2019 CFA level 3 qbank reading 32 risk management applications of forward and futures strategies answers

Explanation We should recall our formula for altering beta, number of contracts = {target beta − Bportfolio} × V / Bfutures × futures price In this case, for the rst step where we conver

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Question #1 of 49

An S&P500 index manager knows that he will have $60,000,000 in funds available in three

months He is very bullish on the stock market and would like to hedge the cash in ow using

S&P 500 futures contracts The S&P 500 futures contract stands at 1100.00 and one contract is

worth 250 times the index Which of the following is the most accurate hedge for this portfolio?

A) Sell 218 contracts.

B) Buy 284 contracts.

C) Buy 218 contracts.

Explanation

In order to be hedged against stock price increases, S&P 500 futures contracts have to be

purchased The quantity of contracts to buy is computed as follows:

# contracts = (beta)(Portfolio value) ÷ (futures price)(contract multiplier)

= (1)(60,000,000) ÷ (1100)(250) ≅ 218.18 = 218 contracts(Study Session 17, Module 32.2, LOS 32.d)

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SchweserNotes - Book 4

Michael Hallen, CFA, manages an equity portfolio with a current market value of $78 million and

a beta of 0.95 Convinced the market is poised for a signi cant upward movement, Hallen

would like to increase the beta of the portfolio by 40 percent, using S&P 500 futures currently

trading at 856 The multiplier is 250 What is the number of futures contracts, rounded up to

the nearest whole number, that will be needed to achieve Hallen's objective?

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First determine the new target beta by multiplying the current beta of the portfolio which is

.95 by 1.4 to achieve a new target beta that is 40% greater than the current portfolio beta:

(.95)(1.4) = 1.33Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)]

A manager of $40 million of mid-cap equities would like to move $5 million of the position to

large-cap equities The beta of the mid-cap position is 1.1, and the average beta of large-cap

stocks is 0.9 The betas of the corresponding mid and large-cap futures contracts are 1.1 and

0.95 respectively The mid and large-cap futures prices are $252,000 and $98,222 respectively

What is the appropriate strategy? Short:

A) 23 mid-cap futures and go long 42 large-cap futures.

B) 29 mid-cap futures and go long 29 large-cap futures.

C) 20 mid-cap futures and go long 48 large-cap futures.

Explanation

We should recall our formula for altering beta,

number of contracts = ({target beta − Bportfolio} × V) / (Bfutures × futures price)

In this case, for the rst step where we convert the mid-cap position to cash, V = $5 million,

and the target beta is 0 The current beta is 1.1, and the futures beta is 1.1:

-19.84 = (0 − 1.1) × ($5,000,000) / (1.1 × $252,000)The manager should short 20 of the futures on the mid-cap index Then the manager should

take a long position in the following number of contracts on the large-cap index:

48.23 = (0.9 − 0) × ($5,000,000) / (0.95 × $98,222)Thus, the manager should take a long position in 48 of the contracts on the large-cap index

(Study Session 17, Module 32.2, LOS 32.e)

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To synthetically create the risk/return pro le of an underlying common equity security:

A) Sell short the corresponding futures contract and invest in a T-bill.

B) Buy the corresponding futures contract and invest in a T-bill.

C) Buy the corresponding futures contract and borrow at the risk-free rate.

When using stock index futures contracts and cash to create a synthetic stock index, the larger

the index multiplier:

A) there is no such thing as an index multiplier.

B) the fewer the number of needed contracts.

C) the greater the number of needed contracts.

Explanation

The formula is:

Number of contractsUnrounded = (V × (1 + risk free rate)T) / (futures price ×multiplier)

As the multiplier increases, the number of needed contracts declines

(Study Session 17, Module 32.3, LOS 32.b)

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A manager has a 70/30 stock and bond portfolio To synthetically create a portfolio that is 60

percent stock and 40 percent bonds, the manager should:

A) go long the bond futures and short the stock index futures.

B) short the bond futures and go long the stock index futures.

C) go long both bond futures and stock index futures.

A manager has a position in Treasury bills worth $175 million with a yield of 2% For the next 6

months, the manager wishes to have a synthetic equity position approximately equal to this

value The manager chooses S&P 500 index futures, which has a dividend yield of 3% The

futures price is 1,050 and the multiplier is $250 How many contracts will this take?

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A manager has a $100 million portfolio that consists of 50% stock and 50% bonds The beta of

the stock position is 1 The modi ed duration of the bond position is 5 The manager wishes to

achieve an e ective mix of 60% stock and 40% bonds The price and beta of the stock index

futures contracts are $277,000 and 1.1 respectively (The futures price includes the e ect of the

index multiplier.) The price, modi ed duration, and yield beta of the futures contracts are

$98,000, 6, and 1 respectively What is the appropriate strategy?

