Risk Management Applications of Forward and Futures StrategiesStatement 1: The fastest and most cost-effective way to reduce the duration of the portfolio by half would be to sell $6 mil
Trang 1Risk Management Applications of Forward and Futures Strategies
Statement 1: The fastest and most cost-effective way to reduce the duration of the portfolio by half would be to sell
$6 million dollars worth of the actual bonds in the portfolio
Statement 2: The portfolio's duration could also be adjusted by selling 40 of the Treasury bond futures contracts
After listening to Swemba's statements, Stuart should:
disagree with both Statement 1 and Statement 2
agree with Statement 1, but disagree with Statement 2
disagree with Statement 1, but agree with Statement 2
Explanation
NOTE - on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material fromderivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Stuart shoulddisagree with both of Swemba's statements Although Stuart's goal of reducing the duration could be accomplished by sellingbonds in the portfolio, doing so would likely incur significant transaction costs Also, since the duration of each bond in theportfolio is likely different, specific bonds would have to be selected in order to accomplish Stuart's goal, making the processmore difficult A derivative overlay, accomplished by using futures contracts, would be much easier and cost effective Swemba
is also incorrect with respect to the number of futures contracts that would need to be sold The correct number of futurescontracts to be sold is: (1.0)[(2.2 - 4.4) / 8.2]($12,000,000 / $102,000) = -31.56 ≈ -32 futures contracts The minus sign meansthat 32 contracts should be sold to achieve the desired duration in the portfolio
A portfolio manager knows that a $10 million inflow of cash will be received in a month The portfolio under management is70% invested in stock with an average beta of 0.8 and 30% invested in bonds with a duration of 5 The most appropriate stockindex futures contract has a price of $233,450 and a beta of 1.1 The most appropriate bond index futures has a duration of 6and a price of $99,500 How can the manager pre-invest the $10 million in the appropriate proportions? Take a:
long position in 25 of the stock futures and 28 of the bond futures
short position in 25 of the bond futures and 22 of the stock futures
long position in 22 of the stock futures and 25 of the bond futures
Explanation
The goal is to create a $7 million equity position with a beta of 0.8 and a $3 million bond position with a duration of 5:
Trang 2Questions #3-8 of 55
number of stock futures = 21.8 = (0.8 − 0) × ($7,000,000) / (1.1 × $233,450)
number of bond futures = 25.13 = (5 − 0) × ($3,000,000) / (6 × $99,500)
The manager should take a long position in 22 of the stock index futures and 25 of the bond index futures
George Kaufman, portfolio manager and CEO of Kaufman Co., is extremely busy He has a number of important issues thatmust be dealt with before the end of the week
The portfolio Kaufman manages consists of $40 million in bonds and $60 million in equities The modified duration of the bondportfolio is 6.3 The beta of the equity portfolio is 1.25 The holding period for each is 1 year Kaufman also has the authority toborrow up to $25 million which may be invested on a short-term basis to earn the spread between the borrowing rate and theinvesting rate
Kaufman is afraid that interest rates will rise 25 basis points in the near future and would like to decrease the duration of thebond portion of the portfolio to 5.0 for a short period of time He prefers to use futures contracts to do this since it is a
temporary change and he does not want to actually sell bonds in the portfolio Kaufman is considering using a Treasury bondfutures contract that has a modified duration of 4.2, a yield beta of 1.1, and a price (including the multiplier) of $245,000 Kaufman would like to borrow money three months from today so he can invest at the expected higher interest rates
However, he would like to lock in today's interest rates for the loan To do this he is considering locking in a loan rate using aforward rate agreement (FRA) A cash settlement will be made based on the actual interest rate three months from now,relative to the FRA interest rate If Kaufman decides on this strategy, he would borrow $20 million at 5 percent for 9 months.The loan date would start three months from today
The equity portion of the portfolio has performed extremely well over the recent past and Kaufman must decide on one of thefollowing two strategies:
Equity Strategy 1: Kaufman could hold on to his current profits for the next six months which should make the reported annualreturn rank in the top one percentile of similar portfolios Again, Kaufman prefers to use futures contracts instead of sellingstocks to lock in the profits The portfolio is composed of the same stocks and sector weightings as the S&P 500 The contract
on the index is at 2000 (with a multiplier of 250), and it expires in 6 months The risk free rate is 2 percent and the dividendyield on the index is 3 percent
Equity Strategy 2: Kaufman believes there is a chance the market may move significantly over the next six months To benefitfrom the expected move in the market, Kaufman could increase the equity portion of the portfolio from its current beta of 1.25
to 1.4 by using equity index futures The appropriate equity index futures contract that Kaufman is considering using has abeta of 0.90 and a price (including the multiplier) of $335,000
Finally, Kaufman Co is expecting a $6 million cash inflow in 4 months and would like to pre-invest the funds to create thesame exposure to the bond and stock market that is found in the original portfolio The most appropriate stock index futurescontract for accomplishing this has a total price (including the multiplier) of $315,650 and a beta of 1.10 The most appropriatebond index futures contract has a total price of $115,460, a yield beta of 1.05 and an effective duration of 6.2
Assume Kaufman Co uses a FRA to hedge the loan rate If interest rates are 4.85 percent at expiration of the FRA, thesettlement payment is closest to:
Trang 3$21,710, with Kaufman paying the bank the settlement.
