Derivatives & Currency management Flashcards
3 types of Equity swaps
Pay fixed, receive equity return.
Pay floating, receive equity return. (equity return payer does not lose voting rights/ equity rate receiver does not gain voting rights)
Pay another equity return, receive equity return.
Benefits include - gain exposure on equity, avoid tax and custody fees.
Disadvantage - Swaps require collateral, swaps are illiquid
What is VIX a measure of? Which index and of what confidence level?
The VIX measures EXPECTED volatility of the S&P500 over a 30 day period. It suggests +/– range for the percentage change in the S&P 500, with a 68% level of confidence.
Currency management strategies
Passive hedging - is rule based and typically matches the portfolio’s currency exposure to that of the benchmark used to evaluate the portfolio’s performance. It will require periodic rebalancing to maintain the match. The goal is to eliminate currency risk relative to the benchmark.
Discretionary hedging - allows the manager to deviate modestly from passive hedging by a specified percentage. An example is allowing 5% deviations from the hedge ratio that would match a currency’s exposure to the benchmark exposure. The goal is to reduce currency risk while allowing the manager to pursue modest incremental currency returns relative to the benchmark.
Active currency management - allows a manager to have greater deviations from benchmark currency exposures. This differs from discretionary hedging in the amount of discretion permitted and the manager is expected to generate positive incremental portfolio return from managing a portfolio’s currency exposure. The goal is to create incremental return (alpha), not to reduce risk.
A currency overlay - The manager is purely seeking currency alpha (incremental return), not risk reduction
Factors affecting strategic decision making to currency risk include:
Correlation between assets
Time horizon
Risk aversion
Liquidity needs
Reasons to implement discretionary hedging:
A long time horizon for portfolio objectives.
Low risk aversion.
Concern with regret at missing opportunities to add value through discretionary currency management.
Low short-term income and liquidity needs.
Little foreign currency bond exposure.
High hedging costs.
Clients who believe in the benefits of discretionary management.
Synthetic cash =
Long Equity - Futures
Buy common equity and sell futures contract
Economic Fundamentals
Increases in the value of a currency are associated with currencies:
This approach assumes that, in free markets, exchange rates are determined by logical economic relationships that can be modeled. This approach assumes that, in the long term, currency value will converge to fair value. Looking at PPP. Several factors will impact the eventual path of convergence over the short and intermediate terms.
Increases in the value of a currency are associated with currencies:
That are more undervalued relative to their fundamental value.
That have the greatest rate of increase in their fundamental value.
With higher real or nominal interest rates.
With lower inflation relative to other countries.
Of countries with decreasing risk premiums.
Technical analysis of currency is based on three principals:
Market technicians believe that in a liquid, freely-traded market the historical price data already incorporates all relevant information on future price movements
- Past price data can predict future price movement and because those prices reflect fundamental and other relevant information, there is no need to analyze such information.
- Fallible human beings react to similar events in similar ways and therefore past price patterns tend to repeat.
- It is unnecessary to know what the currency should be worth (based on fundamental value); it is only necessary to know where it will trade.
Resistance levels, support levels .
Overbought and oversold markets.
A currency overlay manager will most likely implement a carry trade when the yield of investing currencies is:
Falling volatility reaction?
Higher and currency volatility is stable.
Falling volatility will lead a manager to enter a carry trade.
A carry trade should be more profitable in periods of economic stability (low, stable currency volatility) with lower interest rates in the borrowing currencies and higher interest rates in the investing currencies.
A carry trade
A carry trade refers to borrowing in a lower interest rate currency and investing the proceeds in a higher interest rate currency. It can form losses in periods of stress where high yielding currencies depreciate moret than expected.
Covered interest rate parity (CIRP) holds by arbitrage :
The currency with the higher interest rate will trade at a forward discount/premium
The currency with the higher interest rate will trade at a forward discount, F0 < S0
The currency with the lower interest rate will trade at a forward premium, F0 > S0
Managers expecting volatility to increase should enter what call strategy?
Decreasing?
A long straddle. At the money call and put.
(Short straddle if volatility is expected to drop.
What is delta hedging?
How to tilt the delta hedge if currencies are expected to appreciate?
Delta hedging entails creation of a delta-neutral position, which has a delta of zero. The delta-neutral position will not gain or lose value with small changes in the price of the underlying assets, but it will gain or lose value as the implied volatility reflected in the price of options changes. A manager can profit by correctly predicting changes in volatility.
Delta measures the change in value of an option’s price for a change in value of the underlying. If currencies are expected to appreciate then delta neutral positions are expected to tilt to net positive and vice versa
What is a strangle?
A strangle is purchase of our the money puts and calls with the same absolute delta.
(unlike a straddle which is at the money)
Managers expecting market conditions to be stable?
Turn to crisis?
A manager expecting a stable market condition should implement a carry trade.
If market conditions deteriorate then they should discontinue the carry trade.
What is roll yield?
Roll yield is a return from the movement of the forward price over time toward the spot price of an asset. Selling a forward at a PREMIUM to the spot price will have a positive roll yield and vice versa.
Roll yield = hedged currency return (positive return = positive roll yield)
Put spread
Seagull spread.
Buy OTM puts on the CHF and sell puts that are further out of the money
This is a put spread combined with selling a call
A cross hedge
A cross hedge (sometimes called a proxy hedge) refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged. Hedging the risk of a diversified U.S. equity portfolio with S&P futures contracts is a cross hedge when the portfolio is not identical to the S&P index portfolio.
A macro hedge
A macro hedge is a type of cross hedge that addresses portfolio-wide risk factors rather than the risk of individual portfolio assets. Finding a similar (not exactly the same) derivative instrument which covers a basket: interest rate risk, credit risk, and volatility risk exposures at the same time.
Synthetic long
Synthetic short
Synthetic Long Call
Synthetic long = Long Call + Short Put
Synthetic short = Short call + Long Put
Synthetic Long Call = Long stock + Long Put
Bull Call Spread
Bear Call Spread
Bull Put Spread
Bear Put Spread
Bull Call Spread = Buy Call Low Strike, Sell Call High Strike Calls
Cost = 1.64 - 0.51 = 1.13
Max profit = Strike1 - Strike2 - Cost = 17 - 15 - 1.13
Bear Call Spread = Buy Call High Strike, Sell Call Lowe Strike
Bull Put Spread = Buy Put low strike, Sell Put High Strike
Bear Put Spread = Buy put high strike, Sell put low strike
Two types of trading costs in currency management?
Trading costs: bid/offer spreads, currency option premiums, forwards need to be rolled forward.
Opportunity cost: by fully hedging you lose opportunity of favourable ccy gains.
Passive hedging
Discretionary Hedging
Active currency management
Currency overlay
Passive hedging: rules based on a neutral benchmark
Discretionary Hedging: Neutral benchmark. Limited discretion(+/- 5%) 95% - 105%. Primary goal is to protect the portfolio.
Active currency management: More discretion, primary goal is for added alpha: greater than 95% - 105%
Currency overlay: outsourcing currency management to a specialist. Using foreign exchange as an asset class.
Currency correlation with:
Bonds
Equities
Bonds = High correlation hence you’d hedge
Equities = Low correlation hence you wouldn’t hedge as currency exposure is desirable for diversification benefits.
