CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 10 derivatives and risk management answers

DERIVATIVES/RISK MANAGEMENT Answers Question Part A The first two are legitimate goals: identify the risks and quantify them The third is not Just minimizing risk will target the risk-free rate of return and make the business unprofitable (It would not cover the cost of capital.) Sample Scoring Key: point for each correct explanation Part B The first three are nonfinancial They not relate directly to asset price change The fourth, liquidating at a fair price, is liquidity related and a financial risk Sample Scoring Key: point for each correct identification Part C Template for Question C Comment “The analytic method allows for the modeling of the correlation of risks.” “I like using nominal position limits with derivatives because that gives the portfolio manager a set amount of capital to work with and limits the maximum amount that can be lost.” Is the comment correct? (circle one) Yes No Yes No Explanation Correlation can be included in calculating total firm risk (standard deviation), which then becomes part of the analytic VAR calculation Derivatives often involve leverage More than the initial investment can be lost Sample Scoring Key: point each for correctly identifying whether the comment is correct point for each explanation points if yes/no decision is incorrect Part D Yes, TVAR measures the average of what can happen within the left tail, so it looks at events that are worse than the VAR result Sample Scoring Key: point for yes and then points for explaining why Question Part A Comment “A bull spread using call options can be created by selling a call with a low exercise price and buying a call with a high exercise price.” “You can use a long put on interest rates to place an upper limit on the effective interest earned by a floating-rate lender.” “Gamma measures how delta changes in response to a change in an asset’s price.” Is the comment correct? (circle one) Explanation This creates a bear spread Yes No Yes No Or A bull spread is a long call with a lower strike and short a call with a higher strike price This places a floor on return for a floating-rate lender, not an upper limit Yes No Sample Scoring Key: point each for identifying the correct “no” answers points for the “yes” answer point for each requested explanation points if yes/no decision is incorrect Part B A straddle requires a long call and put with the same strike price The only available combination is the 50 strike price Max loss if the stock closes at the strike price of 50, lose the two premiums: 2.50 + $5.25 = 7.75 Breakevens: from the loss of 7.75 if the stock is 50, the stock must increase or decrease 7.75 to: 42.25 or 57.75 Max gain is infinite as the stock increases Sample Scoring Key: points each for the four correct results No points are awarded for simply identifying which options to use Question Part A Hedge 10% of 157 million: 15.7 million ((0 – 1.04) / 0.97) (15,700,000 / (1,024 × 500)) = –32.88 Sell 33 contracts Sample Scoring Key: Two points for setting up the calculation components and one point for 33 contracts Leaving the solution as fractional contracts is not correct Part B The periodic risk-free rate and dividend yield are required  The number of contracts sold will be increased by (1 + rf periodic)  Hold shares of the underlying equal to [500 × 33(1 + rf periodic)] / (1 + dividend yield periodic)  No cash equivalents are required for the trade Sample Scoring Key: One point each for the two additional items required One point each for: accurately calculating the increased number of contracts, shares to hold, and that no cash equivalents are involved Candidate discussion: The goal is reducing equity exposure, which means creating synthetic cash equivalent to 10% of the portfolio For synthetic, the amount hedged must be increased to a FV (i.e., multiply target amount by + rf periodic) Multiplying the number of contacts for a standard hedge by + rf periodic is the exact same numeric result For synthetic cash, sufficient shares must be held (with dividend reinvested) to settle the short contract position at expiration The question specifically says quantify, so you must set up the calculations even though you cannot perform the final numeric calculations In other words, what can be done with the information provided to answer the question asked Part C Gain on contracts sold: (1,024 – 973)(500)(40) = 1,020,000 Plus EV of stocks: 1,020,000 + 147,750,000 = 148,770,000 EV of hedged portfolio Hedged portfolio return: 148.77/157.0 – = –5.24% Effective beta: –5.24/–5.7 = 0.92 Sample Scoring Key: One point each (if correct) for the four calculation elements required to solve the problem Part D      The contract may have behaved differently than its initially estimated beta The portfolio may have behaved differently than its initially estimated beta This is a cross hedge with portfolio stocks differing from those of the index The contract may have been mispriced Goodwell may have made changes in the stock positions during the six months (changing the portfolio’s characteristics) Sample Scoring Key: Two points each for two reasons Candidate discussion: The question directs you not use contract rounding as a reason The contract was held to expiration, so basis risk is not a factor Basis risk is sometimes used as a generic reference to any hedging risk, so you could say basis risk if you then go on to explain a specific relevant item, such as the portfolio or contract beta changed over the period Part E Enter a swap to pay an equity index return and receive a cash equivalent rate of return    The equity index return paid on the swap may be more than the return earned on the stocks held, producing a negative return differential If the index return paid exceeds the cash return received on the swap, Goodwell must pay the difference: a cash flow risk Counterparty risk Sample Scoring Key: One point each for describing each side of the correct swap One point each for two reasons Candidate discussion: The first two reasons are different The first is a return risk and the second a cash-flow risk A generic statement that returns (or cash flows) can differ is too vague The data allows you to determine the market circumstances that would be detrimental Part F No additional data is needed In efficient markets with both risks hedged, the expected return is the investor’s domestic risk-free rate Sample Scoring Key: One point each for: no data is needed, earn risk-free, and making it clear the investor’s risk-free rate is the expected net result Candidate discussion: If you list all the ending values needed to project ex-post results, that is incorrect They are not needed in this case If you fail to explain that expected return is the investor’s risk-free rate, there is not sufficient discussion to show the grader you understand the situation ... simply identifying which options to use Question Part A Hedge 10% of 157 million: 15.7 million ((0 – 1.04) / 0.97) (15,700,000 / (1,024 × 500)) = 32 .88 Sell 33 contracts Sample Scoring Key: Two... setting up the calculation components and one point for 33 contracts Leaving the solution as fractional contracts is not correct Part B The periodic risk- free rate and dividend yield are required ... both risks hedged, the expected return is the investor’s domestic risk- free rate Sample Scoring Key: One point each for: no data is needed, earn risk- free, and making it clear the investor’s risk- free