Cfa Level Iii - Study Session 15

Front 1

Risk Management Applications of Derivatives

Changing beta of an equity pf
(SS15)

Back 1

The number of equity futures contracts required to change the beta of an equity pf is based on:
i. ratio of market value of stock
ii. to the futures price
iii. times the difference in the target beta and the actual beta
iv. divided by the beta of the futures

Front 2

Risk Management Applications of Derivatives

Equitizing cash to create a synthetic stock index fund?
(SS15)

Back 2

A long stock =
1. A long position in futures +
2. A long position in a risk-free bond
i. create a synthetic long by buying futures on stock
ii. and a risk-free bond
iii. this can create a synthetic stock index fund.

Front 3

Risk Management Applications of Derivatives

Cashing equity to create synthetic cash?
(SS15)

Back 3

Cash is equivalent to
1. A long position in stock
2. A short position in stock futures

Synthetic cash is made by
i. Buying stock and
ii. Selling futures

Front 4

Risk Management Applications of Derivatives

"Pre-investing"
(SS15)

Back 4

Pre-investing is when you take a position in an asset class without having cash to actually invest in the asset class
i. used just before you get a big receipt of money at a later date
ii. when you get the money, invest it in the asset class and close out the futures position.

Front 5

Risk Management Applications of Derivatives

Transaction Exposure
(SS15)

Back 5

Transaction exposure is:
1. The risk associated with a foreign exchange rate on a specific business transaction such as a purchase or sale.
2. It is the risk associated with the conversion of foreign financial statements into domestic currency.

Front 6

Risk Management Applications of Derivatives

Economic Exposure
(SS15)

Back 6

Economic Exposure
1. The risk associated with changes in the relative attractiveness of products and services offered for sale
2. This exposure comes out of the competitive effects of changes in exchange rates.

Front 7

Risk Management Applications of Derivatives

How do you rid of the ER exposure of a big receipt or payment?
(SS15)

Back 7

Big foreign receipt?
i. you have incoming currency
ii. you are effectively long that currency
iii. to balance this you need a SHORT FORWARD contract
iv. that locks in the conversion rate
Big foreign payment?
i. you have outgoing currency in Yen lets say
ii. you are effectively short the Yen (at time 1)
iii. to balance this you need a LONG FORWARD contract
iv. this locks in the rate that you'll convert your domestic into foreign to make the payment.

Front 8

Risk Management Applications of Derivatives

Why bother using forwards and futures to equitize etc?
(SS15)

Back 8

Futures and forwards:
1. Significantly lower transaction costs
2. Allows the portfolio manager to make changes in the risk of certain asset classes
3. Allows the portfolio manager to make changes in the allocation to different asset classes without disturbing the asset class or classes themselves.
4. Although futures and forwards tend to be more liquid that their underlying assets, they are not always highly liquid. So you can't say that they are ALWAYS going to solve your liquidity problems.

Front 9

Risk Management Applications of Derivatives

Example - Hedge both equity AND currency risk
(SS15)

Back 9

1. Hedging the equity market risk only is the same as usual to figure out the # of futures contracts.
i. If you hedge the equity part, then you will earn the FOREIGN risk free rate.
ii. lets say you are in Euro's you figure out your contracts in euro's and then you grow up your 100m using the euro risk free rate.
2. Starting pf in $ is just converted back at the spot rate.
3. The next year when you're looking at it, euro equity went down 4.55% given a pf beta = 1.1
YOUR pf went down 4.55(1.10)= 5%
Euro pf now worth
10,000,000euro (1- 0.05) = 9,500,000
4. If NOTHING is hedged then pf is converted to dollars at the new yr1 spot of 0.785 (it fell)
= 9,500,000 x (0.785) = $8,000,000
5. If ONLY the euro equity is hedged (this means your bought futures on it, 96 contracts)
Futures are now worth $110,600 (they went down)
= -96 (euro 110,600 - 120,000)
= 902,400 (you sold the contracts so you can buy them back cheaper)
Add this to the pf value
= 9,500,000 + 902,400
= 10,402,400 euro
= 4.02% return
THIS IS THE FOREIGN IR (4%)
convert to dollars
= 10,402,400 x (0.785)
= $8,165,884, a gain of 2.07%
6. If BOTH the foreign equity and the ER are hedged
= EARN DOMESTIC RISK FREE

