage of payouts versus premiums generated, usually between 60—80% and increasing over time.
• The expense ratio for a given year is the percentage of expenses versus premiums generated, usually between 23—30% and decreasing over time. The largest expenses are usually loss adjustments (e.g., claims investigation and assessing payout amounts) and selling (e.g., broker commissions).
• The combined ratio for a given year is equal to the sum of the loss ratio and the expense ratio.
• The combined ratio after dividends for a given year is equal to the combined ratio plus the payment of dividends to policyholders (if applicable).
• The operating ratio for a given year is the combined ratio (after dividends) less investment income. The mismatch of the cash inflows (generally earlier) and outflows (generally later) for many insurance companies allows them to earn interest income. For example, policyholders tend to pay their premiums upfront at the beginning of the year, but insurance companies tend to pay out claims throughout the year or after year-end.

Question 13

Describe moral hazard and adverse selection risks facing insurance companies, provide examples of each, and describe how to overcome the problems

Answer 13

Moral hazard describes the risk to the insurance company that having insurance will lead the policyholder to act more recklessly than if the policyholder did not have insurance.

Methods to mitigate against moral hazard include: deductibles (e.g., policyholder is responsible for a fixed amount of the loss), coinsurance provisions (e.g., insurance company will pay a fixed percentage of losses, less than 100%, over the deductible amount), and policy limits (e.g., fixed maximum payout).

Adverse selection describes the situation where an insurer is unable to differentiate between a good risk and a bad risk. By charging the same premiums to all policyholders, the insurer may end up insuring more bad risks (e.g., careless drivers, sick individuals).

Methods to mitigate against adverse selection include:

• greater initial due diligence (e.g., mandatory physical examinations for life insurance, researching driving records for automobile insurance) and
• ongoing due diligence (e.g., updating driving records and adjusting premiums to reflect changing risk).

Question 14

Distinguish between mortality risk and longevity risk and describe how to hedge these risks

Answer 14

Mortality risk refers to the risk of policyholders dying earlier than expected due to illness or disease, for example. From the perspective o f the insurance company, the risk of losses increases due to the earlier-than-expected life insurance payout.

Longevity risk refers to the risk of policyholders living longer than expected due to better healthcare and healthier lifestyle choices, for example. From the perspective of the insurance company, the risk of losses increases due to the longer-than-expected annuity payout period.

There is a natural hedge (or offset) for insurance companies that deal with both life insurance products and annuity products. For example, longevity risk is bad for the annuity business but is good for the life insurance business due to the delayed payout (or no payout if the policyholder has term insurance and dies after the policy expires). Mortality risk is bad for the life insurance business but is good for the annuity business because of the earlier than-expected termination of payouts.

To the extent that there is excessive net exposure to mortality risk, longevity risk, or both, an insurance company may consider reinsurance contracts. With this type of contract, the insurance company pays a fee to another insurance company to assume some or all of the risks that were originally insured.

Question 15

Evaluate the capital requirements for life insurance and property-casualty insurance companies.

Answer 15

A life insurance company might have the following summarized balance sheet composition:

• Assets: investments (80%), other assets (20%)
• Liabilities and Equity: policy reserves (85%), subordinated long-term debt (5%), equity capital (10%)

Under an asset-liability management approach, the life insurance company attempts to equate asset duration with liability duration. There is risk associated with both sides of the balance sheet. On the asset side, corporate bonds comprise the bulk of the investments, so there is credit risk assumed. On the liability side, the policy reserves represent the present value of the future payouts as determined by actuaries. The risk is that the policy reserves are set too low if life insurance policyholders die too soon or annuity holders live too long. Equity capital represents contributed capital plus retained earnings and serves as a
protection barrier if payouts are larger than loss reserves.

A P&C insurance company might have the following summarized balance sheet
composition:

• Assets: investments (80%), other assets (20%)
• Liabilities and Equity: policy reserves (50%), unearned premiums (10%), subordinated long-term debt (5%), equity capital (35%)

On the asset side, the investments typically comprise of highly liquid bonds with shorter maturities than those used by life insurance companies. On the liability side, the unearned premiums represent prepaid insurance contracts whereby amounts are received but the coverage applies to future time periods; unearned premiums do not generally exist for life insurance companies. Finally, there is substantially more equity capital for a P&C insurance company than for a life insurance company. This is due to the highly unpredictable nature of claims (both timing and amount) for P&C insurance contracts.

