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PART II: Theory — 4 frågor Final exam 19.12.2019 1. Briefly explain the following words and expressions 10p a) Financial intermediary —> They bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal...

PART II: Theory — 4 frågor Final exam 19.12.2019 1. Briefly explain the following words and expressions 10p a) Financial intermediary —> They bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government). These financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations. A bank or other financial institution that facilitates the flow of funds between different entities in the economy. b) Par yield —> The coupon rate on a bond that makes its price equal to the principal. c) Intermarket Spread Swap —> Is pursued when an investor believes that the yield spread between two sectors of the bonds market is temporarily out of line. (arbitrage opportunity). For example, if the current spread between corporate and government bonds is considered too wide and is expected to narrow, the investor will shift from government bonds into corporate bonds. If the yield spread does in fact narrow, corporates will outperform governments. …Of course, the investor must consider carefully whether there is a good reason that the yield spread seems out of alignment. For example, the default premium on corporate bonds might have increased because the market is expecting a severe recession. d) Hazard rate —> Measures probability of default in a short period of time conditional on no earlier default …(Which analyses the likelihood that an item will survive to a certain point in time based on its survival to an earlier time (t).) e) Dynamic Hedging —> A procedure for hedging an option position by periodically changing the position held in the underlying asset. The objective is usually to maintain a delta-neutral position. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) What type of trading orders might you give to your broker if you want to buy shares of a stock, but you believe that the current stock price is too high given the firm’s prospects. If the shares could be obtained at a price 5% lower than the current value, you would like to purchase shares for your portfolio. (BKM cc 3.3). —> Price-contingent order, and under those type of orders a limit buy order. A limit order is an order specifying a price at which an investor is willing to buy or sell a security. It is an order that can be executed only at a specified price or one more favourable to the investor, which in this case would be at a price 5% or lower than the current value. b) The term structure of interest rates is upward sloping. Put the following in order of magnitude: (a)The five-year zero rate, (b)the yield on a five-year coupon-bearing bond, and (c)the forward rate corresponding to the period between 4.75 and 5 years in the future. (Hull, 4.7). —> When the term structure is upward sloping, c>a>b. When it is downward sloping, b>a>c. c) Explain carefully the difference between hedging, speculation, and arbitrage. (Hull, 1.2). —> Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable. Speculators use them to bet on the future direction of the market variable. Arbitrageurs take offsetting positions in two or more instruments to lock in a profit. Hedgers: hedging can be made using forward contracts or using options. Forward contracts are designed to neutralise risk by fixing the price that the hedger will pay or receive for the underlying asset. Option contracts, by contrast, provide insurance. They offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favourable price movements. Unlike forwards, options involve the payment of an upfront fee. Speculators: speculating can be done using futures or options. When a speculator uses futures, the potential loss as well as the potential gain is very large. When options are used, no matter how bad things get, the speculator’s loss is limited to the amount paid for the options. Arbitrageurs: arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets. d) What does it mean to assert that the delta of a call option is 0.7? How can a short position in 1000 options be made delta neutral when the delta of each option is 0.7? (Hull 18.2). —> For every 1% increase in the price of the underlying asset, the value of the option based on it increases by 0,7 cents for every contract you’ve made, or in other words the price of the option increases by 0,7 of this amount (and vice versa). A short position in 1000 options has a delta of - (0,7*1000) = -700, and can be made delta neutral with the purchase of 700 shares. (FACIT) A delta of 0.7 means that, when the price of the stock increases by a small amount, the price of the option increases by 70% of this amount. Similarly, when the price of the stock decreases by a small amount, the price of the option decreases by 70% of this amount. A short position in 1,000 options has a delta of 700 and can be made delta neutral with the purchase of 700 shares. e) What changes to the basic Black-Scholes option pricing model is needed if you want to determine the price of a call option on a stock index like the SP 500? —>While the Black-Scholes formula is derived assuming that stock volatility is constant, the time series of implied volatilities derived from that formula is in fact far from constant. This contradiction reminds us that the Black-Scholes model (like all models) is a simplification that does not capture all aspects of real markets. In this particular context, extensions of the pricing model that allow stock volatility to evolve randomly over time would be desirable, and, in fact, many extensions of the model along these lines have been developed. The fact that volatility changes unpredictably means that it can be difficult to choose the proper volatility input to use in any option-pricing model. A considerable amount of recent research has been devoted to techniques to predict changes in volatility. These techniques known as ARCH and stochastic volatility models, posit that changes in volatility are partially predictable and that by analysing recent levels and trends in volatility, one can improve predictions of future volatility. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Collateralized debt obligations (CDO): Explain the idea of creating CDO:s and how a CDO is structured using a simple example with 3 tranches. (Hull, 8.1) —> Table of contents: (1) What are CDOs (2) The Purpose of CDOs, Advantages & Disadvantages (3) How a CDO Is Structured (4) CDOs and the Financial Crisis, as well as their role today. (1) CDOs are financial tools that banks use to repackage individual loans into a product sold to investors on the secondary market. These packages consist of car loans, credit card debt,  mortgages or corporate debt. This means that CDOs are a derivative, and by the name of the CDO what type of underlying asset it derives its value from. For example, CDOs where the package consists of mortgages go by the name of mortgage-backed securities. (2) The popularity of CDOs in the past are based on three main reasons. First, CDOs provided more liquidity in the economy, and allowed banks and corporations to sell off their debt. This freed up more capital to invest or loan. Second, CDOs moved the loan’s risk of default from the bank to the investors. Third, CDOs were very profitable, which boosted share prices and manager’s bonuses. (3) CDOs were designed to concentrate the credit risk of a bundle of loans on one class of investors, leaving the other investors in the pool relatively protected from that risk. The idea was to prioritize claims on loan repayments by dividing the pool into senior versus junior slices, called tranches. The senior tranches had first claim on repayments from the entire pool. Junior tranches would be paid only after the senior ones had received their cut. Let’s then say we have a pool divided into three tranches. The senior tranches might receive an ’AAA’ rating, the mezzanine (middle) tranches generally carry ’AA’ to ’BB’ ratings, and the lowest junk or unrated tranches are called the equity tranches. The senior tranche is the first one to absorb cash flows and the last to absorb defaults or missed payments from the underlying assets. (4) CDOs played a big part in the financial crisis, starting with the collapse of the housing market in the U.S. Many of the underlying mortgages for these CDOs were so called subprime mortgages, where mortgages were made to those with a less than prime credit history. Many opted for so called Adjustable-rate mortgages, which offered ’’teaser’’ low-interest rates for the first three to five years. Higher rates kicked in afterwards. Borrowers took the loans, knowing they could only afford to pay the low rates. They expected to sell the house before the higher rates were triggered. People bought homes so they could sell them, and housing prices skyrocketed beyond their actual value. When people eventually started to default on their loans, the CDOs became worthless, and the crisis spread. 4. Derivative mishaps and the lessons to be learned: what lessons are appropriate to all users of derivatives, whether they are financial or non- financial companies? (Hull ch. 35.1) Table of contents: Lessons for all users of derivatives topic + numbers below (1) Define Risk Limits: it is essential that all companies define in a clear and unambiguous way limits to the financial risks that can be taken. They should then set up procedures for ensuring that the limits are obeyed. Ideally, overall risk limits should be set at board level. These should then be converted to limit applicable to the individuals responsible for managing particular risks. *** (2) Take the Risk Limits Seriously: the penalties for exceeding risk limits should be just as great when profits result as when losses result. Otherwise, trader who make losses are liable to keep increasing their bets in the hope that eventually a profit will result and all will be forgiven. (3) Do Not Assume You Can Outguess the Market: if a trader correctly predicts the direction in which market variables will move, it is likely to be a result of good luck rather than superior trading skill. The trader might receive a good bonus, but the trader’s risk limits should nevertheless not be increased (mera självstyre och ansvar I guess). (4) Do Not Underestimate the Benefits of Diversification: the benefits from diversification are huge, and speculating heavily on one market variable should be vey carefully considered. Diversification often results in a higher expected return per unit of risk taken. (5) Carry out Scenario Analyses and Stress Tests: the calculation of risk measures such as VaR should always be accompanied by scenario analyses and stress testing to obtain an understanding of what can go wrong. It is important to be creative in the way scenarios are generated and to use the judgement of experienced managers. One approach is to look at 10 or 20 years of data and choose the most extreme events as scenarios. If