Front 10

Risk Management Applications of Forwards and Futures

Futures or Forwards?
(SS15)

Back 10

1. Futures are exchange traded standardized
2. Futures are guaranteed at clearinghouse against default
3. Forwards subject the counterparty to default risk
4. Futures are regulated
5. Forwards are conducted privately
6. Forwards are used for FOREX (because there is a lot of liquidity)
7. Forwards are more costly to set up if you want to write one on a customized particular portfolio (compared to a standardised futures)
8. Many organizations are prohibited from using futures or forwards.
9. BOTH have zero value at the START and linear payoffs (as opposed to options that need money at the start with nonlinear payoffs)
10. Forwards are good if you just want to balance the risk for ONE date (futures for multiple)

Front 11

Risk Management Applications of Option Strategies

Protective Put
(SS15)

Back 11

1. Profit protective put
= S + max (0, X-S), minus S + p the cost of the underlying plus the option premium.
2. Maximum profit
INFINITE
3. Maximum loss
S + premium - X
4. Puts let you keep the upside potential, while limiting the downside (at the upfront option premium expense)
5. Protective puts hold the underlying asset on the put they've sold.
6. Sometimes this protection for the downside is EXPENSIVE.
7. Protective Put is a classic example of insurance.

Front 12

Risk Management Applications of Option Strategies

Covered Call
(SS15)

Back 12

1. Profit
= S - max(0, S-X), minus S - c
2. Breakeven St
= So - option premium
3. Give up gains if there is a bull market, but earns an option premium to pad the downside of a bear market.
4. Covered calls have a lot of downside and a limited upside, so you'd want the market to STAY STEADY and just earn extra income.
5. Covered call writers don't make a lot of money, but they make it OFTEN.
6. When call writers lose the lose BIG, but they own the underlying to offset the risk

Front 13

Risk Management Applications of Option Strategies

Bull Spread
(SS15)

Back 13

1. Bull Spread is
i. Buy low X ($$$) /Sell high X Calls ($) so cash outlay here
ii. Same expiration
iii. Higher exercise price
2. Max profit
= (X2 - X1) - (c1 - c2)
3. Max loss
NET PREMIUM (c1 - c2)
4. Designed to make money when the market is going UP
5. Bull spreads have a LIMITED gain and a limited loss, selling the call gives up your upside, buying the call protects your downside
6. Bull spread is kind of like a covered call - the low X you bought "covers" the high X you sold

Front 14

Risk Management Applications of Option Strategies

Bear Spread
(SS15)

Back 14

1. Bear spread is:
i. buy put /sell put different X
ii. same expiration
iii. one high X ($$$) sell one lower X ($) so you need a net cash outlay.
2. Maximum loss
NET PREMIUM (p2 - p1)
3. You want these when you think the market is going DOWN
4. Bear spread profits occur on the DOWNSIDE

Front 15

Risk Management Applications of Option Strategies

Butterfly Spread
(SS15)

Back 15

1. A butterfly spread is:
i. buy/sell FOUR 4 calls
ii. BUY one at low X1
iii. SELL two at middle X2
iv. BUY one at high X3
2. Net premium
c1 - 2c2 + c3
3. Maximum loss
NET PREMIUM
4. You can also do a butterfly with put options.
5. Butterfly is a bull AND a bear spread, hence the 4 options.
6. Butterflies want LOW volatility and you want it to trade near the MIDDLE X.
7. If you think there is going to be high volatility SELL a butterfly (it is flying in the air and someone elses problem)