$21,710, with the bank paying Kaufman the settlement
$28,739, with Kaufman paying the bank the settlement
Explanation
Settlement
payment = 20,000,000 × [(0.0485 − 0.05) × (270 / 360)] / [1 + ((0.0485)(270 / 360)]
= 20,000,000 × (−0.001125 / 1.036375) = $21,710.29Since the realized rate at the time of the loan, 4.85%, is lower than the contract rate of 5%, Kaufman would want to pay to getout of the FRA so that he can borrow at the prevailing lower rate (Study Session 14, LOS 27.i)
The value of the bond portfolio given a 25 basis point increase is closest to:
New value = $40,000,000 × (1 − (6.3 × 0.0025)) = $39,370,000 (Study Session 9, LOS 20.g)
The number of Treasury bond futures contracts that Kaufman would need to reduce the duration of the bonds in the portfolio
Trang 4decrease in the market; a short position in approximately 72 contracts will accomplish
Number of Contracts = [(1.4 − 1.25) / 0.90] × ($60,000,000 / $335,000) = 29.85 contracts
The positive sign indicates that we should take a long position in the futures to "leverage up" the position If that is Kaufman'sgoal, he must be expecting an increase in the market (Study Session 15, LOS 29.a)
How many S&P index futures contracts would Kaufman need to buy or sell to create a six-month synthetic cash position?Sell approximately 400 contracts
Buy approximately 121 contracts
Sell approximately 121 contracts
Explanation
[$60,000,000 × (1.02) ] / (2000 × $250) = 121.19 contracts
Kaufman would need to sell the contracts to create the synthetic cash (zero equity) position If he were converting cash to asynthetic equity position, he would of course buy contracts (Study Session 15, LOS 29.c)
The most appropriate strategy to pre-invest the anticipated $6 million inflow would be to:
buy 21 bond futures contracts and buy 35 stock futures contracts
buy 22 bond futures contracts and buy 13 stock futures contracts
buy 22 bond futures contracts and sell 13 stock futures contracts
Explanation
Take the existing portfolio weights, 40% debt and 60% equity and apply them to the new money that is coming in Also,
"mirror" the duration and beta of the original portfolios
Number of bond futures = 1.05 × [(6.3 − 0) / 6.2] × [(6,000,000 × 0.40) / 115,460] = 22.18 contracts
Number of stock futures = [(1.25 − 0) / 1.10] × [(6,000,000 × 0.60) / 315,650] = 12.96
Kaufman Co would take a long position in both the stock index and bond futures contracts because it is synthetically creating
an existing portfolio until the actual $6 million is received and can be invested (Study Session 15, LOS 29.e)
0.50
Trang 5implemented tactical asset allocation measures in his fund sporadically over the years, and thinks now is another time to do
so Because he likes his long-term holdings, he decides to use a futures overlay rather than trading assets to implement hisview of the market Corser decides he wants to increase the beta of his portfolio to 1.25 The appropriate futures contract has
a beta of 1.03 and the total futures price is $310,000 What is the appropriate tactical allocation strategy for Corser to
accomplish his objective?
Buy 373 equity futures contracts
Buy 175 equity futures contracts
Sell 175 equity futures contracts
Explanation
NOTE - on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material fromderivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Because Corserwants to increase the beta of his portfolio, he should buy futures contracts The appropriate number of contracts to buy iscalculated as:
[(1.25 − 0.85) / 1.03] × ($140,000,000 / $310,000) = 175.38 ≈ 175 contracts
Which of the following statements about portfolio hedging is least accurate?
