2019 CFA level 3 qbank reading 32 risk management applications of forward and futures strategies answers

10/12/2018 Learning Management System Question #1 of 49 An S&P500 index manager knows that he will have $60,000,000 in funds available in three months He is very bullish on the stock market and would like to hedge the cash in ow using S&P 500 futures contracts The S&P 500 futures contract stands at 1100.00 and one contract is worth 250 times the index Which of the following is the most accurate hedge for this portfolio? A) Sell 218 contracts B) Buy 284 contracts .in C) Buy 218 contracts en tre Explanation In order to be hedged against stock price increases, S&P 500 futures contracts have to be purchased The quantity of contracts to buy is computed as follows: # contracts = (beta)(Portfolio value) ÷ (futures price)(contract multiplier) bo ok c = (1)(60,000,000) ÷ (1100)(250) ≅ 218.18 = 218 contracts (Study Session 17, Module 32.2, LOS 32.d) Related Material o m SchweserNotes - Book w w Question #2 of 49 Michael Hallen, CFA, manages an equity portfolio with a current market value of $78 million and w a beta of 0.95 Convinced the market is poised for a signi cant upward movement, Hallen would like to increase the beta of the portfolio by 40 percent, using S&P 500 futures currently trading at 856 The multiplier is 250 What is the number of futures contracts, rounded up to the nearest whole number, that will be needed to achieve Hallen's objective? A) 139 B) 143 C) 144 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 1/30 10/12/2018 Learning Management System First determine the new target beta by multiplying the current beta of the portfolio which is 95 by 1.4 to achieve a new target beta that is 40% greater than the current portfolio beta: (.95)(1.4) = 1.33 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(1.33-.95)/1](78,000,000)/(856)(250) = (.38)(364.49) = 138.50, rounded to 139 (Study Session 17, Module 32.1, LOS 32.a) Related Material in SchweserNotes - Book en tre Question #3 of 49 A manager of $40 million of mid-cap equities would like to move $5 million of the position to large-cap equities The beta of the mid-cap position is 1.1, and the average beta of large-cap bo ok c stocks is 0.9 The betas of the corresponding mid and large-cap futures contracts are 1.1 and 0.95 respectively The mid and large-cap futures prices are $252,000 and $98,222 respectively What is the appropriate strategy? Short: A) 23 mid-cap futures and go long 42 large-cap futures m B) 29 mid-cap futures and go long 29 large-cap futures w w Explanation o C) 20 mid-cap futures and go long 48 large-cap futures We should recall our formula for altering beta, w number of contracts = ({target beta − Bportfolio} × V) / (Bfutures × futures price) In this case, for the rst step where we convert the mid-cap position to cash, V = $5 million, and the target beta is The current beta is 1.1, and the futures beta is 1.1: -19.84 = (0 − 1.1) × ($5,000,000) / (1.1 × $252,000) The manager should short 20 of the futures on the mid-cap index Then the manager should take a long position in the following number of contracts on the large-cap index: 48.23 = (0.9 − 0) × ($5,000,000) / (0.95 × $98,222) Thus, the manager should take a long position in 48 of the contracts on the large-cap index (Study Session 17, Module 32.2, LOS 32.e) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 2/30 10/12/2018 Learning Management System Question #4 of 49 To synthetically create the risk/return pro le of an underlying common equity security: A) Sell short the corresponding futures contract and invest in a T-bill B) Buy the corresponding futures contract and invest in a T-bill C) Buy the corresponding futures contract and borrow at the risk-free rate Explanation Related Material Question #5 of 49 bo ok c SchweserNotes - Book en tre (Study Session 17, Module 32.3, LOS 32.b) in Futures + Cash = Security, therefore, buy the corresponding futures contract and invest in a T-bill the index multiplier: m When using stock index futures contracts and cash to create a synthetic stock index, the larger o A) there is no such thing as an index multiplier w w B) the fewer the number of needed contracts C) the greater the number of needed contracts w Explanation The formula is: Number of contractsUnrounded = (V × (1 + risk free rate)T) / (futures price × multiplier) As the multiplier increases, the number of needed contracts declines (Study Session 17, Module 32.3, LOS 32.