CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r28 risk management applications of forward and futures strategies summary

Uses of Equity Futures Contracts Futures contracts can be used to change a portfolio’s beta.. Going long on futures contracts increases portfolio beta.. Going short on futures contracts

Level III

Risk Management Applications of Forward

and Futures Strategies

Summary

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Uses of Equity Futures Contracts

Futures contracts can be used to change a portfolio’s beta

Going long on futures contracts increases portfolio beta

Going short on futures contracts decreases portfolio beta

𝑁𝑓 = 𝛽𝑇 − 𝛽𝑆

𝛽𝑓

𝑆 𝑓

A synthetic equity position can be created by combining a risk

free bond with futures contracts If the amount of money to be

invested is V, the number of futures contracts required to create

a synthetic equity position is calculated using the equation:

𝑁𝑓 = 𝑉 1 + 𝑟

𝑇

𝑞𝑓

This method saves transaction costs and preserves liquidity

Investing V* in bonds and buying Nf* futures contracts at a price of f is equivalent to buying Nf*q/(1 + δ)T units of stock

We can construct a synthetic position is cash by selling futures 𝑉 1 + 𝑟 𝑇

Using Equity and Bond Futures to Adjust Asset Allocation

A $300 million fund is allocated 80 percent to stock and 20 percent to bonds The stock portion has a beta of

1.10 and the bond portion has a duration of 6.5 We would like to temporarily adjust the asset allocation to 50

percent stock and 50 percent bonds

Sell $90 million of stock by converting it to cash using stock index futures

𝑁𝑠𝑓 = (𝛽𝑇 − 𝛽𝑆

𝛽𝑓 )

𝑆

𝑓𝑆 =

0.00 − 1.10 0.96

$90,000,000

$200,000 = −515.63

Buy $90 million of bonds by using bond futures

𝑁𝑏𝑓 = (𝑀𝐷𝑈𝑅𝑇 − 𝑀𝐷𝑈𝑅𝐵

𝑀𝐷𝑈𝑅𝑓 )

𝐵

𝑓𝑏 = (

6.5 − 0.0 7.2 )(

$90,000,000

$105,250 ) = 771.97

Pre-investing

We can ‘pre-invest’ by taking long positions in futures contracts

Will receive $10 million in three months We want to pre-invest $6 million in stocks at an

average beta of 1.08 and $4 million in bonds at a modified duration of 5.25 An appropriate

stock index futures contract is selling at $210,500 and has a beta of 0.97 An appropriate

bond futures contract is selling for $115,750 and has an implied modified duration of 6.05

𝑁𝑠𝑓 = 𝛽𝑇 − 𝛽𝑆

𝛽𝑓

𝑆

𝑓 =

1.08 − 0.0 0.97

$6,000,000

$210,500 = 31.74

𝑁𝑏𝑓 = 𝑀𝐷𝑈𝑅𝑇 − 𝑀𝐷𝑈𝑅𝐵

𝑀𝐷𝑈𝑅𝑓

𝐵

𝑓 =

5.25 − 0.0 6.05

$4,000,000

$115,750 = 29.99

A long position in a futures contract is equivalent to being long the underlying plus a loan

Currency Risk

Risk associated with foreign currency receipt can be managed by selling forward (or futures)

contracts on the foreign currency

Example: An American company will receive €50 million in three months

What is the risk and how can this be managed using forward contracts?

Risk associated with foreign currency payments can be managed by

buying forward (or futures) contracts on the foreign currency

With respect to a foreign currency portfolio, the possible currency hedging strategies are:

1 Hedge market risk and not currency risk Here we will earn the foreign risk free rate

2 Hedge both Here we will earn the domestic risk free rate

3 Hedge currency risk but not market risk

4 Hedge neither

The effectiveness of the hedge depends on:

1 how well hedging instrument is correlated with investment portfolio

2 how well the final investment value is predicted