To synthetically create the risk/return profile of an underlying common equity security,
buy the corresponding futures contract, sell the common short, and invest in a T-bill
Futures contracts have a symmetrical payoff profile
Trang 6For a fixed portfolio insurance horizon, using put options generally requires less
rebalancing and monitoring than with the use of futures contracts
Explanation
To synthetically create the risk/return profile of an underlying common equity security, buy the corresponding futures contractand invest in a T-bill
When expecting to make a future payment in a foreign currency, a firm should take a:
short forward position in the currency to hedge an appreciation of that currency
long forward position in the currency to hedge a depreciation of that currency
long forward position in the currency to hedge an appreciation of that currency
Explanation
Expecting to make a payment is like being short the currency The firm would want to take a long forward position If thecurrency appreciates and there is no hedge, the firm would pay more With the hedge, the overall cost in domestic currency islocked in (cost increases will be offset by gains on the forward contract) Of course, the forward contract will result in a loss ifthe foreign currency actually depreciates, but this will be offset by a decrease in the cost of the underlying transaction
In order to perfectly hedge an investment in foreign equities, a manager would most likely have to use:
currency forwards only
both currency futures and equity forwards
both currency forwards and equity futures
Trang 7Question #15 of 55 Question ID: 466498
ᅞ A)
ᅚ B)
ᅞ C)
Questions #16-21 of 55
most often used to hedge transaction exposure, which is the risk that exchange rates will change the real value (in the
domestic currency) of the contracted price
An investor has a $100 million stock portfolio with a beta of 1.1 He would like to hedge his portfolio using S&P 500 futures contracts,which are currently trading at 596.70 The futures contract has a multiple of 250 Which of the following is the CORRECT trade required tocreate a synthetic T-bill?
Therefore, the investor has to sell 737 S&P 500 futures contracts short
Jackson Inc is a multi-national company based in the U.S that makes freight cars One third of Jackson's freight car sales occur in theNetherlands To manufacture the cars, the firm must import approximately one half of their raw materials from Canada
Heretofore, Jackson's CFO Pete Moore ignored exchange rate risk, figuring that currency fluctuations even out over time However,Jackson is doing more and more business abroad, and Moore is beginning to rethink his position In addition, Moore believes thatexchange rates have become more volatile, thus hedging currency exposure might make sense Given his new mindset, Moore decides
to hedge some of the company's currency exposure
Two months from now, Jackson plans to sell freight cars to a Dutch firm for 15 million To protect the company from any adverse moves
in exchange rates, Moore enters into a 15 million forward contract due in 60 days Moore also enters into a 60-day forward contract to lock
in 8.5 million Canadian dollars which will be used to purchase steel from a Canadian supplier to be delivered in 2 months
The current Euro-to-U.S dollar exchange rate is 0.79/$, while the Canadian dollar-to-U.S dollar exchange rate is C$1.30/$ The 60-dayforward Euro-to-U.S dollar exchange rate is 0.80/$, while the 60-day forward Canadian dollar-to-U.S dollar exchange rate is C$1.33/$ Atthe end of two months, the actual Euro/U.S dollar exchange rate is 0.90/$ and the actual Canadian dollar/U.S dollar rate is C$1.20/$
In addition to his duties at Jackson, Moore is a Level III CFA Candidate To assist with his studies and gain insights that will help himwith Jackson's hedging strategy, Moore has put together the following two tables
Table 1: Types of Exchange Rate Risks
Types of
Exposure
Definition
Trang 8Question #16 of 55 Question ID: 466527
Translation
Exposure
The risk that multinational corporations might see a decline in the value of their assets that are denominated in foreign currencies when those foreign currencies depreciate.
Transaction
Exposure
It is the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency.