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 3/30 10/12/2018 Learning Management System Question #6 of 49 A manager has a 70/30 stock and bond portfolio To synthetically create a portfolio that is 60 percent stock and 40 percent bonds, the manager should: A) go long the bond futures and short the stock index futures B) short the bond futures and go long the stock index futures C) go long both bond futures and stock index futures Explanation in This move will accomplish the goal by reducing the exposure to equity and increasing the exposure to bonds (Study Session 17, Module 32.2, LOS 32.d) en tre Related Material Question #7 of 49 bo ok c SchweserNotes - Book A manager has a position in Treasury bills worth $175 million with a yield of 2% For the next months, the manager wishes to have a synthetic equity position approximately equal to this m value The manager chooses S&P 500 index futures, which has a dividend yield of 3% The w w A) 673 contracts .o futures price is 1,050 and the multiplier is $250 How many contracts will this take? B) 421 contracts w C) 655 contracts Explanation Number of contracts = 673.3 = $175,000,000 × (1.02)0.5/(1050 × 250) (Study Session 17, Module 32.3, LOS 32.b) Related Material SchweserNotes - Book Question #8 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 4/30 10/12/2018 Learning Management System A manager has a $100 million portfolio that consists of 50% stock and 50% bonds The beta of the stock position is The modi ed duration of the bond position is The manager wishes to achieve an e ective mix of 60% stock and 40% bonds The price and beta of the stock index futures contracts are $277,000 and 1.1 respectively (The futures price includes the e ect of the index multiplier.) The price, modi ed duration, and yield beta of the futures contracts are $98,000, 6, and respectively What is the appropriate strategy? A) Short 40 bond futures and go long 106 stock index futures B) Short 85 bond futures and go long 33 stock index futures C) Go long 53 bond futures and go long 40 stock index futures .in Explanation en tre Since the manager wishes to increase the equity position and decrease the bond position by $10 million (10% of $100 million), the correct strategy is to take a short position in the bond futures and a long position in the stock index futures: number of bond futures = -85.03 = [(0 − 5) / 6]($10,000,000 / $98,000) bo ok c number of stock futures = 32.82 = [(1 − 0) / 1.1]($10,000,000 / $277,000) (Study Session 17, Module 32.2, LOS 32.d) Related Material o m SchweserNotes - Book w w Question #9 of 49 Which of the following statements about portfolio hedging is least accurate? w A) To synthetically create the risk/return pro le of an underlying common equity security, buy the corresponding futures contract, sell the common short, and invest i bill B) For a xed portfolio insurance horizon, using put options generally requires less rebalancing and monitoring than with the use of futures contracts C) Futures contracts have a symmetrical payo pro le Explanation To synthetically create the risk/return pro le of an underlying common equity security, buy the corresponding futures contract and invest in a T-bill (Study Session 17, Module 32.3, LOS 32.b) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 5/30 10/12/2018 Learning Management System SchweserNotes - Book Question #10 of 49 An investor has a cash position currently invested in T-Bills but would like to "equitize" it by using S&P futures contracts Which of the following trades will create the desired synthetic equity position? B) Selling the T-Bills and buying S&P 500 futures contracts en tre C) Buying S&P 500 futures contracts .in A) Selling S&P 500 futures contracts short Explanation The trader can buy stock index futures and hold them in conjunction with T-Bills to mimic a stock portfolio So we have: bo ok c Synthetic stock portfolio = T-Bills + stock index futures (Study Session 17, Module 32.3, LOS 32.b) Related Material o m SchweserNotes - Book w w Question #11 of 49 An asset manager says he has perfectly hedged an equity portfolio that is denominated in a w foreign currency by only using forward currency contracts We know then that the: A) asset manager is not telling the truth B) number of contracts used is greater than that used on a comparable equity position C) number of contracts used is equal to that used on a comparable equity position Explanation Since the asset manager cannot know the future value of the equity position, it is impossible to perfectly hedge the position with only currency contracts (Study Session 17, Module 32.4, LOS 32.g) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 6/30 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #12 of 49 With respect to the practice of using forward contracts to eliminate