Front 16

Risk Management Applications of Option Strategies

Collars
(SS15)

Back 16

1. Collars do this:
i. try for no initial outlay with option premiums matching
ii. choose ANY put price
iii. DELIBERATELY choose your call X price so that the premium you pay offsets your put premium.
2. "Zero-cost" only refers to the no upfront cost. At the end you still have to figure things out and money changes hands.
3. A collar is a combination of protective put and covered call.
4. Collars are know as
i. Range forwards
ii. Risk reversals, used to guard against risk without having to pay anything up front.
5. Collars = DIRECTIONAL
(straddles/butterflies = volatility

Front 17

Risk Management Applications of Option Strategies

Straddle
(SS15)

Back 17

1. A straddle is where you think the market is going to have a MOVE but you don't know which way. You don't have an opinion
STRADDLE = No Opinion
2. Straddles LOVE high volatility
3. Short butterfly (selling butterfly into someones elses volatile air is the sam)
4. Straddles = VOLATILITY
(collars = directional)
5. Graph for straddle is V shaped
6. Maximum loss for straddle is if the market does nothing (and you thought it would)
7. Straddles are good around Earnings Announcements.
8. Adding a call (to make your straddle lean up) = Strap
9. Adding a put (to make your straddle lean down) = Strip
10. Straps and strips are leveraged straddles

Front 18

Risk Management Applications of Option Strategies

Box Spreads
(SS15)

Back 18

1. Box spread needs NO estimate for volatility.
2. Boxes can be done with low transaction costs.
3. Boxes are good for when you want to ARBITRAGE. The transaction should be risk free. If the box is underpriced, then you should buy it.
4. Boxes are:
i. long call (buy)
ii. short call (sell money in +)
iii. long put
iv. short put (sell money in +)
5. Box profit is
= X2 - X1 - c1 + c2 - p1 + p2

Front 19

Risk Management Applications of Option Strategies

Example - Box Spread
(SS15)

Back 19

A box spread of exercise 75 and 85. The call prices are 16.02 and 12.28 for exercises of 75 and 85. The put prices are 9.72 and 15.18 for exercise prices of 75 and 85.
Options expire in 6 months and the rf = 5.13%
1. What is the profit for the box spread?
Box spread value at expiration is ALWAYS
X2 - X1 = 85 - 75 = 10
2. Profit is going to come after you take all you option premium costs away from your expiration spread.
∏ = 10 - (c1 - c2 + p2 - p1)
∏ = 10 - (16.02 - 12.28 + 15.18 - 9.72)
= 0.80
3. How much should the box spread be worth now?
Discount it to the present
= 10 / (1.0513)^0.5
= 9.75
Take 9.20 for your option premiums leaves you 0.55 arbitrage profit
So you want to BUY the box.

Front 20

Risk Management Applications of Option Strategies

Using Interest Rate Calls with borrowing
(SS15)

Back 20

1. You can use an interest rate call to establish a max ir that you will end up paying.
2. It does this by 'paying off' if the ir is higher than a specified level and offsets the higher ir that you are charged on the loan.

Front 21

Option Strategies

Example - Loan protection with an interest rate call
(SS15)

Back 21

1. You want to take out a loan of $40m, but buy a call with it to protect yourself from higher ir. Therefore if the call costs you $102,667 you only get proceeds from your loan of
=40,000,000- 102,667= $39,897,333
2. Figure out the interest on the loan
$40,000,000(0.10) (180/360) = $2m
3. If LIBOR is 8% (when you have a call above 5%). Payoff is
= (0.08 - 0.05)$40m(180/360)
= $600,000
4. Effective interest is $2,000,000 - $600,000 = $1,400,000
5. At the end they need to pay back $40,000,000 plus $1,400,000 = $41,400,000
6. Effective annual rate is
41,400,000
(----------------) ^365/180 - 1 = 0.0779
39,897,333