Cfa l3 Notes 3
Cfa l3 Notes 3
Cfa l3 Notes 3
LOS32a. Discuss the need for float adjustment in the construction of international
equity benchmarks;
LOS33a. Explain the ways in which management may act that are not in the best
interest of the firm’s owners (moral hazard) and illustrate how dysfunctional
corporate governance can lead to moral hazard;
The ways which management may not act in the firm’s best interest:
1. Insufficient effort; in wage negotiations, employment supervision, cutting costs
2. Extravagant investments; (oil industry) investment in noncore industries
3. Entrenchment strategies; taking actions that hurt shareholders as in creative
accounting to mask bad performance, taking too much or too little risk, resist
hostile takeovers, investing in activities that make them indispensable
4. Self-dealing; managers may increase their private benefits ranging from benign to
outright illegal activities easier to discover than insufficient effort, extravagant
investments or entrenchment strategies.
LOS33a. Explain the ways in which management may act that are not in the best
interest of the firm’s owners (moral hazard) and illustrate how dysfunctional
corporate governance can lead to moral hazard;
LOS33b. Evaluate explicit and implicit incentives that can align management’s
interests with those of the firm’s shareholders;
Common Features:
Relative illiquidity
Diversifying potential
High due diligence costs: Due diligence takes time, average 3 months, and is a
limiting factor for smaller portfolios.
Difficult performance appraisal (no valid benchmark)
They offer greater scope for adding value through skill superior information.
LOS34b. Explain and justify the major due diligence checkpoints involved in
selecting active managers of alternative investments;
Market opportunity
Investment process
Organization
People
Terms and structure
Service providers
Documents
Write-up
LOS34c. Explain the special issues that alternative investments raise for
investment advisers of private wealth clients;
Tax issues: these investments have distinct tax issues compared with traditional
assets.
Determining suitability: Individual investors has multistage investment horizons
and that changes quickly compared with a pension fund
Communication with client: it’s difficult to communicate with nonprofessional
investors on complex investments
Decision risk
o Negatively skewed returns
o High kurtosis
Concentrated equity position of the client in a closely held company
REAL ESTATE
Homebuilders and real estate operating companies
Real estate investment trusts (REITs)
Commingled Real Estate Funds (CREFs)
Separately managed accounts
Infrastructure funds
Investment Characteristics
Weakly correlated or uncorrelated with traditional stock and bond markets
Return drivers based on trading strategy factors (option-like payoffs) and location factors
(payoffs from a buy and hold policy) help to explain returns of each strategy.
HF strategies attempt to be less affected by the direction of the underlying stock and bond
markets as they don’t have “long bias”
LOS34f. evaluate and justify the return enhancement and/or risk diversification
effects of adding an alternative investment to a reference portfolio (for example, a
portfolio invested solely in common equity and bonds);
LOS34g. Evaluate the advantages and disadvantages of direct equity
investments in real estate;
REITS
ADVANTAGES DISADVANTAGES
Tax subsidies Parcels are not easy to divide, block sale
increases risk
More financial leverage for borrowers who Cost of acquiring information is high
use mortgage loans
Investors have direct control over their Brokers charge high commissions
property
Geographic diversification is effective Substantial operating and maintenance
when correlations are low(and also costs
disasters)
Returns have relatively low volatility Risk of neighborhood deterioration
compared with public equities
Tax benefits can be removed by politicians
LOS34h. Discuss the major issuers and buyers of venture capital, the stages
through which private companies pass (seed stage through exit), the
characteristic sources of financing at each stage, and the purpose of such
financing;
Major issuers:
1. Formative stage companies
2. Expansion stage companies
Major buyers:
1. Angel investors
2. Venture Capitalists
3. Large companies
Stages:
Early Stage
o Seed Stage The small amount of money provided by the entrepreneur to
get the idea off the ground
o Start-up usually a pre-revenue stage that brings the entrepreneur’s idea
to commercialization
o First-Stage additional funds, if the idea is sound but start-up funds have
run out
Later Stage: occurs after revenue has started and funds are needed to expand sales
Exit Stage: is the time when the venture capitalist realizes the value of the
investment. IPO, sale or merger
LOS34i. Compare and contrast venture capital funds to buyout funds;
LOS34j. Discuss the use of convertible preferred stock in direct venture capital
investment;
LOS34k. Explain the typical structure of a private equity fund, including the
compensation to the fund’s sponsor (general partner), and typical timelines;
The compensation to the fund manager of a private equity fund consists of a management
fee plus an incentive fee
1. The management fee is usually a percentage of limited partner commitments to
the fund. (If the investor has made a capital commitment of US$50 million but
actually invested US$10 million, the investor generally pays a management fee on
the US$50 million committed.)
