Level III Review, Risk Management with Derivatives

Study session 15 in the Level III CFA Program curriculum concludes the readings on risk management with three readings (36-38) on applications of derivatives. The last three readings are a little more quantitatively intense. Resist the temptation to skip over the difficult parts. Instead use the practice problems until you are confident that you could reproduce the concepts in an essay question.

Risk Management Applications of Forward and Futures Strategies
The number of futures contracts for a portfolio hedge is extremely testable and you need to know how to work through the calculation. Think through the formula to understand what is going on and it will become easier to remember.  # Futures contracts =

  • (desired beta minus current beta) divided by beta on futures      contracts: if you want to decrease the portfolio beta (decreasing      risk) then you will be selling futures contracts and you’re answer should      have a negative sign. Here you are taking the difference between the risk      you want and the risk you have and dividing by the riskiness of the      futures contracts to answer how much each futures contract will change the      risk of your portfolio.
  • Multiplied by (value portfolio divided by price of a futures      contract): This tells you how many futures contracts you need given      the portfolio size.
  • * A common question is to reduce beta to zero so the formula would      change to (0-portbeta)/futuresbeta * (portfolio      value/ futures contract price)
  • Pre-investing is also a common question and really just the      opposite of the above. Here you need to create index beta from 0 so it      would be (indexbeta-0/ futuresbeta)

Remember, a futures hedge on a portfolio is only a hedge for the similarity in risks between the index used for the futures contract and the portfolio. Example, the futures sold on the S&P500 would not be a good hedge on a portfolio of small-cap stocks because the index is a lg-cap index.

The formulas for creating a synthetic index fund and creating cash out of equity are also testable so do not avoid them.

Remember the advantages to using futures to manage risk (i.e. lower transaction costs, greater liquidity, provide better timing and allocation strategies, require less capital to trade).

Risk Management Applications of Options Strategies
Know the basic strategies (covered calls, protective puts, spreads, straddles, and collars) and how to figure out value at expiration. Here I think the curriculum is a little convoluted with the formulas when it is really a pretty basic concept.

Covered calls are holding a long stock position and selling calls against it to reduce some downside risk so you are going to deduct the collected premiums from your costs. Your upside is capped at the strike price plus the premium while you still risk losing everything except the premium (if the stock goes to zero).

Protective puts offer greater risk reduction and retain upside in the shares but cost more. The are formed by buying puts against a long stock position so you are going to add the cost of the puts into your costs.

Whether bull or bear, spreads involve two option strikes one higher and one lower so your costs will just be the difference in the premiums. Your risk is limited to the net difference in premiums while your upside is limited to the difference in the strike prices.

Collars involve both a call and a put option with the sell of one financing the purchase of the other. The most used example is a zero-cost collar where a call option is sold to fully finance a put option which provides downside protection at the expense of giving up upside potential.

Straddles involve buying a put and a call with the same strike and the same expiration and can be costly. The investor makes money if the shares move higher or lower than the combined price of the two options.

Risk Management Applications of Swap Strategies
For me, this was one of the most difficult readings in the curriculum. You need to be able to work through an example of a swap for interest rates, currency and equities and explain who has the risk in the transaction.

Remember, market value risk is the uncertainty associated with the value of an asset or liability while cash flow risk is the uncertainty associated with the size and timing of cash flows. Credit risk is the uncertainty that the other side of the transaction will be able to make their payment.

*Currency swaps usually involve the payment of notational principal at initiation and payments are not netted because they involve different currencies. This is different than other swaps where there is usually no initial principal exchanged and payments are netted.

Swaptions are options to enter into a swap either as payer or receiver. The payer swaption allows the holder to be a fixed-rate payer/floating-rate receiver and is similar to a bond put. The receiver swaption allows the holder to be the fixed-rate receiver/floating-rate payer and is similar to a bond call.

Study session 16 in the Level III CFA Program curriculum covers execution of portfolio decisions with two readings on monitoring and rebalancing.

‘til next time, happy studyin’
Joseph Hogue, CFA


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