Question 16

Compare the guaranty system and the regulatory requirements for insurance companies with those for banks

Answer 16

In the United States, a guaranty system exists for both insurance companies and banks. Insurance companies are regulated at the state level while banks are regulated at the federal level.

For insurance companies, every insurer must be a member of the guaranty association in the state(s) in which it operates. If an insurance company becomes insolvent in a state, each of the other insurance companies must contribute an amount to the state guaranty fund based on the amount of premium income it earns in that state. The guaranty fund proceeds are distributed to the small policyholders of the insolvent company.

Question 17

Defined benefit plans

Answer 17

Defined benefit plans (i.e., employee benefit known, employer contribution unknown) explicitly state the amount of the pension that the employee will receive upon retirement. It is usually calculated as a fixed percentage times the number of years of employment times the annual salary for a specific period of time. There is significant risk borne by the employer because it is obligated to fund the benefit to the employee; therefore, when the present value of the pension obligation exceeds the market value of the pension assets, the employer must cover the deficiency. As a result, there is no risk borne by the employee (in theory).

Additionally, some defined benefit plans may include one or more of the following features:

• indexation of pension amounts to account for inflation,
• continued pension payments (likely on a reduced basis) to the surviving spouse upon the death of a retired employee, or
• a lump sum payment to an employee’s dependents upon the death of a currently active employee.

Question 18

Defined contribution plans

Answer 18

Defined contribution plans (i.e., employer contribution known, employee benefit unknown) involve both employer and employee contributions being invested in one or more investment options selected by the employee. Upon retirement, the employee could opt to receive a lifetime pension (based on the ending value of the contributions) in the form of an annuity or, in some cases, simply to receive a lump sum. There is virtually no risk borne by the employer because it is obligated simply to make a set contribution and no more. The risk of underperformance of the plan’s investments is borne solely by the employee.

A defined contribution plan involves one individual account associated with one employee. The individual pension is computed based only on the funds in that account. In contrast, a defined benefit plan involves one pooled account for all employees; all contributions go into and all payments come out of the one account.

Question 19

Open-End Mutual Funds

Answer 19

Mutual funds are pooled investment vehicles that offer instant diversification for their investors.

Open-end mutual funds, which are often simply called mutual funds, are the most common pooled investment vehicle.

The professional management team will conduct research and ultimately invest commingled assets on behalf of their investors. These investors begin their investment by purchasing a set dollar amount of an open-end mutual fund and then they receive a proportional ownership interest (in the form of shares) in the mutual fund. This means that the number of shares goes up as new investors arrive and goes down as investors withdraw assets.

At a high level, open-end mutual funds are broken down into four main categories: money market funds, equity funds, bond funds, and hybrid funds.

• Money market funds invest in short-term interest-bearing instruments, such as Treasury bills, commercial paper, and banker’s acceptances. Money market investors are typically risk averse. This category is an alternative to interest-bearing bank accounts and is often the “cash” portion of an investor’s asset allocation mix.
• Equity funds invest solely in stocks. Within this category you can find index funds that track a broad market index, such as the S&P 300 Index, funds that follow a certain style, such as medium company value funds, or sector funds, such as a health care sector fund.
• Bond funds invest only in fixed-income instruments, such as sovereign debt, corporate bonds, and asset-backed securities.
• Hybrid funds will blend stock and bond ownership into the same fund.

An investor who decides at 10:00 am that they want to buy shares will enter a buy order for a set dollar amount, but they will not know the price at which they will transact until after the market closes. For this reason, we say that open-end fund investors have poor price visibility. Since shares are transacted at an unknown price, investors cannot use stop orders or limit orders. They must place a market order to transact in shares of an open-end mutual fund.

Taxes are levied against open-end mutual fund investors as if they owned the diversified fund’s holdings outright.

Open-end mutual funds have a management fee, an advertising surcharge (called a 12b-1 fee), and potentially a sales charge. The management fee covers the operational costs of the openend mutual fund company, including the salaries of the management team. Management fees are typically around 1.0%, but they can be as high as 2.5—3.0% for international funds because they have increased complexity. The advertising surcharge is a stipend paid to the advisor who recommends the investment, and these fees can range from 0.0—1.0% with the most common fee being 0.25%. Sales charges are commonly called loads. A front-end load is a set percentage that is charged to the investor when the asset is originally sold. Alternatively, some funds choose to charge a sales charge if an investor leaves a fund within a certain window of time. This is called a back-end load.