2. The fund manager’s incentive fee, the carried interest (incentive fee), is the
share of the private equity fund’s profits that the manager is due once the fund has
returned the outside investors’ capital. Carried interest is usually expressed as a
percentage (usually 20%) of the total profits of the fund.
3. In some funds, the carried interest is computed on only those profits that represent
a return in excess of a hurdle rate (the hurdle rate is also known as the preferred
return)
4. Claw-back provision
Timeline: Commitment period (when capital calls made) then period till liquidation.
LOS34l. State and discuss the issues that must be addressed in formulating a
private equity investment strategy;
Investment Characteristics:
Illiquidity as convertible preferred shares does not trade in the secondary
market and investors are more restricted opportunities to withdraw funds
Long-term commitments required
Higher risks than seasoned public equity investments
High expected IRR required
Limited information
1. Direct Commodity Investments: cash market purchase, storage and carry costs or
exposure to spot market via futures
2. Indirect Commodity Investments: equity in companies specializing in commodity
production (but they do not provide effective exposure to commodity price
changes)
LOS34n. Explain the three components of return for a commodity futures
contract and the effect that an upward- or downward-sloping term structure of
futures prices will have on roll yield;
Convenience Yield Future Price < Spot Price Backwardation Positive Roll Yield
Downward-sloping term structure is profitable
When the futures markets are in backwardation, a positive return will be earned from a
simple buy and hold strategy. The positive return is earned because as the futures contract
gets closer to the maturity, its price must converge to that of the spot price of the
commodity. Because in backwardation the spot price is greater than the futures price, the
futures price must increase in value. (The opposite is true with an upward-sloping term
structure of futures prices, or contango.) All else being equal, an increase in
commodity’s convenience yield should lead to futures market conditions offering higher
roll returns; the converse holds for a decline in convenience yields.
LOS34o. Discuss the relationship between commodities and inflation and explain
why some commodity classes may provide a better hedge against inflation than
others;
Direct investment in energy and, to a lesser degree, industrial and precious metals may
provide significant inflation hedge.
Types of HF investments:
Equity Market Neutral: Combined long and short positions for over-undervalued
securities while neutralizing the portfolio’s exposure to market risk by combining
long and shirt positions. Constraint on shorting securities for some investors make
correction slower for overvalued securities
Convertible arbitrage: Buy the convertible bond short the stock.
Fixed income arbitrage
Distressed securities
Merger arbitrage: Long target, short acquirer
Hedged equity (Equity L/S): Portfolios not structured to be market industry and sector
neutral. Identify over-undervalued securities.
Global macro: They concentrate on major market trends rather than on individual
security opportunities
Emerging markets
Fund of Funds(FOF): For diversification, two layer of fees
Strategies:
Relative value
Event Driven
Equity hedge
Global asset allocators
Short selling
LOS34q. Explain the typical structure of a hedge fund, including the fee structure
and the rationale for high water marks;
The fees are 2-20% on AUM and profits respectively.
High-Water Mark (HWM) provision The purpose of HWM provision is to ensure that
the HF manager earns an incentive fee only once for the same gain. For HF manager, the
HWM is like a call option on a fraction of the increase in the value of the fund’s NAV.
Lock-up periods to avoid unwinding positions early
LOS34s. Critique the conventions and special issues involved in hedge fund
performance evaluation, including the use of hedge fund indices and the Sharpe
ratio;
Conventions:
1. Young funds outperform old ones on total return basis
2. Large funds underperform small funds
3. Funds with longer (quarterly) lock-ups have higher returns than similar strategy
funds with shorter (monthly) lock-ups.