A) Short 40 bond futures and go long 106 stock index futures.

B) Short 85 bond futures and go long 33 stock index futures.

C) Go long 53 bond futures and go long 40 stock index futures.

Explanation

Since the manager wishes to increase the equity position and decrease the bond position by

$10 million (10% of $100 million), the correct strategy is to take a short position in the bond

futures and a long position in the stock index futures:

number of bond futures = -85.03 = [(0 − 5) / 6]($10,000,000 / $98,000)number of stock futures = 32.82 = [(1 − 0) / 1.1]($10,000,000 / $277,000)(Study Session 17, Module 32.2, LOS 32.d)

Which of the following statements about portfolio hedging is least accurate?

A) To synthetically create the risk/return pro le of an underlying common equity

security, buy the corresponding futures contract, sell the common short, and invest

i bill

B) For a xed portfolio insurance horizon, using put options generally requires less

rebalancing and monitoring than with the use of futures contracts

C) Futures contracts have a symmetrical payo pro le.

Explanation

To synthetically create the risk/return pro le of an underlying common equity security, buy

the corresponding futures contract and invest in a T-bill

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An investor has a cash position currently invested in T-Bills but would like to "equitize" it by

using S&P futures contracts Which of the following trades will create the desired synthetic

equity position?

A) Selling S&P 500 futures contracts short.

B) Selling the T-Bills and buying S&P 500 futures contracts.

C) Buying S&P 500 futures contracts.

Explanation

The trader can buy stock index futures and hold them in conjunction with T-Bills to mimic a

stock portfolio So we have:

Synthetic stock portfolio = T-Bills + stock index futures

An asset manager says he has perfectly hedged an equity portfolio that is denominated in a

foreign currency by only using forward currency contracts We know then that the:

A) asset manager is not telling the truth.

B) number of contracts used is greater than that used on a comparable equity

position

C) number of contracts used is equal to that used on a comparable equity position.

Explanation

Since the asset manager cannot know the future value of the equity position, it is impossible

to perfectly hedge the position with only currency contracts

(Study Session 17, Module 32.4, LOS 32.g)

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With respect to the practice of using forward contracts to eliminate the exchange-rate risk

associated with a receiving a future payment in a foreign currency, which of the following is

correct? A rm that expects to receive a foreign-currency payment is:

A) “short” the currency and should short the forward contract on the foreign currency.

B) “short” the currency and should go long the forward contract on the foreign

currency

C) “long” the currency and should short the forward contract on the foreign currency.

Explanation

In hedging foreign exchange risk, anticipating a receipt (payment) of a currency is like being

long (short) the currency To hedge the associated risk, a manager should take the opposite

position in the forward contract

(Study Session 17, Module 32.4, LOS 32.f)

The exchange-rate risk associated with falling asset values in foreign subsidiaries caused by

currency uctuations is called:

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Translation exposure refers to the fact that multinational corporations might see a decline in

the value of their assets that are denominated in foreign currencies when those foreign

currencies depreciate When the consolidated balance sheet is composed, changing exchange

rates will introduce variation in account values from year to year

(Study Session 17, Module 32.4, LOS 32.f)

Tom Corser is the manager of the $140,000,000 Intrepid Growth Fund Corser's long-term view

of the equity market is negative, and as a result, his portfolio is allocated defensively with a

beta of 0.85 Despite his negative long-term outlook, Corser thinks the market is temporarily

mispriced, and could rise signi cantly over the next few weeks Corser has implemented 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 his view 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?

A) Sell 175 equity futures contracts.

B) Buy 175 equity futures contracts.

C) Buy 373 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 from derivatives as tactical asset allocation can be accomplished by

selling assets, or with a derivative overlay Because Corser wants to increase the beta of his

portfolio, he should buy futures contracts The appropriate number of contracts to buy is

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An investor has a $100 million stock portfolio with a beta of 1.2 He would like to alter his

portfolio beta using S&P 500 futures contracts The contracts are currently trading at 596.90

The futures contract has a multiple of 250 Which of the following is the CORRECT trade

required to double the portfolio beta?

To double the portfolio beta we buy 804 contracts

(Study Session 17, Module 32.1, LOS 32.a)

A manager of a $20,000,000 portfolio wants to decrease beta from the current value of 0.9 to

0.5 The beta on the futures contract is 1.1 and the futures price is $105,000 Using futures

contracts, what strategy would be appropriate?

A) Short 69 contracts.

B) Short 19 contracts.

C) Long 69 contracts.

Explanation

Number of contracts = -69.26 = (0.5 − 0.9) × ($20,000,000) / (1.1 × $105,000), and this rounds

down to 69 (absolute value) Since the goal is to decrease beta, the manager should go short

which is also indicated by the negative sign

(Study Session 17, Module 32.1, LOS 32.a)

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In the hedging of currency risk, the issue of basis risk is:

A) not a concern when using either futures contracts or options.

