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CISI: Derivatives > Chapter 8: Trading, Hedging and Investment Strategies > Flashcards

Chapter 8: Trading, Hedging and Investment Strategies Flashcards

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1
Q

What is a structured product?

A

Investment strategy that is based on derivatives

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2
Q

What is a futures spread?

A

Simultaneously buying and selling futures contracts

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3
Q

What are Intra-Market Spreads?

A

Buying and selling of futures with different expiry dates but the same underlying asset

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4
Q

Why would a trader enter an intra-market spread? (4)

A

Anticipating changes in the basis
Reducing risk
Arbitrage (buy one exchange and sell another)
Roll over existing hedge to a new expiry date

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5
Q

What is an inter-market spread?

A

Buying and selling futures on different (but correlated) assets

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6
Q

Why would a trader enter a inter-market spread? (3)

A

If the price relationship between the two assets has broken down and the trader expects a return to baseline
Hedging
Changing asset allocation in portfolio

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7
Q

Where are Inter-Market spreads popular and why?

A

Interest rate markets, allows traders to bet on relationship between short and long term interest rates (yield curve)

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8
Q

How could a fund manager look to reduce their long equities exposure by selling some shares and use the sale proceeds to buy bonds - without trading the actual securities?

A

By using the futures market (eg, selling FTSE 100 futures and buying long gilt futures), it is possible to produce the same effect without the need to trade the actual securities.

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9
Q

What is the difference between intra and inter market spreads?

A

Intra - Same asset different expiry
Inter - Different asset

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10
Q

What do intra and inter mean and how to they represent the difference in spread?

A
  • Intra (‘within’) = underlying assets are the same.
  • Inter (‘between’) = underlying assets are different.
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11
Q

How do hedgers offset price risk?

A

By taking an opposite position in the futures market

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12
Q

What will affect the performance of a hedge?

A

Basis changes

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13
Q

What is the cheapest to deliver (CTD)?

A

A long bond futures contract contains a basket of deliverable bonds
The cheapest one to deliver is know as the CTD bond

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14
Q

What is the implied repo rate?

A

Measure of the funding cost implied in futures prices
Reflects difference between cash price and price of futures contract

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15
Q

What will be the implied repo rate of the CTD bond?

A

The highest in the basket of bonds in the futures contract

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16
Q

Which bond do they use in the portfolio to calculate the number of contracts needed to hedge?

A

The CTD, cheapest to deliver

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17
Q

What is the formula for number of contracts to hedge for bonds?

A

price factor * (nominal value of the CTD portfolio) / (nominal value of the contract)

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18
Q

What hedging method is used if you do not have a portfolio of CTD bonds?

A

duration based hedge ratios

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19
Q

What is the formula to calculate the hedge ratio for CTD bonds?

A

Number of contracts = (P* DP) / (FC * DF)
Where P = Nominal value of portfolio
DP = Duration of portfolio
FC = Interest-rate futures price
DF = Duration of the underlying asset in the interest rate future

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20
Q

What is a stock or portfolios beta?

A

Its volatility relative to the entire market

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21
Q

What is the calculation for beta?

A

Beta = Covariance (Rp, Rm) / Variance (Rm)
Where
Rp = Return of stock / portfolio
Rm - Return of overall market, usually index

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22
Q

What if the beta is?
More than 1
Equal to 1
Between 1 and 0
Equal to 0
Less than 0

A

More than 1 = the stock or portfolio is more volatile than the market
Equal to 1 = in line with the market
Between 0 and 1 = less volatile than the market
Equal to 0 = no relationship
Less than 0 = inverse relationship

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23
Q

What is the calculation for beta in simple word terms

A

Covariance of return of stock and market
over
Variance of return of market

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24
Q

Why is beta useful when using futures to hedge an equity porfolio?