Volatility and Downside Volatility: The assumption is the returns follows normal
distribution but HF returns do not. So standard deviation incorrectly represents the actual
risk of a hedge fund’s strategies.
Semideviation uses a threshold return, which can be zero or a short-term rate. Manager is
not penalized for positive returns
Drawdown is the largest point between HWM value and subsequent low point until new
HW is reached.
LOS34t. Explain the market opportunities that may be exploited to earn excess
returns in derivative markets that are otherwise zero-sum games;
Since not all market participants can use derivatives, as with short selling and investing in
distressed debt, investors in derivatives may be able to capture returns not available to all
investors
LOS34u. Discuss the sources of distressed securities and explain the major
strategies for investing in them;
Investors look to distressed securities investing primarily for the possibility of high
returns from security selection (exploiting mispricing) activism and other factors.
1) Long-only Value Investing: When distressed securities are public debt, this approach is
high-yield investing.
2) Distressed Debt Arbitrage: Long bond, short equity. In times of distress equity will fall
more than bond and three will be gains and vice versa in good times as bonds are more
senior.
As the value goes up gradually it takes longer to payoff your investment. Outcome
depends on legal process and takes many years. Stale pricing is inevitable for illiquid
securities.
LOS36a. Discuss the unique pricing factors for commodity forwards and futures,
including storability, storage costs, production, and demand, and their influence
on lease rates and the forward curve;
If a commodity is non-storable, large price swings over the day primarily reflect changes
in the expected spot price, which in turn reflects changes in demand over the day
FORWARD PRICING
1
r ln( F0,T / S )
T
EFFECTIVE ANNUAL LEASE RATE
(1 r )
l 1
1
T
( F0,T / S )
Contango occurs when the lease rate is less than the risk-free rate
Backwardation occurs when the lease rate exceeds the risk-free rate
LOS36b. Identify and explain the arbitrage situations which arise as a result of
the convenience yield of a commodity and commodity spreads;
LOS36c. Compare and contrast the basis risk of commodity futures with that of
financial futures.
It is a generic problem with commodities because of storage and transportation costs and
quality differences.
Stack and Roll Hedge Stacking futures contracts in the near-term contract and rolling
over into the new near-term contract. Why we use stack hedge:
1. Near term have high volume and more liquid, lower bid-ask spreads. Lower
transaction costs
2. Manager may wish to speculate the shape of the yield curve looks steep and then
flattens then you will have locked all your oil at the relatively cheap near-term
price and implicitly made gains from not having locked in the relatively high strip
prices.
READING 37 (RISK MANAGEMENT)
LOS37a. Compare and contrast the main features of the risk management
process, risk governance, risk reduction, and an enterprise risk management
system;
Risk management is a process involving the identification of the exposures to risk, the
establishment of appropriate ranges for exposures, the continuous measurement of these
exposures, and the execution of appropriate adjustments to bring the actual level and
desired level of risk into alignment.
Businesses need to take risk in areas in which they have expertise and possibly a
comparative advantage in order to earn profits.
Risk governance refers to the process of setting risk management policies and standards
for an organization. Senior management, which is ultimately responsible for all
organizational activities, must oversee the process.
LOS37b. Recommend and justify the risk exposures an analyst should report as
part of an enterprise risk management system;
Financial Risk:
1. Market Risk
a. Interest rates
b. Stock prices
c. Exchange rates
d. Commodity prices
2. Credit Risk-The nature of credit risk has changed as the introduction of credit
instruments, without the underlying probability of default changing
3. Liquidity Risk, bid-ask spread / security prices
Non-Financial Risk:
1. Operational Risk
2. Model Risk
3. Settlement Risk: The possibility that one side of a position is paying while the
other side is defaulting. It is a problem in FX markets.
