CFA Level 3 - Derivatives Session 15 - Reading 36

CFA Level 3 - Derivatives Session 15 - Reading 36 (Notes, Practice Questions, Sample Questions) 1. 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 short position in 16 contracts. B)A long position in 4 contracts. C)A long position in 16 contracts [Explanation: Number of contracts = -16 = (0 − beta) × (16 × futures price) / (beta × futures price)] 2. A manager of a $20,000,000 portfolio wants to decrease beta from the current value of 0.9 to 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)Long 69 contracts. B)Short 19 contracts. C)Short 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] 3. 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 contracts, what strategy would be appropriate? A)Long 11 contracts. B)Long 7 contracts. C)Short 7 contracts [Explanation: 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] 4. Michael Hallen, CFA, manages an equity portfolio with a current market value of $78 million and a beta of 0.95. Convinced the market is poised for a significant 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)143. B)139. C)144 [Explanation: 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: (0.95)(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] 5. 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)Sell 804 contracts. B)Buy 804 contracts. C)Buy 1608 contracts [Explanation: 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 / (596.90 × $250) × 1.2 = 804 contracts Selling this many contracts reduces the beta to zero so to double the beta we simply buy this many contracts, or buy 804 contracts] 6. 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 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 590 contracts. B)Buy 295 contracts. C)Sell 295 contracts [Explanation: 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] 7. The practice of taking long positions in futures contracts to create an exposure that converts a yet-to be received cash position into a synthetic equity or bond position is: A)called leveraging down. B)illegal. C)called pre-investing [Explanation: This is the definition of pre-investing using futures contracts, and it is not illegal] 8. A portfolio manager knows that a $10 million inflow of cash will be received in a month. The portfolio under management is 70% invested in stock with an average beta of 0.8 and 30% invested in bonds with a duration of 5. The most appropriate stock index futures contract has a price of $233,450 and a beta of 1.1. The most appropriate bond index futures has a duration of 6 and a price of $99,500. How can the manager pre-invest the $10 million in the appropriate proportions? Take a: A)short position in 25 of the bond futures and 22 of the stock futures. B)long position in 22 of the stock futures and 25 of the bond futures. C)long position in 25 of the stock futures and 28 of the bond futures [Explanation: The goal is to create a $7 million equity position with a beta of 0.8 and a $3 million bond position with a duration of 5: 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) / (6 × $99,500) The manager should take a long position in 22 of the stock index futures and 25 of the bond index futures] 9. A portfolio manager has a net long position in both stocks and bonds and no cash. When pre-investing a future cash inflow, 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)have to choose a single futures contract and net the bond and stock position. C)go long both stock and bond futures [Explanation: Since the original portfolio is long in both stocks and bonds, the manager will go long both stock and bond futures contracts] 10. The risk associated with a fall in demand for a firm’s product caused by an appreciation of the home currency of the firm is called: A)economic exposure. B)translation exposure. C)transaction 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 effectively increased in price from the dollar appreciation] 11. Derivatives are most often used to hedge which type of exchange-rate risk? A)Translation exposure. B)Transaction exposure. C)Economic exposure [Explanation: 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] 12. The exchange-rate risk associated with falling asset values in foreign subsidiaries caused by currency fluctuations is called: A)translation exposure. B)economic exposure. C)transaction exposure [Explanation: 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] 13. 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 firm that expects to receive a foreign-currency payment is: A)“short” the currency and should go long the forward contract on the foreign currency. B)“short” the currency and should short the forward contract on the foreign currency. C)“long” the currency and should short the forward contract on the foreign currency [Explanation: 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] 14. A maker of large computers has just received an order for some of its products. The agreed upon price is in British pounds: ₤8 million. The firm will receive the pounds in 60 days. The current exchange rate is $1.32/₤ and the 60-day forward rate is $1.35/₤. If the firm uses the forward contract to hedge the corresponding exchange rate risk, how many dollars will it expect to receive? A)$10,560,000. B)$5,925,926. C)$10,800,000 [Explanation: On the day the order comes in, the firm effectively has a long position in pounds; therefore, it should take a short position in a forward contract. This contract would obligate the firm to deliver the pounds that it will receive for dollars. The contract would be to exchange ₤8 million for: $10,800,000 = (₤8,000,000) × $1.35/₤] 15. When expecting to make a future payment in a foreign currency, a firm should take a: A)short forward position in the currency to hedge an appreciation of that currency. B)long forward position in the currency to hedge a depreciation of that currency. C)long 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 firm would want to take a long forward position. If the currency appreciates and there is no hedge, the firm would pay more. With the hedge, the overall cost in domestic currency is locked in (cost increases will be offset 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 offset by a decrease in the cost of the underlying transaction] 16. An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forward currency contracts. We know then that the: A)number of contracts used is equal to that used on a comparable equity position. B)asset manager is not telling the truth. C)number of contracts used is greater than 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] 17. If a manager plans to use currency forwards to hedge a long position in foreign equities, then which of the following would represent a strategy that would prevent over-hedging? A)Short an amount that is less than the current equity position. B)Short an amount that is more than the current equity position. C)Go long an amount that is more than the current equity position [Explanation: The forward contracts foreign currency. over-hedging, the manager would want to short the to hedge depreciation of the To prevent hedging too much, manager would hedge an amount less than the equity position because that position may decline in value from the equity risk] 18. If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year. The worst-case scenario is if the portfolio’s return is: A)less than the expected value and the currency appreciates. B)less than the expected value and the currency depreciates. C)greater than the expected value and the currency appreciates. [Explanation: This should be obvious because a decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates. If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate] 19. When hedging the exchange-rate risk of a foreign currency-denominated equity portfolio, a manager must recognize that the position has: A)exchange-rate risk only. B)equity risk only. C)both equity risk and foreign exchange risk [Explanation: The position will have both equity and foreign exchange risk. This makes the position, in isolation, more risky than a domestic equity portfolio] 20. In order to perfectly hedge an investment in foreign equities, a manager would most likely have to use: A)currency forwards only. B)both currency forwards and equity futures. C)both currency futures and equity forwards [Explanation: 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] 21. When investing in foreign equity assets, the exchange-rate dimension of the investment generally: A)increases the total risk. B)diversifies the position and thus lowers risk. C)can be completely hedged [Explanation: 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]