the exchange-rate risk associated with a receiving a future payment in a foreign currency, which of the following is correct? A rm that expects to receive a foreign-currency payment is: in A) “short” the currency and should short the forward contract on the foreign currency B) “short” the currency and should go long the forward contract on the foreign en tre currency C) “long” the currency and should short the forward contract on the foreign currency Explanation bo ok c In hedging foreign exchange risk, anticipating a receipt (payment) of a currency is like being long (short) the currency To hedge the associated risk, a manager should take the opposite position in the forward contract (Study Session 17, Module 32.4, LOS 32.f) w w o SchweserNotes - Book m Related Material w Question #13 of 49 The exchange-rate risk associated with falling asset values in foreign subsidiaries caused by currency uctuations is called: A) transaction exposure B) translation exposure C) economic exposure Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 7/30 10/12/2018 Learning Management System Translation exposure refers to the fact that multinational corporations might see a decline in the value of their assets that are denominated in foreign currencies when those foreign currencies depreciate When the consolidated balance sheet is composed, changing exchange rates will introduce variation in account values from year to year (Study Session 17, Module 32.4, LOS 32.f) Related Material SchweserNotes - Book in Question #14 of 49 Tom Corser is the manager of the $140,000,000 Intrepid Growth Fund Corser's long-term view en tre of the equity market is negative, and as a result, his portfolio is allocated defensively with a beta of 0.85 Despite his negative long-term outlook, Corser thinks the market is temporarily mispriced, and could rise signi cantly over the next few weeks Corser has implemented tactical asset allocation measures in his fund sporadically over the years, and thinks now is another bo ok c time to so Because he likes his long-term holdings, he decides to use a futures overlay rather than trading assets to implement his view of the market Corser decides he wants to increase the beta of his portfolio to 1.25 The appropriate futures contract has a beta of 1.03 and the total futures price is $310,000 What is the appropriate tactical allocation strategy for m Corser to accomplish his objective? o A) Sell 175 equity futures contracts w w B) Buy 175 equity futures contracts C) Buy 373 equity futures contracts w Explanation NOTE – on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material from derivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Because Corser wants to increase the beta of his portfolio, he should buy futures contracts The appropriate number of contracts to buy is calculated as: [(1.25 − 0.85) / 1.03] × ($140,000,000 / $310,000) = 175.38 ≈ 175 contracts (Study Session 17, Module 32.1, LOS 32.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 8/30 10/12/2018 Learning Management System Question #15 of 49 An investor has a $100 million stock portfolio with a beta of 1.2 He would like to alter his portfolio beta using S&P 500 futures contracts The contracts are currently trading at 596.90 The futures contract has a multiple of 250 Which of the following is the CORRECT trade required to double the portfolio beta? A) Buy 1608 contracts B) Sell 804 contracts C) Buy 804 contracts .in Explanation en tre The number of futures contracts required to double the portfolio beta is computed as follows: Number of contracts = [(target beta - portfolio beta)/futures beta] x (Portfolio value / Futures contract value) = [(2.4 - 1.2) / 1] x [$100 million / (596.90 × $250)] = 804 contracts bo ok c To double the portfolio beta we buy 804 contracts (Study Session 17, Module 32.1, LOS 32.a) Related Material o m SchweserNotes - Book w w Question #16 of 49 A manager of a $20,000,000 portfolio wants to decrease beta from the current value of 0.9 to w 0.5 The beta on the futures contract is 1.1 and the futures price is $105,000 Using futures contracts, what strategy would be appropriate? A) Short 69 contracts B) Short 19 contracts C) Long 69 contracts Explanation Number of contracts = -69.26 = (0.5 − 0.9) × ($20,000,000) / (1.1 × $105,000), and this rounds down to 69 (absolute value) Since the goal is to decrease beta, the manager should go short which is also indicated by the negative sign (Study Session 17, Module 32.1, LOS 32.a) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 9/30 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #17 of 49 In the hedging of currency risk, the