Question 20

Closed-end mutual fund

Answer 20

Closed-end mutual funds are a similar concept to open-end funds with a few notable differences.

1. The first difference is that closed-end funds tend to invest in niche areas like specific emerging markets, while open-end mutual funds tend to invest in broader areas like a diversified emerging markets fund.
2. The second difference is that a purchase of shares in an open-end mutual fund will increase the number of shares outstanding because new shares are created, but a closed-end fund’s number of shares remains static. Investors who desire to purchase shares of a closed-end fund do not transact direcdy with the fund company but rather with other investors.
3. The third difference is that closed-end fund investors cannot simply redeem their shares from the fund company. They must find another investor to buy their shares.
4. The fourth difference is that, while open-end funds always transact at the next available NAV, a closed-end fund can transact at a price other than NAV. It is very common for a closed-end fund to trade at either a discount or a premium to its actual NAV.
5. In terms o f trading, a closed-end fund behaves much like an individual stock. Investors can trade closed-end funds throughout the trading day, which means they have better price visibility and can utilize stop orders and limit orders if they so choose.

Question 21

Exchange-traded funds

Answer 21

Exchange-traded funds must disclose their holdings twice each day, which enables investors to have tremendous visibility into their underlying investments. Open-end mutual funds, on the other hand, disclose their holdings very infrequently, perhaps as delayed as once per quarter.

Another big difference is the management fees. Exchange-traded funds often have a considerably lower internal expense ratio, which means less of a hurdle for the investment to rise above.

Because open-end funds, closed-end funds, and exchange-traded funds all solicit investment from small retail customers, they are subject to significant regulatory oversight.

Question 22

Explain the key differences between hedge funds and mutual funds

Answer 22

Mutual funds are marketed to any and all investors, while hedge funds are restricted to only wealthy and sophisticated investors. Because of this, hedge funds escape certain regulations that apply to mutual funds. Specifically, they do not need to provide the redemption of shares at any time the investor chooses, a daily calculated NAV, or the full disclosure o f their investment policies and strategies.

Hedge funds are also permitted to use leverage while mutual funds are not. Because hedge funds can use leverage and are also permitted to use both long and short investment strategies, they are considered to be an alternative investment class.

Since hedge funds are not required to redeem shares any time an investor requests, they have implemented advance notification requirements and lock-up periods for any withdrawal requests. The advance notification could mean that the investor must wait 90 days after requesting a withdrawal before they can expect to have access to their money. The lock-up period is a certain amount of time in which the investor is not able to withdraw his funds. This could be one year, two years, or some other customized time period.

Question 23

Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund including the terms hurdle rate, high-water mark, and clawback

Answer 23

The typical hedge fund fee structure is known as “2 plus 20%,” which means that they charge a flat 2% of all assets that they manage plus an additional 20% of all profits above a specified benchmark.

• Hedge funds do soften the incentive fee structure with a few safeguards for investors. The first safeguard is the hurdle rate, which is the benchmark that must be beaten before incentive fees can be charged.
• The second safeguard is a high-water mark clause, which essentially states that previous losses must first be recouped and hurdle rates surpassed before incentive fees once again apply
• The third safeguard for investors is a clawback clause, which enables investors to retain a portion of previously paid incentive fees in an escrow account that is used to offset investment losses should they occur.

Question 24

Describe various hedge fund strategies, including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed fixtures, and identify the risks faced by hedge funds

