CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set answers, study session 15, reading 28

FinQuiz Level III 2018 – Item-sets Solution Reading 28: Risk Management Applications of Forward and Futures Strategies Correct Answer: C The statement is incorrect with respect to the

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CFA Level III Item-set - Solution

Study Session 15

June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 28: Risk Management Applications of Forward and Futures Strategies

Correct Answer: C

The statement is incorrect with respect to the portfolio return If the foreign stock market risk is

hedged, the portfolio’s return will be the foreign risk free, before converting to the domestic currency

In other words, the portfolio will earn the foreign risk free rate in local currency terms

Correct Answer: B

The statement is incorrect Although it is true that for the risk management of foreign currency, forwards are preferred over futures because of their greater liquidity and customization benefit, the risk of most bond portfolios is still managed using Treasury bond futures

Correct Answer: A

A forward contract will be more appropriate in this case because the client would most likely prefer the precision provided by customized transactions The risk of inflows and outcomes of specific currency transactions, especially those associated with very specific dates, is better managed using forward contracts, because of their customization benefit

Clint is correct with respect to the first benefit Since forward contracts can be customized to meet the exact specific needs of an investor, they offer a better hedge than futures However, since they can

provide a close to perfect hedge, they tend to be more costly

Forward contracts are essentially unregulated while futures are heavily regulated However, this difference is not usually a major consideration in deciding which type of contract to use for hedging The other two factors are important for deciding which contract to use

The statement is correct Futures or forwards can be used to change the risk of certain asset classes or alter the allocations between asset classes Instead of asking one manager to sell securities and

another to buy securities, derivatives can be used to change the allocation (or risk) of a portfolio Thus, the asset class managers can concentrate on doing the best they can within their respective areas

of responsibility and need not even know that the overall asset allocation (risk) has been changed

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7 Question ID: 8806

To hedge the European market return, AMA would have to achieve a beta of zero on their €20 million

portfolio To reduce the beta to zero, AMA will have to sell futures contracts The required number

equals:

0 – 1.10/0.95[20,000,000/155,000] = – 149.40

Therefore AMA will need to sell 149 futures contracts

After hedging the European market return, the portfolio will be perfectly hedged against all European stock market risk Hence, it should earn the foreign risk free rate The Euro interest rate is 5% and since the investment is made for six months, AMA should expect to earn 0.05 × (180/360) = 2.5%

If AMA hedges the European market return, the portfolio would grow to a value of

€20,000,000[1+0.05(180/360)] = €20,500,000

Hence, AMA could hedge the currency risk of this portfolio with a forward contract with this much notional principal

If the European market return is hedged, the portfolio will grow to a value of €20,500,000 If AMA then decides to hedge the currency risk as well, it will enter a forward contract with a notional

principal equal to €20,500,000 Given the current spot exchange rate, and the risk free rates in the two regions, the six month forward exchange rate equals:

1.078(1.055/1.05)0.5 = $1.080/€

Hence, at contract expiration the notional principal will convert to a value of 20,500,000(1.080) =

$22,151,554

In dollar terms, the portfolio was originally worth 20,000,000(1.078) = $21,560,000

At the end of six months, the portfolio is worth $22,151,554 This translates to a return equal to: [22,151,554/21,560,000] – 1 = 2.744% which is approximately equal to the U.S risk free rate for six months (5.5/2 = 2.75%)

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The foreign market risk should be hedged if it is expected that the stock market will go down (weak market), so that the portfolio is hedged against such losses The currency risk should not be hedged if

it is expected that the foreign currency would be strong over the holding period (stronger than implied

by the interest rate differential), so that gains from appreciation of the foreign currency can be reaped

Since Superior Goods Inc has to deliver the foreign currency for the planned purchase, it is short the pound, and therefore, to hedge the exchange rate risk, it should go long the forward contract

Under the forward contract, Superior Goods will have to pay 1.355(50,000,000) = $67,750,000 to purchase ₤50 million If the spot exchange rate is $1.298/₤ in one month, Superior Goods will only have to pay (1.298)(50,000,000) = $64,900,000 to purchase the required ₤50 million This means it will be $2,850,000 better off in the spot market (that is, without the hedge in place)

If Superior Goods hedges the purchase of the raw material, it will purchase ₤50 million from the dealer, and pay 50,000,000/0.756= $66,137,566

If the spot rate after one month is ₤0.758/$, to purchase the ₤50 million, Superior Goods would need 50,000,000/0.758 = $65,963,061 only Hence, it would be $1,786,939 ($67,750,000 – $65,963,061) better off in the spot market (since to settle the forward contract it needs $67,750,000)

Since Oil Explorers Limited has to make a payment of $4.5 million, therefore it is short dollars Hence to hedge the foreign currency risk, it should go long the forward contract The notional

principal will equal $4,500,000

Oil Explorers Ltd will close the contract by receiving $4.5 million and delivering 4,500,000(0.987) = CAD4,441,500 in return