4. Regulatory Risk
5. Legal/Contract Risk
6. Tax Risk
7. Accounting Risk
8. Sovereign and Political Risks (when a company invests overseas, goes hand in
hand w/ FX risk)
9. Other Risks (ESG Risk, Performance Netting Risk for HFs)
Standard deviation,
Market risk had two dimensions:
1. The sensitivity of the assets to the factor (duration)
2. Changes in that sensitivity to that factor (convexity)
Power outage, sovereign risk.
Advantages:
Easy to calculate, easy to understood
Allows modeling the correlation of risks
Can be applied to different time periods according to industry custom
Disadvantages:
Reliance of simplified assumptions such as normality. Real life returns show
negative skewness and leptokurtic. Also normality is not good for portfolios
contain options (limited downside and unlimited upside).
The difficulty in estimating the correlations between individual assets in very
large portfolios
Advantage:
NONPARAMETRIC. No need probability distribution assumptions
Easy to calculate and easy to understood
Can be applied to different time periods
Disadvantage:
Historical data it uses may not hold in the future.
Bonds and derivatives behave differently at different times in their lives
Advantage:
Any return distribution can be used. It does not require a normal distribution but
it’s common.
Disadvantage:
The analyst must make thousands of assumptions about the returns distributions
for all inputs as well as their correlations.
LOS 37.g. Discuss the advantages and limitations of VAR and its extensions,
including cash flow at risk, earnings at risk, and tail value at risk;
Backtesting should be applied to portfolios to see the same patterns fit. Also it should be
applied for different time intervals.
Incremental VAR The portfolio’s VAR while including a specified asset and the
portfolio’s VAR with that asset eliminated.
CFAR The minimum cash flow loss
EAR Minimum earnings loss
Those two are used for companies that generate cash flows or profits but cannot readily
valued publicly
TVAR VAR+ the expected loss in excess of VAR when such excess loss occurs.
LOS37.h. Compare and contrast alternative types of stress testing and discuss
the advantages and disadvantages of each;
Scenario analysis:
Stressing Models:
Factor Push to push the prices and risk factors of an underlying model in a
most disadvantageous way and work out the combined effect on the portfolio’s
value. (Disadvantage=enormous model risk in extreme risk climate)
Maximum loss optimization it tries to optimize mathematically the risk
variable that will produce the maximum loss.
Worst-case scenario analysis
LOS37i. Evaluate the credit risk of an investment position, including forward
contract, swap, and option positions;
Credit VAR the main focus is upper tail, not lower tail like original VAR.
Forward
Valuelong SpotT
(1 r )n
P0 $100
n 1
r 5%
F0 $100*(1.05) $105
after 3 months :
P1 $102
$105
Value $102 $0.7728
(1.05)0.75
The Credit Risk of Swaps
For interest and equity swaps the potential credit risk is largest during the middle period
of the swap’s tenor. As the counterparties perform sufficient credit research for each
other at the beginning
For FX swaps the greatest risk is between the midpoint and the end of the life of the
swap.
LOS37.j. demonstrate the use of risk budgeting, position limits, and other
methods for managing market risk;
This is mainly related with Risk Budgeting. RB is about efficiently allocating risk
among the units, divisions, portfolio managers or individuals (traders).
The enterprise allocates risk capital before the fact in order to provide guidance on the
acceptable amount of risky activities that a given unit can undertake.
The sum of risk budgets for individual units will typically exceed the risk budget for the
organization as a whole because of the impacts of diversification.
RB is used to allocate funds to PMs based on their IRs.
LOS37.k Demonstrate the use of exposure limits, marking to market, collateral,
netting arrangements, credit standards, and credit derivatives to manage credit
risk;
LOS37.l. compare and contrast the Sharpe ratio, risk-adjusted return on capital,
return over maximum drawdown, and the Sortino ratio as measures of risk-
adjusted performance;
Sortino ratio uses minimum return objective instead of RFR and downside
deviation instead of standard deviation.
Sharpe Ratio Sortino and Sharpe ratios can tell a more detailed story of risk-
adjusted return than either will in isolation, but SR is better grounded in financial
theory and analytically more tractable. Principal drawback to applying the Sharpe
is the assumption of normality in the excess return distribution. This is a problem
when the portfolio contains options and other instruments with non-symmetric
payoffs
Risk Adjusted Return on Capital (RAROC) expected return on an investment
divided by a measure of capital at risk.