Answer 24

• Long/Short Equity
  Long/short equity hedge funds endeavor to find mispriced securities. Mangers of a long/short equity fund spend a great deal of time conducting fundamental analysis on stocks, that are largely ignored by most analysts, in an attempt to find mispricings. They will buy (go long) a stock that they believe to be undervalued, and they will short sell (go short) a stock that they believe to be overvalued. Sometimes funds can have a net long bias or a net short bias depending on what opportunities they see in the markets. Funds can also be sector neutral, where they net long and short positions that cancel out sector exposure. Market neutral funds are where long and short positions make the fund ambivalent to market direction, and factor neutral funds are where positions are isolated from a specific factor like oil or interest rate policy.
• Dedicated Short
  Dedicated short hedge funds are focused exclusively on finding a company that they think is overvalued and then short selling the stock. Traditionally, short sellers are looking for companies with weak financials, those that switch auditors frequently, those that delay SEC filings, those in industries with overcapacity, or those engaged in lawsuits that could go horribly wrong.
• Distressed Securities
  Bonds with a credit rating of BB or less are considered to be “junk” bonds, while those with a CCC rating are considered to be “distressed.” Distressed bonds usually trade at deep discounts to par value and often offer yields upwards of 10% greater than a comparable Treasury. Of course, an investment in a distressed bond could prove worthless if the wrong events happen. Distressed securities hedge funds are searching for distressed bonds with the potential to turn things around. Many of these distressed companies are in or close to being in bankruptcy proceedings. Some distressed bond investors passively wait for the investment to turn around, while others take an active approach to influencing the target company’s
  reorganization. Distressed bond investors do their homework to figure out if they can gain an advantage by buying specific debt tranches. If they own more than one-third of any class of a bond, then they can block any reorganization plan that is not in their best interest. There is tremendous profit to be made in this area for investors who know what they are
  doing.
• Merger Arbitrage
  Merger arbitrage hedge funds try to find arbitrage opportunities after mergers are announced. These are primarily positive deals where the managers are planning on the deal going through. There are two different types of mergers: cash deals and stock deals.
• Convertible Arbitrage
  Some hedge funds invest using convertible bonds, which are fixed-income instruments that can be converted into shares o f stock if the stock price rises above a pre-specified value. If convertible bonds are not converted into shares of stock, then they simply retain their bond status and continue to offer interest payments and a certain principal repayment at maturity. This debt instrument conceptually merges a bond with a call option on the stock.
  Sometimes, if the convertible bond is also callable, the issuer will announce its intention to call the bond in order to force convertible bondholders to convert to stock. A conversion into stock will shift the investor from being a debtholder to an equity holder and will therefore reduce the debt burden of the issue without them actually repaying any debt. A convertible arbitrage hedge fund develops a sophisticated model to value convertible bonds that factors everything from default risk to interest rate risk. Sometimes they offset investment risk by shorting the issuer’s stock or by using more sophisticated assets like credit default swaps and interest rate swaps.
• Fixed Income Arbitrage
  Fixed income arbitrage hedge funds attempt to exploit perceived mispricings in the realm of fixed-income securities.
• Emerging Market
  Emerging market hedge funds focus on investments in developing countries. These managers often expend great effort to research their investments by visiting potential investment targets, attending conferences, meeting with analysts, talking directly with management, and possibly hiring consultants with local knowledge. Some hedge funds choose to invest in developing country securities in their local market while others invest using American depository receipts (ADRs), which are certificates issued in America that provide ownership in foreign countries coupled with currency exposure.
• Global Macro
  Several of the most financially successful hedge fund managers have made their fortunes with a global macro hedge fund strategy. In this strategy, hedge fund managers attempt to profit from a global macroeconomic trend that they feel is not in equilibrium (priced correctly and rationally). They will place very large dollar bets on the equilibrium being reestablished. Typically, the investment focus o f global macro funds is either on foreign exchange rates or on interest rates. The biggest challenge for these funds is that there is noway to know for certain when a perceived deviation from equilibrium will be corrected. There is a saying that the markets can stay irrational (out of equilibrium) longer than most investors can stay solvent. In other words, a deviation from equilibrium could take a long time to correct itself and some hedge funds will not be able to wait out the trend.
• Managed Futures
  Managed futures hedge funds attempt to predict future movements in commodity prices based on either technical analysis or fundamental analysis. Technical analysis attempts to infer patterns from past price movements and use those patterns as a basis for predictions. When technical analysis is used, fund managers will backtest their trading rules using historical data. Fundamental analysis studies economic, political, and other relevant measurable factors to determine a valuation for the given commodity and then buy or short sell based on the outcome of this fundamental research.

Question 25

Describe hedge fund performance and explain the effect of measurement biases on performance measurement

Answer 25

Hedge fund performance is not as easy to assess as mutual fund performance, which is readily available and accurately reported by numerous independent parties. Participation in hedge fund indices is voluntary. If the fund had good performance, then they will report their results to the index vendor. If they did not have good results, then they simply do not report their results to the index.

This is known as the measurement bias of hedge fund index reporting. When returns are reported by a hedge fund, the database is then backfilled with the fund’s previous returns. This is known as backfill bias and it creates an issue with reliability for hedge fund benchmarks.

Question 26

Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages.