A

Calculate how many contracts you need for the portfolio to be fully hedged

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25
Why is the formula different for STIR (short-term interest rate) futures?
It's dependent on the relative change in portfolio and STIR prices given one basis-point change in yields
26
What is the hedge ratio for STIR futures calculation?
Price change in portfolio given one basis point change in yields / Price change in STIR futures given one basis point change in yields
27
What is basis?
The difference between the cash and the futures price
28
What is basis risk?
That the change in future prices will be different to the changes in the cash price
29
What is basis trading?
Strategies to profit from anticipated basis changes
30
Who has the biggest disadvantage in basis changes?
Hedgers If futures are used to hedge cash positions, basis changes mean that the hedge will become less efficient
31
Who has the biggest advantage in basis changes?
Speculators and arbitrageurs
32
What is the efficiency of hedging using options based on?
Whether the delta of the option position mirrors the delta of the position, creating a delta neutral portfolio E.g. +0.5 delta pos, and -0.5 options is good
33
What are the deltas? (long only) Long underlying Long future Long call (deep ITM) Long call (ATM) Long put (deep ITM) Long put (ATM)
Long underlying = +1 Long future = +1 Long call (deep ITM) = +1 Long call (ATM) = +0.5 Long put (deep ITM) = -1 Long put (ATM) = -0.5
34
What is the delta of an option ATM?
+- 0.5
35
How does a futures hedge performance differ to a options hedge?
Futures will always outperform as options have premium paid
36
What does an options hedge provide that a futures does not?
Flexibility Profits can still be made even if underlying moves in an investors favour as loss is limited to premium paid
37
What is a buy-write strategy?
Covered option, own underlying
38
What is the same class of options on an options spread?
Same contract type and underlying E.g. buy put and sell put on AAPL
39
How do you construct a covered short put?
Writing a put and having sufficient funds to buy the asset if necessary Having a short position
40
What is an options spread?
Simultaneous buying and selling of options in the same class
41
What are the three different types of options spread?
Vertical spread Horizontal or calendar spread Diagonal spread
42
What is a vertical spread?
Buying and selling calls (or puts) with different strikes but same expiry
43
What is a horizontal spread?
Buying and selling calls (or puts) with same strike but different expiry
44
What is a diagonal spread?
Buying and selling calls (or puts) with different strikes and different expiry
45
How do you set up a bull and bear spread?
Bull spread - buys lower strike, sells the higher strike Bear spread - sells lower strike, buys higher strike
46
What are horizontal spreads motivated by?
Expected moves in volatility
47
What horizontal spread will you do if volatility is expected to increase in the long term?
Sell shorter maturity, buy longer maturity on same asset / strike
48
How does sell shorter maturity, buy longer maturity work for expecting volatility to increase?
Short dated options will lose their time value faster then longer dated options. This means they will react more quickly to a fall in volatility. Basically isolating volatility as a factor Longer dated options will increase more
49
What horizontal spread will you do if volatility is expected to increase in the short term?
Buy shorter maturity, sell longer maturity on same asset / strike
50
What are diagonal trades designed to take advantage of?
Changes in volatility
51
How are diagonal spreads structured?
Puts or Calls sell short dated, buy long dated diff strikes and expiry
52
What is the difference between a straddle and a strangle?
Straddles are put and call with same strike and expiry Strangles are put and call with different strike and expiry
53
What are the two different combination strategies?
Straddle and strangle
54
What would would a trader want to happen if entering a short straddle or strangle strategy
Decrease in volatility
55
Which combination strategy will usually have a higher premium outlay for?
Strangle
56
Which combination strategy needs more volatility to succeed and why?
Strangle higher premiums difference in strike prices needs to be overcome
57
What is the difference between the maximum loss (on a long) or gain (on a short) for a strangle versus a straddle
Straddle has a precipice, one price where you will have maximum gain/loss Strangle has a range of price where you will have max gain/loss
58
Which combination strategy will have a higher total premium received?
Straddle
59
How do you create positions synthetically?
Combining futures and options
60
How would you create a synthetic future, long and short?
Same strike and expiry for all Long future - buy a call and sell a put Short future - sell a call and buy a put
61
How would you create a synthetic call, long and short?
Long call - buy a future and buy a put Short call - sell a future and sell a put
62
How would you create a synthetic put, long and short?
Long put - buy a call and sell a future Short put - sell a call and buy a future
63
What is the main reason for using synthetics?
Arbitrage
64
How is arbitrage achieved with synthetics?
Put/call parity formula defines relationship of premiums and asset price If call and put premiums are out of line you can lock in riskless profits using synthetics
65
What are the advantages of OTCs over ETDs? (2)
Flexible contracts to fit exposure No margin required
66
What are the advantages of ETDs over OTCs? (3)
More liquid Full price transparency CP risk limited
67
What are the disadvantages of ETDs? (2)
Margin payments Standardised contracts
68
What are the disadvantages of OTCs? (3)
CP risk Limited price transparency Higher costs
69
What are the two main routes for investors waiting to invest in derivatives?
Accounts - client entrusts money to a regulated firm Pooled funds - collective investment scheme managed by fund companies
70
What are the three main type of derivative-based fund?
Speculative - max loss 100% Guaranteed - structured funds (max loss 0 or preset amt like 5%) Synthetics - designed to replicate performance of an index
71
What are the two types of unit trust and how do they differ?
Authorised (AUT) Unauthorised Authorisation comes from FCA and allows marketability to all customers
72
What is the benefit and risk off offshore funds?
Tax efficient and greater choice Less regulation and higher charges Luxembourg, the Cayman Islands, the British Virgin Islands or Mauritius
73
Why would a private client use derivatives?
Hedging and moderate speculation Some restrictions from banks, need KYC and risk appetite
74
Why would a institutional asset manager use derivatives?
Hedge and speculate to increase returns Client transition periods, where they want to change manager; Derivatives can be used to track benchmark until full transition is made Access to difficult assets, capital controls, difficult custody
75
Why would a hedge fund use derivatives?
Hedging to highly geared speculation Short exposure in markets where securities loans are not possible
76
What derivative could a fund use to implement a ESG focused investment strategy?
Carbon emission derivatives
77

CISI: Derivatives (10 decks)

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