Return over Maximum Drawdown (RoMAD) is simply the average return in a
given year that a portfolio generates, expressed as a percentage of this drawdown
figure. It is more intuitive than standard deviation as a measure of risk, because it
deals with more “concrete” numbers. However, like standard deviation, it
implicitly assumes that historical return pattern will continue.
Rp
ROMAD
Maximum Drawdown
Am I willing to accept an occasional drawdown of X percent in order to generate an
average return of Y percent? An investment with X=10% and Y=15% (RoMAD = 1.5)
would be more attractive than an investment with X=40% and Y=10% (RoMAD = 0.25)
LOS37.m. demonstrate the use of VAR and stress testing in setting capital
requirements.
1. Nominal (notional) position limits
2. VAR-based position limits
3. Maximum loss limits
4. Internal capital requirements
5. Regulatory capital requirements
READING 38 (RISK MANAGEMENT
APPLICATIONS OF FORWARD AND
FUTURES STRATEGIES)
LOS.38a. demonstrate the use of equity futures contracts to achieve a target
beta for a stock portfolio and calculate and interpret the number of futures
contracts required;
T S S S N f f f (contractvalue)
So to adjust the beta,
S S
Nf T
f f ( contractvalue )
To completely hedge the risk,
S S
N f
f f ( contractvalue )
LOS38b. Construct a synthetic stock index fund using cash and stock index
futures (equitizing cash);
Consider the Cash flows of both sides and you can get the following:
Return on future contracts = Ft(Future price at time t) - St( spot at time t) = S0(1+Rf)^t -
St
Return = S0(1+Rf)^t - St + St - S0
Long stock = Long risk-free bond + Long futures (this one replicates the
underlying)
Starting Money = V
This money will grow to V *(1 r )T and we’ll deliver it when the contact
expires.
V (1 r )T
So we need to buy
N *
f futures
q* f
Round N, and the actual money invested to the index is:
N f *q* f
V *
(1 r )T
The number of units of stock that we have effectively purchased at the start is
N *f * q
V
(1 )T
When rebalancing portfolio and adjustment of duration was asked at the same time;
1. First rebalance the portfolio and find synthetic positions or number of contracts to
adjust the share of stock and equity
2. Then find the number of contracts to adjust the beta of the stock portfolio and the
duration of the equity portfolio.
LOS38c. Create synthetic cash by selling stock index futures against a long
stock position;
Just the sign changes
V (1 r )T
N
*
f
q* f
LOS38d. Demonstrate the use of equity and bond futures to adjust the allocation
of a portfolio between equity and debt;
$300 million portfolio 80% stock ($240 million) 20% bonds ($60 million)
Beta of the equity=1.1
Duration of bonds= 6.5
Equity futures beta = 0.96
Bond futures duration = 7.2
Contract price (stock) = $200,000
Contract price (bonds) = $105,250
S S 0 1.1 $90,000,000
Nf T Nf
f
0.96 $200,000
=-515.63
f
2 goals:
0 6.5 $10,000,000
1) Move $10 million into cash = N f =
7.2 $105, 250
2) Change the target duration for $20 million of the portfolio to 7.5 =
7.5 6.5 $20,000,000
Nf
7.2 $105, 250
LOS38f. Discuss the three types of exposure to exchange rate risk and
demonstrate the use of forward contracts to reduce the risk associated with a
future transaction (receipt or payment) in a foreign currency;
Transaction Exposure Is the FX risk that foreign traders exposed, when exporting or
importing
Translation Exposure Is the FX risk exposure while consolidating foreign
subsidiaries financial statements to the parents’ financial statements
Economic Exposure even the companies do not trade goods they are exposed the FX
valuation of home countries because an overvalued currency hurts travel to the country
and more people visit other countries instead of local spots.