Answer 26

An over-the-counter (OTC) market differs from a traditional exchange. It is a customized trading market which utilizes telephone and computers to make trades. This market typically involves much larger trades than traditional exchanges. The most typical OTC trade is conducted over the phone. Since terms are not specified by an “exchange,” participants have more flexibility to negotiate the most mutually agreeable or attractive trade.

Advantages of over-the-counter trading:

• Terms are not set by any exchange.
• Participants have flexibility to negotiate.
• In the event of a misunderstanding, calls are recorded.
• Disadvantages* of over-the-counter trading:
• OTC trading has more credit risk than exchange trading. Exchanges are organized in such a way that credit risk is eliminated.

Question 27

Call Option

Answer 27

For the option buyer:

c_T = max(0,S_T – X)

Value at expiration = c_T

Profit: Π = c_T – c₀

Maximum profit = ∞

Maximum loss = c₀

Breakeven: S_T* = X + c₀

Question 28

Put option

Answer 28

Buying a put we have:

p_T = max(0,X – S_T)

Value at expiration = p_T

Profit: Π = p_T – p₀

Maximum profit = X – p₀

Maximum loss = p₀

Breakeven: S_T* = X – p₀

Question 29

Forward Contract Payoff

Answer 29

The payoff to a long position in a forward contract is calculated as follows:

payoff = S_T — K

where:
S_T = spot price at maturity
K = delivery price

Conversely, the payoff to a short position in a forward contract is calculated as follows:

payoff = K — S_T

Question 30

Futures contract characteristics: Price quotations and tick size, Daily price limits, Position limits

Answer 30

Futures contract characteristics specified by the exchange include the following:

• Price quotations and tick size. The exchange determines how the price of a contract will be quoted as well as the minimum price fluctuation for the contract, which is referred to as the tick size. For example, grain is quoted in dollars per bushel, and the minimum tick size is 1/4 cent per bushel. Since a grain contract consists of 5,000 bushels, the minimum tick size is $12.50 (= 5,000 x $0.0025) per contract.
• Daily price limits. The exchange sets the maximum price movement for a contract during a day. For example, wheat cannot move more than $0.20 from its close the preceding day, for a daily price limit of $1,000. When a contract moves down by its daily price limit, it is said to be limit down. When the contract moves up by its price limit, it is said to be limit up.
• Position limits. The exchange sets a maximum number of contracts that a speculator may hold in order to prevent speculators from having an undue influence on the market. Such limits do not apply to hedgers.

Question 31

Basis in futures

Answer 31

The basis is the difference between the spot price and the futures price.

basis = spot price — futures price

As the maturity date nears, the basis converges toward zero.

Question 32

Describe the rationale for margin requirements and explain how they work.

Answer 32

Margin is cash or highly liquid collateral placed in an account to ensure that any trading losses will be met. Marking to market is the daily procedure of adjusting the margin account balance for daily movements in the futures price. The amount required to open a futures position is called the initial margin. The maintenance margin is the minimum margin account balance required to retain the futures position. When the margin account balance falls below the maintenance margin, the investor gets a margin call, and he must bring the margin account back to the initial margin amount. The amount necessary to do this is called the variation margin.

Question 33

Describe the role of a clearinghouse in futures and over-the-counter market transactions.

Answer 33

Each exchange has a clearinghouse. The clearinghouse guarantees that traders in the futures market will honor their obligations.

All trades eventually go through the clearinghouse members, who must have a clearing margin posted at the clearinghouse in the same way an investor has a margin account with a broker.

Question 34

Describe the role of collateralization in the over-the-counter market and compare it to the margining system

Answer 34

The over-the-counter (OTC) market includes the trading in all securities not listed on one of the registered exchanges. This market is subject to a good deal of credit risk since the party on the other side of an OTC contract could default on its payments. One way to reduce this credit risk is by means of collateralization. Collateralization is basically a marked to market feature for the OTC market where any loss is settled in cash at the end of the trading day.

Arguments for the use of clearinghouses in OTC markets include:

1. automatic posting of collateral,
2. reduction of financial system credit risk, and
3. increased transparency of OTC trades. Governments have pushed for the use of clearinghouses in OTC markets in an attempt to reduce systemic risk, which is the risk that a failure by a significant financial institution will impact other institutions and potentially lead to a collapse of the overall financial system

Question 35

Identify the differences between a normal and inverted futures market

Answer 35

The settlement price is analogous to the closing price for a stock but is not simply the price of the last trade. It is an average of the prices of the trades during the last period of trading, called the closing period, which is set by the exchange. This feature of the settlement price prevents manipulation by traders. The settlement price is used to make margin calculations at the end of each trading day.