issue of basis risk is: A) not a concern when using either futures contracts or options C) a concern when using options and not futures contracts en tre Explanation in B) a concern when using futures contracts and not options bo ok c Basis risk is the di erence between the forward or futures price and the spot price The variability of this measure is a source of risk in a futures or forward hedge where the maturity of the derivative is di erent from the horizon Basis risk is not an issue in hedging with options (Study Session 17, Module 32.4, LOS 32.g) Related Material m SchweserNotes - Book w w o Question #18 of 49 A manager wishes to make a synthetic adjustment of a mid-cap stock portfolio The goal is to increase the beta of the portfolio by 0.5 The beta of the futures contract the manager will use w is one If the value of the portfolio is 10 times the futures price, then the futures contract position needed is a: A) long position in 20 contracts B) short position in contracts C) long position in contracts Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 10/30 10/12/2018 Learning Management System Futures contracts are less regulated than forward contracts, and thus have higher default risk Forward contracts can be established for any settlement date, futures contracts have a limited number of available settlement dates Question #25 of 49 With respect to Table 1, which of the following statements is most accurate? The de nition for: A) economic exposure is correct; the de nition for transaction exposure is correct .in B) translation exposure is correct; the de nition for transaction exposure is incorrect C) translation exposure is incorrect; the de nition for transaction exposure is en tre incorrect Explanation bo ok c The loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to the foreign currency is economic exposure The risk that contracted future cash ows become less valuable in terms of the domestic currency or that planned purchases become more expensive is known as transaction exposure Derivatives are primarily used to hedge transaction exposure (Study Session 17, Module 32.4, LOS 32.f) w w o SchweserNotes - Book m Related Material w Question #26 of 49 When hedging their exchange rate risk on the freight car sale, Moore used a forward contract to: A) buy 15 million in exchange for $18.75 million B) sell 15 million in exchange for $18.75 million C) sell 15 million in exchange for $16.67 million Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 16/30 10/12/2018 Learning Management System The day the freight cars are sold, Jackson is e ectively long Euros so the optimal solution is to sell the Euro forward contract in exchange for $18,750,000 (15,000,000 / $0.80) If the company did not hedge, two months from now the sale would net only $16,666,667 (15,000,000 / $0.90) (Study Session 17, Module 32.4, LOS 32.f) Related Material SchweserNotes - Book in Question #27 of 49 en tre To hedge the foreign exchange risk relative to the Canadian dollar, Jackson should: A) sell a forward contract to exchange $6,390,977 for CAD 8.5 million B) buy a forward contract to exchange $6,390,977 for CAD 8.5 million bo ok c C) buy a forward contract to exchange $7,083,333 for CAD 8.5 million Explanation Jackson wants to "lock in" the price of $6,390,977 (8,500,000 / $1.33) for the Canadian steel now by buying Canadian dollars with a forward contract Related Material w w o SchweserNotes - Book m (Study Session 17, Module 32.4, LOS 32.f) w Question #28 of 49 In regard to Table , which of the following is CORRECT? The: A) receiving foreign currency position is incorrect; the action is also incorrect B) paying foreign currency position is correct; the action is correct C) receiving foreign currency position is correct; the action is incorrect Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 17/30 10/12/2018 Learning Management System Being long the currency means holding or expecting to receive a foreign currency, therefore to hedge this foreign currency exposure you must sell forward contracts (deliver foreign currency and receive domestic currency at the expiration of the contract) Being short the currency indicates either an expectation to pay the foreign currency or the future obligation to deliver foreign currency which has already been sold To hedge this foreign currency exposure it is necessary to buy forward contracts (deliver home currency and receive foreign currency at the expiration of the contract) (Study Session 17, Module 32.4, LOS 32.f) Related Material in SchweserNotes - Book en tre Question #29 of 49 Regarding the advantages of futures contracts, which statement is