Managing the risk of a FX Receipt (exporter) because the exporter is effectively long
the FC, he will take a short position on the FC in the forward market
Managing the risk of a FX Payment (importer) because the importer is effectively
short the FC, he will take a long position on the FC in the forward market
In both cases the future spot rate does not matter because the investor is hedged as long
as the basis doesn’t change.
LOS38g. Explain the limitations to hedging the exchange rate risk of a foreign
market portfolio and discuss two feasible strategies for managing such risk.
It is tempting to believe that the managers should accept the foreign market risk, using it
to further diversify the portfolio, and hedge the foreign currency risk. In fact, many assets
managers claim to do so. A closer look, however, reveals that is virtually impossible to
actually do this. Because the future amount of the portfolio to be hedged is uncertain.
Once the company hedges the foreign market return, it can expect to earn only the foreign
risk-free rate. If it hedges the foreign market return and the exchange rate, it can expect to
earn only its domestic risk-free rate. Neither strategy makes sense in the LR. In the short
run, however, this strategy can be a good tactic for investors who are already in foreign
markets and who wish to temporarily take a more defensive position without liquidating
the portfolio and converting it to cash.
Bull Spread: designed to make money when market goes up. Sell a call and buy a call
with the lower exercise price. As C1>C2 the spread will require a net outlay of funds
Bear Spread: designed to make money when market drops. The maximum profit occurs
when both puts expire in the money. Two ways to design the strategy:
1. Buy a call and sell a call with the lower exercise price (the reverse of the bull
spread)
2. Sell a put and buy a put at the higher exercise price. (more intuitive way)
Butterfly Spreads: Buying calls with the exercise prices of X1 and X3 and selling two
calls with the exercise prices of X2.
If the exercise prices are equally spaced as X1=30, X2=40 and X3=50, so 2X2-X1-X3
will be zero.
Also V0 c1 2c2 c3 is always a positive number. Because the bull spread we buy is
more expensive than the bull spread we sell.
The investor believes that the underlying will be less volatile than the market
expects. If the investor buys the butterfly spread and the market is more volatile
than expected, the strategy is likely result in a loss.
If you believe the market will be more volatile, sell the butterfly spread as selling
calls with the exercise prices of X1 and X3 and buying two calls with the exercise
prices of X2.
PUT-CALL PARITY
P0 S0 C0 Xe rT
Collars: Sell a call on a protective put with the same put price (to cover the cost of the
put). The call’s exercise price will be above the current price of the underlying.
When the premiums offset it is called zero-cost collar. The investor is giving up gains
above a certain level buy writing the call.
It is a modified version of a protective put and a covered call.
Asset managers often use them to guard against losses without having to pay cash up
front for the protection. They are virtually the same as bull spreads.
They perform based on the direction of the movement in the underlying.
http://www.cboe.com/Strategies/EquityOptions/EquityCollars/Part1.aspx
Straddles: Buying the volatility by buying a call and a put at the same strike price when
you have no idea about the direction.
An investor who leans one way or the other might consider adding a call or a put to
the straddle.
Adding a call is strap
Adding a put is strip
Box Spread: It is an arbitrage strategy and does not require binomial, B-S models and
estimating volatility, low cost and faster execution. It is a combination of a bull spread
and a bear spread
In either case when you buy an interest rate call option or put option the payout is paid at
the end of the loan term and the interest is calculated on the LIBOR on exercise date.
When you buy an interest rate call option you pay the premium upfront and borrow the
whole premium. The initial outlay is:
= Loan principal - FV of the option premium on the expiration date
When you buy an interest rate put option you pay the premium upfront and lend the
whole premium. The initial outlay is:
Effective Annual rate is calculated by exponential 365, whereas all other calculations are
in days/360 (LIBOR)
The collar establishes a range, the cap exercise rate minus the floor exercise rate, within
which there is interest rate risk. The borrower will benefit from falling rates and be
hurt by rising rates within that range. Any rate increases above the cap rate will
have no effect, and any rate decreases below the floor exercise rate will have no
effect. The net cost of this position is zero, provided that the floor premium offsets the
cap premium. It is probably easy to see that collars are popular among borrowers.