Depending on the direction of futures settlement prices, the market may be normal or inverted. Increasing settlement prices over time indicates a normal market. Conversely, decreasing settlement prices over time indicates an inverted market.

Question 36

Describe the mechanics of the delivery process and contrast it with cash settlement

Answer 36

There are four ways to terminate a futures contract:

1. A short can terminate the contract by delivering the goods. When the long accepts this delivery, he pays the contract price to the short. This is called delivery. The location for delivery (for physical assets), terms of delivery, and details of exactly what is to be delivered are all specified in the notice of intention to deliver file.
2. In a cash-settlement contract, delivery is not an option. The futures account is marked to market based on the settlement price on the last day of trading.
3. You may make a reverse, or offsetting, trade in the futures market. This is how most futures positions are settled.
4. A position may also be settled through an exchange for physicals. Here you find a trader with an opposite position to your own and deliver the goods and settle up between yourselves, off the floor of the exchange (i.e., an ex-pit transaction). This is the sole exception to the federal law that requires that all trades take place on the floor of the exchange. You must then contact the clearinghouse and tell them what happened. An exchange for physicals differs from a delivery in that the traders actually exchange the goods, the contract is not closed on the floor of the exchange, and the two traders privately negotiate the terms of the transaction. Regular delivery involves only one trader and the clearinghouse.

Question 37

Evaluate the impact of different trading order types

Answer 37

There are several different types of orders in the marketplace:

• Market orders are orders to buy or sell at the best price available. A discretionary order is a market order where the broker has the option to delay transaction in search of a better price.
• Limit orders are orders to buy or sell away from the current market price. A limit buy order is placed below the current price. A limit sell order is placed above the current price. Limit orders have a time limit, such as instantaneous, one day, one week, one month, or good till canceled. Limit orders are turned over to the specialist by the commission broker.
• Stop-loss orders are used to prevent losses or to protect profits
• Stop-limit orders are a combination of a stop and limit order. The stop price and limit price must be specified, so that once the stop level is reached, or bettered, the order would turn into a limit order and hopefully transact at the limit price. Market-if-touched orders, or MIT orders, are orders that would become market orders once a specified price is reached in the marketplace.
• For those orders that remain outstanding until the designated price range is reached, the trader making the order needs to indicate the time period for the order (time-of-day order). Good-till-canceled (GTC) orders (a.k.a. open orders) are orders that remain open until they either transact or are canceled. A popular method of submitting a limit order is to have it automatically canceled at the end of the trading day in which it was submitted. Fill-or-kill orders must be executed immediately or the trade will not take place.

Question 38

Regulation in Futures market

Answer 38

In the United States, the Commodity Futures Trading Commission (CFTC) is responsible for regulating futures markets.

The CFTC licenses futures exchanges as well as traders who offer futures trading services to the public. It also approves new futures contracts and any revisions to existing futures contracts.

In addition, the CFTC is responsible for communicating prices to the public, addressing public complaints, and taking disciplinary actions against members who violate futures exchange rules.

Question 39

Accounting aspects of futures recognition

Answer 39

When accounting for changes in the market value of a futures contract, changes must be recognized when they occur. The exception to this accounting standard is when a futures contract is being used for hedging purposes. Hedge accounting specifies that gains/losses from a hedging instrument be recognized in the same period as gains/losses from the asset being hedged.

Question 40

Taxes aspects for futures

Answer 40

Regarding U.S. tax regulations, differences arise due to the nature o f taxable gains/losses and the timing of realized gains/losses. For corporate taxpayers, capital gains are taxed at the same level as ordinary income and capital losses are restricted. For non-corporate taxpayers, capital gains are taxed at the same level as ordinary income, but long-term gains (investments held over one year) are subject to a maximum 15% tax rate. Another difference is that capital losses are deductible for non-corporate taxpayers.

For tax purposes, futures contracts are considered closed out at the end of each year. This gives rise to a 60/40 rule for non-corporate taxpayers where capital gains/losses are treated as 60% long term and 40% short term. This rule, however, does not apply to hedging activities. Using futures for hedging purposes must be declared on the same day the transaction is entered. Gains/losses on hedging transactions are taxed at the same rate as ordinary income.

