R27 risk management applications of forward and futures strategies

Strategies and Applications for Managing Equity Market Risk 4.. Strategies and Applications for Managing Foreign Currency Risk 6... Managing Interest Rate RiskForward rate agreements FRA

Reading 27

Risk Management Applications of Forward

and Future Strategies

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1 Introduction

2 Strategies and Applications for Managing Interest Rate Risk

3 Strategies and Applications for Managing Equity Market Risk

4 Asset Allocation with Futures

5 Strategies and Applications for Managing Foreign Currency Risk

6 Futures or Forwards

7 Final Comments

2 Managing Interest Rate Risk

Forward rate agreements (FRA)

Duration

Change in bond price and duration

Interest rate risk of bond futures contracts

Bond futures can be used to increase or

decrease duration of bond portfolio

3 Strategies and Applications for Managing Equity

Market Risk

3.1 Measuring and Managing the Risk of Equities

3.2 Managing the Risk of an Equity Portfolio

3.3 Creating Equity out of Cash

3.1 Measuring and Managing the Risk of Equities

We will use beta as our risk measure

Dollar Beta = beta x market value

We can use futures contracts to change the portfolio beta

3.2 Managing the Risk of an Equity Portfolio

2 September

Scenario on 3 December

3.3 Creating Equity out of Cash

Use stock index futures to create synthetic positions in equity

 Transaction cost saving

 Liquidity

Long stock + Short futures = Long risk-free bond

Long stock = Long risk-free bond + Long futures

Constructing a synthetic index fund

Multiplier tells you how many shares you effectively have per contract

Actual synthetic investment:

Invest this amount at risk free rate:

Number of shares effectively purchased:

Dividend yield of 2.5% is used in calculations but fund does NOT earn these dividends

Strategy depends on correct pricing of futures contracts

Equitizing Cash: take a given amount of cash and convert into an

equity position while maintaining liquidity provided by cash

3.4 Creating Cash out of Equity

Construct synthetic position in cash buy selling futures against a long stock

position

Scenario on 2 June:

End of Video Segment 1

4 Asset Allocation with Futures

Most important factor in the performance of an asset portfolio is

the allocation of the portfolio among asset classes

We can allocate a portfolio among asset classes using futures

4.1 Adjusting the Allocation among Asset Classes

4.2 Pre-Investing in an Asset Class

4.1 Adjusting the Asset Allocation among Asset Classes

Scenario on 15 November

Do example presented in Exhibit 7 for practice

Manager wants to convert a portion of his long-term bond portfolio to cash to improve liquidity

Key point: Reducing duration to replicate a short term instrument does not remove the problemthat long term instruments, which are still held, may have to be liquidated

Do example presented in Exhibit 8 which shows how to adjust allocation between one equity

class (large-cap) and another (mid-cap)

4.2 Pre-Investing in an Asset Class

Pre-investing: Use futures contracts to gain exposure to an asset class without

a cash outlay; when cash is received close out the futures position and invest the cash

5 Strategies and Applications for Managing Foreign

Currency Risk

• Transaction exposure

• Translation exposure

• Economic exposure

5.1 Managing the Risk of Foreign Currency Receipt

5.2 Managing the Risk of a Foreign Currency Payment

5.3 Managing the Risk of a Foreign Market Asset Portfolio

5.1 Managing the Risk of Foreign Currency Receipt

5.2 Managing the Risk of a Foreign Currency Payment

5.3 Managing the Risk of a Foreign-Market Asset Portfolio

From the previous example we see that the possible currency hedging strategies are:

1 Hedge market risk and not currency risk  foreign risk free rate

2 Hedge both  domestic risk free rate

3 Hedge currency risk but not market risk

4 Hedge neither

Effectiveness of hedge depends on:

1 how well hedging instrument is correlated with investment portfolio

2 how well the final investment value is predicted

6 Forwards and Futures