least accurate? bo ok c A) Statement B) Statement C) Statement Explanation m Futures contracts trade on an exchange so they are required to be more regulated than forward contracts, and thus have lower default risk w w Related Material o (Study Session 17, Module 32.4, LOS 32.f) w SchweserNotes - Book Question #30 of 49 All of the following are advantages of using futures and forward contracts to hedge risk in a portfolio, relative to adjusting the actual debt and equity positions, EXCEPT: A) the manager gets a leverage e ect with futures because the only required “investment” is the margin deposit B) liquidity, at least for shorter maturity contracts, is often greater in the futures market than in the underlying market https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 18/30 10/12/2018 Learning Management System C) it is typically less expensive to use derivatives than to adjust the actual portfolio Explanation The point of a hedge is not to leverage a position If the investor is speculating, or even if they are pre-investing or turning cash into synthetic equity or debt, there may be a leverage advantage to futures rather than buying the underlying However, with respect to hedging, leverage is not the desired outcome The main advantages to using futures and forwards rather than adjusting the underlying security positions are cost, less disruption, and greater liquidity (Study Session 17, Module 32.4, LOS 32.f) Related Material en tre in SchweserNotes - Book Question #31 of 49 generally: A) can be completely hedged B) increases the total risk bo ok c When investing in foreign equity assets, the exchange-rate dimension of the investment m C) diversi es the position and thus lowers risk .o Explanation w w w The exchange-rate dimension generally adds risk The two hedging strategies utilized by global portfolio managers to manage the risk of a foreign-denominated portfolio involve selling forward contracts on the foreign market index (to manage market risk) and selling forward contracts on the foreign currency (to manage the currency risk) They can choose to hedge one or the other, both, or neither (Study Session 17, Module 32.4, LOS 32.g) Related Material SchweserNotes - Book Question #32 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 19/30 10/12/2018 Learning Management System If the value of a stock portfolio equals 16 times the futures price of the appropriate equity index contract and beta of the equity portfolio and futures price were equal, how many contracts would it take to reduce the beta of the equity index to zero? A) A long position in 16 contracts B) A long position in contracts C) A short position in 16 contracts Explanation Number of contracts = -16 = (0 − beta) × (16 × futures price) / (beta × futures price) in (Study Session 17, Module 32.1, LOS 32.a) Related Material bo ok c Question #33 of 49 en tre SchweserNotes - Book A manager of a $10,000,000 portfolio wants to increase beta from the current value of 0.9 to 1.1 The beta on the futures contract is 1.2 and the futures price is $245,000 Using futures A) Short contracts .o B) Long 11 contracts m contracts, what strategy would be appropriate? w w C) Long contracts Explanation w Number of contracts = 6.80 = (1.1 − 0.9) × ($10,000,000) / (1.2 × $245,000), and this rounds up to seven Since the goal is to increase beta, the manager should go long (Study Session 17, Module 32.1, LOS 32.a) Related Material SchweserNotes - Book Question #34 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 20/30 10/12/2018 Learning Management System A manager wants to synthetically convert to cash $45 million of a diversi ed stock portfolio for three months The manager will use the CME E-mini S&P stock index futures contract, which has a multiplier equal to $50, and the price of the three month contract is 1610.50 The dividend yield on the portfolio is 2.4% The risk-free rate is 4.04% The number of contracts the fund needs to use is closest to: A) 532 B) 564 C) 588 T Vp(1+RF) Pf $45,000,000(1.0404)  = - 3/12 $50(1610.50) = −564.393 en tre # equity contracts = - in Explanation The negative sign indicates the need to take a short position (Study Session 17, Module 32.3, LOS 32.c) SchweserNotes - Book m Question #35 of 49 bo ok c Related Material o When expecting to make a future payment in a foreign currency, a rm should take a: w w A) long forward position in the currency to hedge a depreciation of that currency B) long forward position in the currency to hedge an appreciation of that currency w C) short forward position in the currency to hedge an appreciation of that currency Explanation Expecting to make a payment