Question 41

Define and differentiate between short and long hedges and identify their appropriate uses

Answer 41

• A short hedge occurs when the hedger shorts (sells) a futures contract to hedge against a price decrease in the existing long position. When the price of the hedged asset decreases, the short futures position realizes a positive return, offsetting the decline in asset value. Therefore, a short hedge is appropriate when you have a long position and expect prices to decline.
• A long hedge occurs when the hedger buys a futures contract to hedge against an increase in the value of the asset that underlies a short position. In this case, an increase in the value of the shorted asset will result in a loss to the short seller. The objective of the long hedge is to offset the loss in the short position with a gain from the long futures position. A long hedge is therefore appropriate when you have a short position and expect prices to rise.

Question 42

Describe the arguments for and against hedging and the potential impact
of hedging on firm profitability

Answer 42

• It is easy to see that the benefit from hedging leads to less uncertainty regarding future profitability. However, there are some arguments against hedging. The main issue is that hedging can lead to less profitability if the asset being hedged ends up increasing in value. The increase in value will be offset by a corresponding loss in the futures contract used for the hedge.
• Another argument against hedging is the questionable benefit that accrues to shareholders. Clearly, hedging reduces risk for a company and its shareholders, but there is reason to believe that shareholders can more easily hedge risk on their own.
• A third argument deals with the nature of the hedging company’s industry. For example, assume that prices in an industry frequently adjust for changes in input prices and exchange rates. If competitors do not hedge, then there is an incentive to keep the status quo. In this way, the company ensures that profitability will remain more stable than if it were to hedge frequent changes.

Question 43

Define the basis and explain the various sources of basis risk, and explain how basis risks arise when hedging with futures

Answer 43

When all of the existing position characteristics match perfectly with those of the futures contract specifications, we have a perfect hedge. With a perfect hedge, the loss on a hedged position will be perfectly offset by the gain on the futures position. Perfect hedges are not very common. There are two major reasons why this is so:

1. the asset in the existing position is often not the same as that underlying the futures (e.g., we may be hedging a corporate bond portfolio with a futures contract on a U.S. Treasury bond), and
2. the hedging horizon may not match perfectly with the maturity of the futures contract. The existence of either one of these conditions leads to what is called basis risk.

When the spot price increases faster than the futures price over the hedging horizon, basis increases and a strengthening of the basis is said to occur. When the futures price increases faster than the spot price and the basis decreases, a weakening of the basis occurs. When hedging, a change in basis is unavoidable. The change in basis over the hedge horizon is termed basis risk, and it can work either for or against a hedger.

Three sources of basis risk are:

1. interruption in the convergence of the futures and spot prices,
2. changes in the cost of carry, and
3. imperfect matching between the cash asset and the hedge asset.
4. Interruption in the convergence of the futures and spot prices. Normally, spot prices and futures prices will converge as the time to maturity decreases, and basis reduces to zero at maturity. However, if the position is unwound prior to maturity, the return to the futures position could be different from the return to the cash position. A more rapid convergence results in a more rapid transfer of margin payments, while a less rapid convergence would delay payments. An interruption in the convergence could result in payments from the seller to the buyer. All of these effects are types of basis risk.
5. Changes in the cost of carry. Significant basis risk can arise due to changes in the components of the cost of carry. The cost of carry includes storage and safekeeping, interest, insurance, and related costs. Perhaps the most volatile of these costs is interest costs. An increase in the interest rates increases the opportunity cost of holding the asset, so the cost of carry and, hence, the difference in the basis of the contract rises.
6. Imperfect matching between the cash asset and the hedge asset. Sometimes it may be more efficient to cross hedge or hedge a cash position with a hedge asset that is closely related but different from the cash asset. For example, Eurodollar deposits are closely related to T-bill rates and may be considered a good hedge. However, if there is a structural shock that changes the close relationship of these two assets, the position may not be hedged as effectively as originally believed. This is the most common form of basis risk. Other forms of mismatch include maturity or duration mismatches, liquidity mismatches, and credit risk mismatches:

• Maturity or duration mismatch. Hedging a portfolio of mortgages with 10-year Treasury notes (T-notes) may seem reasonable if the effective duration of the mortgages matches the duration of the T-notes. However, if rates fall and the mortgages prepay faster (resulting in a shorter duration), the position will not be matched.
• Liquidity mismatch. Hedging an illiquid asset with a more liquid one will result in greater basis risk. Although over the long term the prices may be comparable, the difference in liquidity may result in large gaps between the pricing of the two assets. Hence, basis risk is inversely proportional to the liquidity of the hedged asset.
• Credit risk mismatch. The widening or narrowing of credit spreads constitutes another form of basis risk when the credit risk of the hedged asset is different (or becomes different) from the credit risk of the hedge instrument.