Table 2: Hedging Currency Positions
Currency Exposure Position Action
Receiving foreign
currency
Long Buy forward contract
Paying foreign currency Short Sell forward contract
Up to now, Moore has used only forward contracts to hedge the foreign currency exposure However, after reading about futures
contracts, he thinks futures may be appropriate To help him decide, Moore makes a list of the advantages and disadvantages of usingfutures contracts
Pros & Cons of Futures vs Forwards
Futures contracts are standardized contracts, forward contracts are not
Futures contracts are less regulated than forward contracts, and thus have higher default risk
Forward contracts can be established for any settlement date, futures contracts have a limited number of available settlementdates
With respect to Table 1, which of the following statements is most accurate? The definition for:
economic exposure is correct; the definition for transaction exposure is correct
translation exposure is correct; the definition for transaction exposure is incorrect
translation exposure is incorrect; the definition for transaction exposure is incorrect
Explanation
The loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to the foreign currency iseconomic exposure The risk that contracted future cash flows become less valuable in terms of the domestic currency or that plannedpurchases become more expensive is known as transaction exposure Derivatives are primarily used to hedge transaction exposure.(Study Session 15, LOS 29.f)
Trang 9Question #17 of 55 Question ID: 466528
When hedging their exchange rate risk on the freight car sale, Moore used a forward contract to:
sell 15 million in exchange for $16.67 million
sell 15 million in exchange for $18.75 million
buy 15 million in exchange for $18.75 million
Explanation
The day the freight cars are sold, Jackson is effectively long Euros so the optimal solution is to sell the Euro forward contract in
exchange for $18,750,000 (15,000,000 / $0.80) If the company did not hedge, two months from now the sale would net only $16,666,667(15,000,000 / $0.90) (Study Session 15, LOS 29.f)
To hedge the foreign exchange risk relative to the Canadian dollar, Jackson should:
buy a forward contract to exchange $6,390,977 for CAD 8.5 million
buy a forward contract to exchange $7,083,333 for CAD 8.5 million
sell a forward contract to exchange $6,390,977 for CAD 8.5 million
Explanation
Jackson wants to "lock in" the price of $6,390,977 (8,500,000 / $1.33) for the Canadian steel now by buying Canadian dollars with aforward contract (Study Session 15, LOS 29.f)
In regard to Table 2, which of the following is CORRECT? The:
paying foreign currency position is correct; the action is correct
receiving foreign currency position is correct; the action is incorrect
receiving foreign currency position is incorrect; the action is also incorrect
Regarding the advantages of futures contracts, which statement is least accurate?
Statement 1
Statement 2
Statement 3
Trang 10Question #21 of 55 Question ID: 466532
it is typically less expensive to use derivatives than to adjust the actual portfolio
liquidity, at least for shorter maturity contracts, is often greater in the futures market than in
the underlying market
Explanation
The point of a hedge is not to leverage a position If the investor is speculating, or even if they are pre-investing or turning cash intosynthetic equity or debt, there may be a leverage advantage to futures rather than buying the underlying However, with respect tohedging, leverage is not the desired outcome The main advantages to using futures and forwards rather than adjusting the underlyingsecurity positions are cost, less disruption, and greater liquidity (Study Session 15, LOS 29.g)
A manager of $30 million in mid-cap equities would like to move half of the position to an exposure resembling small-cap equities Thebeta of the mid-cap position is 1.0, and the average beta of small-cap stocks is 1.6 The betas of the corresponding mid and small-capfutures contracts are 1.05 and 1.5 respectively The mid and small-cap futures prices are $260,000 and $222,222 respectively What isthe appropriate strategy?
Short 17 small-cap futures and go long 17 mid-cap futures
Short 17 mid-cap futures and go long 17 small-cap futures
Short 55 mid-cap futures and go long 72 small-cap futures
Explanation
We should recall our formula for altering beta,
number of contracts = ({target beta − B } × V) / (B × futures price)
In this case, for the first step where we convert the mid-cap position to cash, V=$15 million, and the target beta is 0 The current beta is1.0, and the futures beta is 1.05:
Trang 11Question #23 of 55 Question ID: 466501
Thus, the manager should take a long position in 72 of the contracts on the small-cap index
When using stock index futures contracts and cash to create a synthetic stock index, the larger the index multiplier:
the fewer the number of needed contracts
the greater the number of needed contracts
there is no such thing as an index multiplier
Explanation
The formula is:
Number of contracts = (V × (1 + risk free rate) ) / (futures price × multiplier)
As the multiplier increases, the number of needed contracts declines
An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forwardcurrency contracts We know then that the:
number of contracts used is greater than that used on a comparable equity position
number of contracts used is equal to that used on a comparable equity position
asset manager is not telling the truth
take a short position in 156 contracts
take a short position in 152 contracts
take a long position in 152 contracts
Explanation