is like being short the currency The rm would want to take a long forward position If the currency appreciates and there is no hedge, the rm would pay more With the hedge, the overall cost in domestic currency is locked in (cost increases will be o set by gains on the forward contract) Of course, the forward contract will result in a loss if the foreign currency actually depreciates, but this will be o set by a decrease in the cost of the underlying transaction (Study Session 17, Module 32.4, LOS 32.f) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 21/30 10/12/2018 Learning Management System Question #36 of 49 A manager of $30 million in mid-cap equities would like to move half of the position to an exposure resembling small-cap equities The beta of the mid-cap position is 1.0, and the average beta of small-cap stocks is 1.6 The betas of the corresponding mid and small-cap futures contracts are 1.05 and 1.5 respectively The mid and small-cap futures prices are $260,000 and $222,222 respectively What is the appropriate strategy? B) Short 17 mid-cap futures and go long 17 small-cap futures Explanation We should recall our formula for altering beta, en tre C) Short 17 small-cap futures and go long 17 mid-cap futures .in A) Short 55 mid-cap futures and go long 72 small-cap futures bo ok c number of contracts = ({target beta − Bportfolio} x V) / (Bfutures x futures price) In this case, for the rst step where we convert the mid-cap position to cash, V=$15 million, and the target beta is The current beta is 1.0, and the futures beta is 1.05: -54.95 = (0 − 1) × ($15,000,000) / (1.05 × $260,000) m The manager should short 55 of the futures on the mid-cap index Then the manager should take a long position in the following number of contracts on the small-cap index: o 72.00 = (1.6 − 0) × ($15,000,000) / (1.5 × $222,222) w w Thus, the manager should take a long position in 72 of the contracts on the small-cap index (Study Session 17, Module 32.2, LOS 32.e) Related Material w SchweserNotes - Book Question #37 of 49 The risk associated with a fall in demand for a rm's product caused by an appreciation of the home currency of the rm is called: A) transaction exposure B) translation exposure https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 22/30 10/12/2018 Learning Management System C) economic exposure Explanation Economic exposure is the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency That is, if the euro/dollar exchange rate increases, a U.S exporter to Europe would see a fall in revenue as the European buyers purchase fewer U.S exports that have e ectively increased in price from the dollar appreciation (Study Session 17, Module 32.4, LOS 32.f) Related Material en tre in SchweserNotes - Book Question #38 of 49 Redden Capital Management manages an intermediate, high-quality bond portfolio with a value bo ok c of $12 million dollars The modi ed duration of the portfolio is 4.4 years with a yield beta of 1.0 Scott Stuart, the manager of the portfolio is concerned about rising interest rates over the next few months and wants to make a tactical adjustment and cut the duration of the portfolio in half Stuart asks Amy Swemba, a junior portfolio manager with Redden, to accomplish this task Swemba is aware that a Treasury bond futures contract exists with a value of $102,000, with a o statements: m modi ed duration of 8.2 years Swemba replies to Stuart's comments with the following The fastest and most cost-e ective way to reduce the duration of the portfolio by half would be to sell $6 million dollars worth of the actual bonds in the portfolio Statement 2: The portfolio's duration could also be adjusted by selling 40 of the Treasury bond futures contracts w w w Statement 1: After listening to Swemba's statements, Stuart should: A) agree with Statement 1, but disagree with Statement B) disagree with both Statement and Statement C) disagree with Statement 1, but agree with Statement Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 23/30 10/12/2018 Learning Management System NOTE – on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material from derivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Stuart should disagree with both of Swemba's statements Although Stuart's goal of reducing the duration could be accomplished by selling bonds in the portfolio, doing so would likely incur signi cant transaction costs Also, since the duration of each bond in the portfolio is likely di erent, speci c bonds would have to be selected in order to accomplish Stuart's goal, making the process more di cult A derivative overlay, accomplished by using futures contracts, would