All of these represent basis risk. The size and type of basis risk can vary during the term of the contract, even if the position is perfectly hedged at maturity.

Question 44

Optimal hedge ratio

Answer 44

We can account for an imperfect relationship between the spot and futures positions by calculating an optimal hedge ratio that incorporates the degree of correlation between the rates.

The effectiveness of the hedge measures the variance that is reduced by implementing the optimal hedge. This effectiveness can be evaluated with a coefficient of determination (R²) term where the independent variable is the change in futures prices and the dependent variable is the change in spot prices.

Question 45

The number of futures contracts required to completely hedge an equity position

Answer 45

The number of futures contracts required to completely hedge an equity position is determined with the following formula:

Question 46

Tailing the hedge strategy

Answer 46

A hedger may actually over-hedge the underlying exposure if daily settlement is not properly accounted for. To correct for the possibility of over-hedging, a hedger can implement a tailing the hedge strategy. The extra step needed to carry out this strategy is to multiply the hedge ratio by the daily spot price to futures price ratio. In practice, it is not efficient to adjust the hedge for every daily change in the spot-to-futures ratio.

Question 47

Explain how to use stock index futures contracts to change a stock portfolio`s beta

Answer 47

Question 48

Explain the term “rolling the hedge forward” and describe some of the risks that arise from this strategy

Answer 48

When the hedging horizon is long relative to the maturity of the futures used in the hedging strategy, hedges have to be rolled forward as the futures contracts in the hedge come to maturity or expiration. Typically, as a maturity date approaches, the hedger must close out the existing position and replace it with another contract with a later maturity. This is called rolling the hedge forward.

When rolling a hedge forward, hedgers are not only exposed to the basis risk of the original hedge, they are also exposed to the basis risk of a new position each time the hedge is rolled forward. This is referred to as rollover basis risk, or simply rollover risk.

Question 49

LIBOR

Answer 49

The London Interbank Offered Rate (LIBOR) is the rate at which large international banks fund their activities.

Some credit risk exists with LIBOR.

Question 50

Calculate the value of an investment using different compounding frequencies. Convert interest rates based on different compounding frequencies

Answer 50

Question 51

Calculate the theoretical price of a bond using spot rates

Answer 51

Spot rates are the rates that correspond to zero-coupon bond yields.

A coupon bond is a series of zero coupon bonds, and its value, assuming continuous compounding and semiannual coupons, is:

Question 52

Bond Yield

Answer 52

The yield of a bond is the single discount rate that equates the present value of a bond to its market price.

The bond’s par yield is the rate which makes the price of a bond equal to its par value.

Question 53

Derive forward interest rates from a set of spot rates

Answer 53

Question 54

Derive the value of the cash flows from a forward rate agreement (FRA)

Answer 54

Question 55

Calculate the duration, modified duration and dollar duration of a bond

Answer 55

Question 56

Using Convexity to Improve Price Change Estimates

Answer 56

In order to obtain an estimate of the percentage change in price due to convexity, or the amount of price change that is not explained by duration, the following calculation will need to be made:

convexity effect = 1/2 x convexity x Δy²

For an option-free bond, the convexity effect is always positive, no matter which direction interest rates move. Thus, for option-free bonds, convexity is always added to duration to modify the price volatility errors embedded in duration. This decreases the drop in price (due to an increase in yields) and adds to the rise in price (due to a fall in yields).

Question 57

Compare and contrast the major theories of the term structure of interest rates

Answer 57

The expectations theory suggests that forward rates correspond to expected future spot rates. That is, forward rates are good predictors of expected future spot rates. In reality, the expectations theory fails to explain all future spot rate expectations. The market segmentation theory states that the bond market is segmented into different maturity sectors and that supply and demand for bonds in each maturity range dictate rates in that maturity range. The liquidity preference theory suggests that most depositors prefer short-term liquid deposits. In order to coax them to lend longer term, the intermediary will raise longer-term rates by adding a liquidity premium.