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Since the company has to make payment in Japanese yen, it is short the foreign currency (yen) Therefore, to hedge the exchange rate risk, the company should go long a forward contract (that is, a contract that allows buying the foreign currency at a fixed exchange rate) A currency swap is usually used to hedge a series of foreign cash flows

Since SSI will receive euros for the sale to Blue-Ray Technologies, it is effectively long the euro in its software sale, so a short position in the forward contract, denominated in dollars/euro, is

appropriate

Since SSI is long the euro, it should take a short position in the forward contract If the contract is cash settled, the company would sell the euros on the market for St and the forward contract would be cash settled for –(St –F) The net effect is that the company receives F, the forward rate for the euros

The sale is worth €35 million, and the forward exchange rate is $0.997/€ Therefore, SSI will deliver

€35 million and receive a rate of $0.997/€ The total amount it will receive equals:

35,000,000(0.997) = $34,895,000

Under the forward contract, SSI would receive 35,000,000(0.997) = $34,895,000 If the realized spot exchange rate in three months is $0.967/€, SSI would receive 35,000,000(0.967) = $33,845,000, or

$1,050,000 less than with the forward hedge in place

If the realized spot exchange rate in three months is $1.253/€, SSI would receive 35,000,000(1.253) =

$43,855,000 if it transacted in the spot market This is $8,960,000 more than what SSI would receive under the forward contract at a forward rate of $0.997/€ Therefore, SSI would be better off not hedging under this scenario

To increase the portfolio’s duration, the number of futures contracts to buy equals:

(7.7 – 5.55/6.27) ($187,500,000/375,000) (1.2) = 205.74

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In this case, the number of futures contracts would equal:

(7.7 – 5.55/6.27) ($187,500,000/375,000) (1) = 171.45

The return on the futures contract equals:

206(385,000 – 375,000) = $2,060,000

The overall gain with the futures contract = 5,013,750+$2,060,000

= $7,073,750

The return without the futures contract = 5,013,750/187,500,000

= 0.026740 = 2.674%

The return with the futures contract = $7,073,750/187,500,000

= 0.0377 = 3.773%

Difference = 2.674 – 3.773 = –1.099%

The duration of the portfolio can be measured by dividing the percentage change in the portfolio value by the 48 bps change in the portfolio yield

Without the futures contract: 0.02674/0.0048 = 5.57

With the futures contract: 0.03772/0.0048 = 7.86

To eliminate all interest rate risk means decreasing the duration to zero For this, the number of contracts needed would equal:

(0 – 5.55/6.27)($187,500,000/375,000)(1.2) = – 531.10 (so we need to sell this many contracts)

Statement 2 is incorrect Changing the duration, whether increasing it or reducing it, is an inexact process, because duration provides only an approximation of the change in bond prices

Statement 3 is correct

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By selling futures, one can indeed reduce the duration of a portfolio to replicate a short-term

instrument However, if cash is needed, the fund would still have to sell the long-term bonds and buy back the futures Although the latter would not present a liquidity problem, the sale of the long term bonds would Therefore, this conversion does not handle the liquidity problem

The amount invested in bonds equals (56%)($40 million) = $22.4 million

Of this $22.4 million 37% or (0.37)(22.4) = $8.288 million needs to be converted to six month

instruments with a duration of three months or 0.25 So the number of futures contracts needed equals:

[0.25-5.7/6.12][8,288,000/37,500] = – 196.81 or – 197 contracts (the negative sign means we need to

sell contracts)

Out of the $22.4 million, $8.288 million has been converted to short-term instruments The duration

of the remaining $14.1120 million needs to be increased from the current level of 5.7 to 6.5 For this

we need to buy:

[6.5-5.7/6.12][14,112,000/37,500] = 49.19 or 49 contracts

After the adjustments the duration of $8.288 million will have been converted to 0.25, and the

duration of $14.1120 million will have been raised to 6.5 The overall duration would be:

(8.288/22.4)0.25 + (14.1120/22.4)6.5 = 4.1875

The bond portfolio is worth $22.4 million 50% of this amount equals 0.50(22.4)= $11.2 million The objective is to increase the duration of $11.2 from its current level of 5.7 to 6.7, and decrease the duration of the other $11.2 million from 5.7 to 5.0

The number of futures contracts to increase the duration equals:

[6.7-5.7/6.12][11,200,000/37,500] = 48.80, so we need to buy 49 contracts

The number of futures contracts to decrease the duration equals:

[5.0-5.7/6.12][11,200,000/37,500] = -34.15, so we need to sell 34 contracts

Since these transactions involve the same futures contract, the net effect is that, to achieve the

objective, we need to buy 49-34 = 15 contracts

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Option B is inaccurate Reducing the duration of a bond portfolio to replicate a short-term instrument does not remove the problem that long-term instruments (which will still be held) may have to be liquidated Hence, this conversion does not solve the illiquidity problem of the long-term instruments The other options are correct

With the current allocation, Robust Chemicals has $345 million invested in stocks and $230 million invested in bonds To change the allocation to 50%-50%, $287.5 million needs to be invested in both bonds and stocks This means $57.5 million needs to be moved from stocks to bonds

Thus, Claudius will need to sell $57.5 million of stock and buy $57.5 million of bonds

The number of stock index futures to sell equals:

(0 – 1.3/1.1)(57,500,000/266,500) = – 254.988 or – 255 contracts

With the current allocation, Robust Chemicals has $345 million invested in stocks and $230 million invested in bonds To change the allocation to 50%-50%, $287.5 million needs to be invested in both bonds and stocks This means $57.5 million needs to be moved from stocks to bonds

The number of bond futures to buy equals:

(7.7-0/6.4) (57,500,000/175,000) (1.04) = 411.125 contracts or 411 contracts

If the yield on the bond portfolio and the yield on the bond futures contract change one-for-one, the yield beta would equal 1

(7.7 – 0/6.4)(57,500,000/175,000)(1.0) = 395.31 contracts or 395 contracts

With the current allocation, Robust Chemicals has $345 million invested in stocks and $230 million invested in bonds To change the allocation to 30%-70%, $172.5 million needs to be removed from stocks and invested in bonds

The number of stock index futures to sell equals:

(0 – 1.3/1.1)(172,500,000/266,500) = – 764.966 or 765 contracts

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With the current allocation, Robust Chemicals has $345 million invested in stocks and $230 million invested in bonds To change the allocation to 30%-70%, $172.5 million needs to be removed from stocks and invested in bonds

(7.7 – 0/6.4) (172,500,000/175,000) (1.04) = 1,233.375 contracts

To convert a stock position to a bond position, or, in other words, reduce the allocation to stock and increase the allocation to bonds, we would need to sell stock index futures to reduce the beta to zero and effectively convert the stock to cash, and then buy bond futures to increase the duration on the cash to the desired level

Economic exposure refers to the risk that the products or services of a domestic company will become less competitive with those of comparable foreign companies because of exchange rate movements The loss of sales of a domestic exporter due to an appreciation of the domestic currency relative to the foreign currency is an example of economic risk

Transaction exposure is the risk that exchange rate fluctuations will cause foreign currency receipts to decrease in value in domestic terms, and cause foreign currency payments to increase in value in domestic terms For example, the sales of a company’s foreign subsidiary have to be converted back into the domestic currency, and thus the sales in domestic terms depend on the exchange rate

movements

Exchange rate volatility affects a company’s accounting statements When a consolidated balance sheet of a multinational company is composed, the numbers from the balance sheets of foreign

subsidiaries need to be converted into the domestic currency at the appropriate exchange rate

Changing exchange rates introduce variation in account values, and this risk is called translation exposure

The statement is incorrect Economic exposure can affect any type of company, even if it does not sell its goods or services in foreign markets For example, a strong U.S dollar will make U.S products more expensive to non-U.S residents and will lead to a reduction in sales by a U.S company

(whether it exports or not), because non-U.S residents would purchase fewer U.S products Option

C refers to transaction exposure

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The management of a single cash flow is generally done using forward contracts, since futures tend to

be too standardized to meet the needs of most companies A series of foreign cash flows is usually managed using currency swaps

Futures are primarily used by dealers to manage their foreign exchange portfolios Currency options

can be used to manage the currency risk of single cash flows (as are used by portfolio managers in

some cases) Since movements in exchange rates are difficult to predict, even for experts in the foreign exchange business, most businesses manage transaction exposure by locking in the exchange rate on future cash flows with the use of derivatives (instead of speculating future movements)

Statement 1 is correct In pre-investing, an investor effectively borrows against the cash he will receive in the future (he invests the cash before he actually receives it)

Statement 2 is incorrect An outright long position in futures is a fully leveraged position in the

underlying as described by the following equation for pre-investing:

Long underlying + Loan = Long futures

To pre-invest $7 million in stocks, the approximate number of stock index futures is:

1.45-0/1.21[7,000,000/188,000] = 44.61 or 45

Therefore, Roberts should go long 45 stock index futures contracts

To pre-invest $3 million in bonds, the approximate number of bond futures is:

5.5 – 0/5.7[3,000,000/139,000] = 20.825 or 21 contracts

Therefore, Roberts should go long 21 bond futures contracts

The difference in portfolio values when actually investing versus synthetically investing is due to the fact that stocks and bonds do not always respond in the manner predicted by their betas and durations, and also, that the number of futures contracts is rounded off Option A is not a reason

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