be much easier and cost e ective Swemba is also incorrect with respect to the number of futures contracts that would need to be sold The correct number of futures contracts to be sold is: (1.0)[(2.2 – 4.4) / 8.2] ($12,000,000 / $102,000) = -31.56 ≈ -32 futures contracts The minus sign means that 32 contracts should be sold to achieve the desired duration in the portfolio (Study Session 17, Module 32.2, LOS 32.d) in Related Material en tre SchweserNotes - Book bo ok c Question #39 of 49 An investor has a $100 million stock portfolio with a beta of 1.1 He would like to hedge his portfolio using S&P 500 futures contracts, which are currently trading at 596.70 The futures contract has a multiple of 250 Which of the following is the CORRECT trade required to create a o A) Buy 670 contracts m synthetic T-bill? B) Sell 670 contracts w w C) Sell 737 contracts w Explanation The position created by risk-minimizing hedging is essentially the creation of a synthetic TBill The number of futures contracts required for the risk-minimizing hedge is computed as follows: Number of contracts = Portfolio value / Futures contract value × beta $100 million / (596.70 × $250) × 1.1 = 737 contracts Therefore, the investor has to sell 737 S&P 500 futures contracts short (Study Session 17, Module 32.3, LOS 32.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 24/30 10/12/2018 Learning Management System Question #40 of 49 In order to perfectly hedge an investment in foreign equities, a manager would most likely have to use: A) both currency futures and equity forwards B) currency forwards only C) both currency forwards and equity futures Explanation in Forwards are most often used for currency risk and futures are most often used for equity risk The manager would have to use both contracts to completely hedge all the risk (Study Session 17, Module 32.4, LOS 32.g) en tre Related Material Question #41 of 49 bo ok c SchweserNotes - Book An investment of $240,000,000 in T-bills earning percent is combined with 886 stock index futures that have a price of 1,100 and a multiplier of 250 In three months, when the futures o m mature and the index value is 1,120, what will be the value of the position at that time? A) $243,650,000.00 w w B) $248,080,000.00 C) $246,210,097.00 w Explanation Payo of futures plus T-bill = 886 × $250 × (1,120 − 1,100) + $240,000,000 × 1.03 0.25 Payo of futures plus T-bill = $246,210,097 (Study Session 17, Module 32.3, LOS 32.b) Related Material SchweserNotes - Book Question #42 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 25/30 10/12/2018 Learning Management System The performance of a synthetically reallocated portfolio, e.g., a synthetic adjustment from stocks to bonds, would not exactly match the target position for all of the following reasons EXCEPT: A) the risk free rate is not zero B) duration is not constant C) rounding of the number of contracts used Explanation Related Material Question #43 of 49 bo ok c SchweserNotes - Book en tre (Study Session 17, Module 32.2, LOS 32.d) in The risk free rate does not enter into the formulas for determining the strategy for synthetically adjusting a stock/bond portfolio Although the risk free rate may play a role in some futures strategies to synthetically adjust a portfolio, the e ectiveness of the strategy would not depend upon its value m To create a synthetic cash position: A) buy the common equity, sell short the corresponding futures contract, invest in a T- o bill w w B) buy the common equity and sell short the corresponding futures contract C) sell short the common equity, buy the corresponding futures contract, invest in a T- w bill Explanation Security – Futures = Cash, therefore, buy the common equity and sell short the corresponding futures contract (Study Session 17, Module 32.3, LOS 32.b) Related Material SchweserNotes - Book Question #44 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 26/30 10/12/2018 Learning Management System Robert Zorn, CFA, manages an equity portfolio with a current market value of $150 million The beta of the portfolio is 1.23 and Zorn is forecasting a short-term market adjustment that will signi cantly lower equity values and will occur in the near future Zorn has decided to use S&P 500 futures, currently trading at 1260, to reduce the portfolio's systematic risk exposure by 30 percent The multiplier is 250 What is the number of futures contracts, rounded up to the nearest whole number, that will be needed to achieve Zorn's objective? A) Sell 169 B) Sell 176 C) Buy 182 .in Explanation en tre First determine the new target beta by multiplying the current beta of the portfolio