LOS39d. Explain why and how a dealer delta hedges an option portfolio, why the
portfolio delta changes, and how the dealer adjusts the position to maintain the
hedge
Covered-call Buy one share of stock sell one call option
Delta-Hedging Buy (#of calls*delta shares of stock) sell one call option
Assume you shorted a call option. There are various ways to hedge:
Find the exact opposite trade (buy call) which is not easy
Use put call parity c = p + S – X/(1+rfr)^T. This is a static hedge because you do
not need to change the position as time passes.
Hedging with another derivative maybe other calls as, trading derivatives are
often easier and more cost effective than trading underlying (As we did in delta
hedge)
Gamma Hedging =Gamma is the options convexity. If the delta hedged position were
risk-free, its gamma would be zero. The larger the gamma, the more the delta-hedged
position deviates from being risk-free.
Dealers usually monitor their gammas and in some cases hedge their gammas by adding
other options to their positions such that the gammas offset.
Gamma is highest when option is ATM or close to expiration.
READING 40 (RISK MANAGEMENT
APPLICATIONS OF SWAP STRATEGIES)
***DO NOT FORGET to add or subtract duration of the other loan that is
hedged!!!
So, for one year pay fixed-receive floating swap the duration is 0.125-0.75 = -0.625.
The buyer of this swap benefits from rising interest rates and falling market value.
LOS40c. Explain the impact to cash flow risk and market value risk when a
borrower converts a fixed-rate loan to a floating-rate loan;
The company which uses swaps to convert floating to fixed payments does not appear to
be exposed to the uncertainty of changing LIBOR, but we shall see that it is indeed
exposed.
Because the duration of floating rate only payments are roughly equal to the -0.125
and when the duration of the position when we combine this position to convert it to a
fixed position is 6 times as we effectively paying a fixed rate loan. The declining rates
and increasing market values will hurt fixed-rate borrower. The advantages and
disadvantages are:
From cash flow perspective it is a hedge as we pay fixed. This is a hedge from
accounting and budgeting perspective
From market value perspective it is highly speculative as the objective of the
corporation is maximizing shareholder value.
Such a transaction despite stabilizing a company’s cash outflows, however,
increases the risk of the company’s market value.
LOS40d. Determine the notional principal value needed on an interest rate swap
to achieve a desired level of duration in a fixed-income portfolio;
Find the duration of fixed and floating rates, then find the duration of the swap. Then use
it in below formula.
MDURTARGET MDURPORT
NP B *
MDURSWAP
Here the key point is when you select a swap with too small duration you get a very large
swap to execute.
LOS40e. Explain how a company can generate savings by issuing a loan or
bond in its own currency and using a currency swap to convert the obligation into
another currency;
LOS40f. Demonstrate how a firm can use a currency swap to convert a series of
foreign cash receipts into domestic cash receipts
The plain vanilla swap rates on both currencies will be given and notional values will be
found by using the swap payments and the interest rates given on plain vanilla swaps.
There’s no initial and final exchange of the principals.
For International Diversification case, the main issue is the stock holding may have a
high tracking error (with the benchmark) and the obligation to swap the returns on
domestic benchmark may create cash flow problems. In addition the company has a
currency and market risk and passes on to USRM its costs of hedging that risk.
For changing the allocations to stocks and bonds; of course, the transactions will not
completely achieve TMM’s goals as the performance of various sectors and of its equity
and fixed-income portfolios are not likely to match; tracking error. Also the actual stock
and bond portfolio will generate cash only from dividends and interest. The capital gains
on the stock and bond portfolio will not be received in cash unless a portion of the
portfolio is liquidated. But avoiding liquidation of the portfolio is the very reason that the
company wants to use swaps.
LOS40h. Demonstrate the use of an interest rate swaption (1) to change the
payment pattern of an anticipated future loan and (2) to terminate a swap.
In using a swaption to terminate a current swap is set the exercise rate the same as the
fixed rate paid received on the swap so swap is terminated. The moneyness determines
whether the swaption will be exercised or not.