B) a concern when using futures contracts and not options.

C) a concern when using options and not futures contracts.

Explanation

Basis risk is the di erence between the forward or futures price and the spot price The

variability of this measure is a source of risk in a futures or forward hedge where the

maturity of the derivative is di erent from the horizon Basis risk is not an issue in hedging

A manager wishes to make a synthetic adjustment of a mid-cap stock portfolio The goal is to

increase the beta of the portfolio by 0.5 The beta of the futures contract the manager will use

is one If the value of the portfolio is 10 times the futures price, then the futures contract

position needed is a:

A) long position in 20 contracts.

B) short position in 5 contracts.

C) long position in 5 contracts.

Explanation

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We should recall our formula for altering beta,

number of contracts = ({target beta − Bportfolio } × V) / (Bfutures × futures price)the provided information gives:

number of contracts = 5 = 0.5 × 10 × (futures price) / (1 × futures price)

A portfolio holds $20 million of its assets in an index fund that mimics the return of the Dow

Jones Industrial Average (DJIA) The dividend yield on the DJIA index is 2.8% The manager of the

portfolio would like to synthetically convert half of the position to cash for a one month period

The futures contract on the DJIA that expires in a month is priced at 14520.01 It has a

multiplier equal to $10 The risk-free rate is 3.85% The number of contracts the fund needs to

use is closest to:

A) 66

B) 69

C) 72

Explanation

The negative sign indicates the need to take a short position

(Study Session 17, Module 32.3, LOS 32.c)

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If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity

portfolio in one year The worst-case scenario is if the portfolio's return is:

A) less than the expected value and the currency appreciates.

B) less than the expected value and the currency depreciates.

C) greater than the expected value and the currency appreciates.

Explanation

This should be obvious because a decline in the equity position is bad and the short position

in a forward currency contract hurts when the foreign currency appreciates If the equity

position falls short of the contracted amount, in addition to the loss from the decline in asset

prices, then the manager will su er a loss equal to the di erence in the hedged amount and

the actual equity value times the di erence in the spot and contracted forward rate

If a manager plans to use currency forwards to hedge a long position in foreign equities, then

which of the following would represent a strategy that would prevent over-hedging?

A) Short an amount that is less than the current equity position.

B) Short an amount that is more than the current equity position.

C) Go long an amount that is more than the current equity position.

Explanation

The manager would want to short the forward contracts to hedge depreciation of the foreign

currency To prevent hedging too much, over-hedging, the manager would hedge an amount

less than the equity position because that position may decline in value from the equity risk

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The practice of taking long positions in futures contracts to create an exposure that converts a

yet-to be received cash position into a synthetic equity or bond position is:

A) called pre-investing.

B) illegal.

C) called leveraging down.

Explanation

This is the de nition of pre-investing using futures contracts, and it is not illegal

A maker of large computers has just received an order for some of its products The agreed

upon price is in British pounds: ₤8 million The rm will receive the pounds in 60 days The

current exchange rate is $1.32/₤ and the 60-day forward rate is $1.35/₤ If the rm uses the

forward contract to hedge the corresponding exchange rate risk, how many dollars will it

On the day the order comes in, the rm e ectively has a long position in pounds; therefore, it

should take a short position in a forward contract This contract would obligate the rm to

deliver the pounds that it will receive for dollars The contract would be to exchange ₤8

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A portfolio manager knows that a $10 million in ow of cash will be received in a month The

portfolio under management is 70% invested in stock with an average beta of 0.8 and 30%

invested in bonds with a duration of 5 The most appropriate stock index futures contract has a

price of $233,450 and a beta of 1.1 The most appropriate bond index futures has a duration of

6 and a price of $99,500 How can the manager pre-invest the $10 million in the appropriate

proportions? Take a:

A) long position in 25 of the stock futures and 28 of the bond futures.

B) short position in 25 of the bond futures and 22 of the stock futures.

C) 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:

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

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 the Netherlands To manufacture the cars, the rm must

import approximately one half of their raw materials from Canada

Heretofore, Jackson's CFO Pete Moore ignored exchange rate risk, guring that currency

uctuations 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 that exchange 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 rm 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

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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-day forward 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$1.33/$ At the 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 him with Jackson's hedging strategy, Moore has put together the

following two tables

Table 1: Types of Exchange Rate Risks

Economic Exposure

The risk that exchange rate uctuations will make contracted future cash ows from foreign trade partners' decrease in domestic currency value.

Table 2: Hedging Currency Positions

Receiving foreign

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 using futures contracts

Pros & Cons of Futures vs Forwards

Futures contracts are standardized contracts, forward contracts are not

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