which is 1.23 by to achieve a new target beta that is 30% less than the current portfolio beta: (1.23)(.7) = 0.861 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] bo ok c [(0.861-1.23)/1](150,000,000)/(1260)(250) = (-.369)(476.19) = -175.71, rounded to -176 (Study Session 17, Module 32.1, LOS 32.a) Related Material w w o m SchweserNotes - Book Question #45 of 49 w A portfolio manager has a net long position in both stocks and bonds and no cash When preinvesting a future cash in ow, to replicate the existing portfolio, using bond and stock futures, which of the following statements is most accurate? The manager will: A) go long the stock futures but short the bond futures B) go long both stock and bond futures C) have to choose a single futures contract and net the bond and stock position Explanation Since the original portfolio is long in both stocks and bonds, the manager will go long both stock and bond futures contracts (Study Session 17, Module 32.2, LOS 32.e) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 27/30 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #46 of 49 Derivatives are most often used to hedge which type of exchange-rate risk? A) Economic exposure B) Translation exposure .in C) Transaction exposure en tre Explanation bo ok c The three types of exchange-rate risk are transaction exposure, economic exposure, and translation exposure Futures are most often used to hedge transaction exposure, which is the risk that exchange rates will change the real value (in the domestic currency) of the contracted price (Study Session 17, Module 32.4, LOS 32.f) Related Material m SchweserNotes - Book w w o Question #47 of 49 An investor has an $80 million stock portfolio with a beta of 1.1 He would like to partially hedge his portfolio using S&P 500 futures contracts The contracts are currently trading at 596.70 The w futures contract has a multiple of 250 Which of the following is the CORRECT trade to reduce the portfolio beta by 50 percent? A) Sell 295 contracts B) Buy 295 contracts C) Sell 590 contracts Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 28/30 10/12/2018 Learning Management System The number of futures contracts required for the 100% risk-minimizing hedge (or to reduce the beta to zero) is computed as follows: Number of contracts = Portfolio value / Futures contract value × beta$80 million / (596.70 × $250) × 1.1 = 590 contracts Therefore, to reduce the by 50% we simply use half this number of contracts or 295 contracts (Study Session 17, Module 32.1, LOS 32.a) Related Material in SchweserNotes - Book en tre Question #48 of 49 A manager wants to synthetically convert to cash $12 million of a diversi ed stock portfolio for three months The manager will use the CME E-mini S&P stock index futures contract, which bo ok c has a multiplier equal to $50, and the price of the three month contract is 1598.80 The dividend yield on the portfolio is 2.8% The risk-free rate is 3.96% To accomplish this, the best choice would be to: A) take a long position in 152 contracts m B) take a short position in 152 contracts w w Explanation o C) take a short position in 156 contracts Pf T $12,000,000(1.0396)  = - $50(1,598.80) 3/12  = -151.577 w # equity contracts =  VP (1 + RF ) The negative sign indicates the need to take a short position (Study Session 17, Module 32.3, LOS 32.c) Related Material SchweserNotes - Book Question #49 of 49 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 29/30 10/12/2018 Learning Management System When hedging the exchange-rate risk of a foreign currency-denominated equity portfolio, a manager must recognize that the position has: A) both equity risk and foreign exchange risk B) exchange-rate risk only C) equity risk only Explanation The position will have both equity and foreign exchange risk This makes the position, in isolation, more risky than a domestic equity portfolio .in (Study Session 17, Module 32.4, LOS 32.g) Related Material w w w o m bo ok c en tre SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447974/print 30/30 ... 1 .33 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(1 .33 -.95)/1](78,000,000)/(856)(250) = ( .38 ) (36 4.49) = 138 .50, rounded to 139 (Study Session 17, Module 32 .1, LOS 32 .a)... A) Short 40 bond futures and go long 106 stock index futures B) Short 85 bond futures and go long 33 stock index futures C) Go long 53 bond futures and go long 40 stock index futures .in Explanation... of 0.8 and a $3 million bond position with a duration of 5: bo ok c number of stock futures = 21.8 = (0.8 − 0) × ($7,000,000) / (1.1 × $ 233 ,450) number of bond futures = 25. 13 = (5 − 0) × ( $3, 000,000)