READING 41 (EXECUTION OF PORTFOLIO
DECISIONS)
LOS41a. Compare and contrast market orders to limit orders, including the price
and execution uncertainty of each
Market Orders Price uncertainty, Execution certainty
Limit Orders Price certainty, Execution uncertainty
LOS41b. Calculate and interpret the effective spread of a market order and
contrast it to the quoted bid-ask spread as a measure of trading cost
Effective Spread is two times the deviation between the executed price and previously
quoted mid-point price. It is a better spread measure because:
It captures both price improvement and,
The tendency for large orders to move prices (market impact)
Limit BOOK at the time before order Bid price $19.97 Ask price $20.03 so spread
is $0.06 (the cost of round trip transaction)
The trader enters market order 500 shares to buy, and the dealer reduces the ask price to
$20.01“step in front of”
The market has relatively low bid-ask spreads. Little price changes at high
volume orders
The market is deep: Depth means that big trades tend not to cause large price
movements. Deep markets have high quoted depths.
The market is resilient; fast correction of misvaluation.
Corporations benefit from liquidity as they attract more capital and the higher prices will
lower cost of capital. Investors pay premium for more liquid securities. Also:
Many buyers and sellers
Diversity of opinion, finding the other side of the trade with an opposite opinion
Convenience: a readily accessible physical location or an easily mastered and
well-thought-out electronic platform attracts investor.
Market Integrity, more fair and honest treatment more trading again.
Pre-trade transparency v post-trade transparency
Assurity of the contract
Explicit Costs
Direct costs of trading, such as broker commission costs, taxes, stamp duties and
fees paid to exchanges
Implicit Costs
The bid-ask spread
Market Impact
Missed trade opportunity costs: it arises from the failure to execute a trade in a
timely manner
Delay costs: Inability to complete a trade due to its size and the liquidity of the
markets
Gaming the Effective Spread: One trader may wait for other traders to come to them. By
doing so, the first trader can trade at favorable bid and ask spreads. However, the delay
may result in forgone profits.
Decision made:
# of shares=1,000
Price= $10.00
$87/$10,000=0.87%
3. Delay Costs reflect the price difference due to delay in filling order. The
calculation is based on the amount of the order actually filled:
4. Missed trade opportunity cost reflects the difference between the cancellation
price and the original benchmark price. The calculation is based on the amount of
the order that was not filled:
The relationship between the variables and estimated costs can be non-linear. These
estimates can be used in two ways:
1. To form a pre-trade estimate of the cost of trading that can be juxtaposed against
the actual realized cost once trading is completed to assess execution quality.
2. to help the portfolio manager gauge the right trade size to order in the first place
LOS41j. Discuss the major types of traders, based on their motivation to trade,
time versus price preferences, and preferred order types
LOS41k. Describe the suitable uses of major trading tactics, evaluate their
relative costs, advantages, and weaknesses, and recommend a trading tactic
when given a description of the investor’s motivation to trade, the size of the
trade, and key market characteristics
LOS41l. Explain the motivation for algorithmic trading and discuss the basic
classes of algorithmic trading strategies
Algorithmic Trading = Slice and Dice the Orders to reduce market impact
Decimalization led to smaller spreads but also led to reduced quoted depth which is a
disadvantage for institutional orders that are large relative to normal trading volume. The
underlying logic behind the algorithmic trading is to exploit market patterns of trading
volume so as to execute orders with controlled risk and costs. This approach typically
involves breaking large orders up into smaller orders that blend into the normal flow of
trades in a sensible way to moderate price impact
LOS41m. Discuss and justify the factors that typically determine the selection of
a specific algorithmic trading strategy, including order size, average daily trading
volume, bid-ask spread, and the urgency of the order
Low UrgencyLow size of the order relative to the daily volumeVWAP
High UrgencyLow size of the order relative to the daily volumeImplementation Shortfall
Low UrgencyHigh size of the order relative to the daily volume and Large SpreadBroker/ Crossing Sys
Meaning = the trading process Firms apply that seeks to maximize the value of a client’s
portfolio within the client’s stated investment objectives and constraints.
Prudence addresses the appropriateness of holding certain securities, while Best
Execution addresses the appropriateness of the methods by which securities are acquired
or disposed.