there is not enough data on a specific variable, choose one that is similar. ***The argument here is not that no risks should be taken. A trader in a financial institution or a fund manager should be allowed to take positions on the future direction of relevant market variables. But the sizes of the positions that can be taken should be limited and the systems in place should accurately report the risks being taken. Final exam 15.12.2017 1. Briefly explain the following words and expressions: a) Daily settlement —> At the end of each trading day, the margin account (and initial margin) is adjusted to reflect the investor’s gain or loss. A trade is first settled at the close of the day on which it takes place. It is then settled at the close of trading on each subsequent day. b) VIX-index —> Index of the volatility of the S&P 500. It is calculated from the prices investors are willing to pay for options tied to the Standard & Poor’s 500-stock index. As investors become nervous, they are willing to pay more for options, driving up the value of the VIX. Man vill alltså skydda sig mot en möjlig downturn av SP500, vågar inte köpa indexandelar utan köper istället optioner på dessa. VIX is an index of the implied volatility of 30-day options on the S&P 500 calculated from a wide range of calls and puts. It is sometimes referred to as the ’’fear factor’’. An index value of 15 indicates that the implied volatility of 30-day options on the S&P 500 is estimated as 15%. Trading in futures on the VIX started in 2004 and trading in options on the VIX started in 2006. One contract is on 1000 times the index. c) Modified duration —> Formula: Duration/(1+y), where duration equals the average number of years to an asset’s discounted cash flows. Modified duration measures the percentage change in a bond’s price for a 1 percentage-point change in yield. It is a handy measure of interest-rate risk. It is a modification to the standard duration measure so that it more accurately describes the relationship between proportional changes in a bond price and actual changes in its yield. The modification takes account of the compounding frequency with which the yield is quoted. d) Open interest —> The total number of long positions outstanding in a futures contract (equals the total number of short positions). If there is a large amount of trading by day traders, the volume of trading in a day can be greater than either the beginning-of-day or end-of-day open interest. e) Hair cut —> Discount applied to the value of an asset for collateral purposes. Securities can often be used to satisfy margin/collateral requirements. The market value of the securities is reduced by a certain amount to determine their value for margin purposes. This reduction is known as a haircut. ’’Regardless of how transactions are cleared, initial margin when provided in the form of cash usually earns interest. The daily variation margin provided by clearing house members for futures contracts does not earn interest’’. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) Why are U.S. Treasury rates significantly lower than other rates that are close to risk free? Give two reasons. (4.19). —> There are three reasons (see Business Snapshot 4.1): (1) Treasury bills and Treasury bonds must be purchased by financial institutions to fulfil a variety of regulatory requirements. This increases demand for these Treasury instruments driving the price up and the yield down. (2) The amount of capital a bank is required to hold to support an investment in Treasury bills and bonds is substantially smaller than the capital required to support a similar investment in other very-low- risk instruments. (3) In the United States, Treasury instruments are given favourable tax treatment compared with most other fixed-income investments because they are not taxed at the state level. b) Describe one advantage, and one disadvantage of including callable bonds in a portfolio. —> The advantage of a callable bond is the higher coupon (and higher promised yield to maturity) when the bond is issued. If the bond is never called, then an investor earns a higher realised compound yield on a callable bond issued at par than a non-callable bond issued at par on the same date. The disadvantage of the callable bond is the risk of a call. If rates fall and the bond is called, then the investor receives the call price and then has to reinvest the proceeds at interest rates that are lower than the yield to maturity at which the bond original c) The prices of long-term bonds are more volatile than prices of short-term bonds. However, the yields to maturity of short-term bonds fluctuate more than yields on long-term bonds. How do you reconcile these two empirical observations? —> While it is true that short-term rates are more volatile than long-term rates, the longer duration of the longer-term bonds makes their prices and their rates of return more volatile. The higher durations magnifies the sensitivity to interest-rate changes. d) Evaluate the criticism that futures markets siphon off capital from more productive uses. —> Because long positions equal short positions, futures trading must entail a “canceling out” of bets on the asset. Moreover, no cash is exchanged at the inception of futures trading. Thus, there should be minimal impact on the spot market for the asset, and futures trading should not be expected to reduce capital available for other uses. e) According to the Black-Scholes formula, what will be the value of the hedge ratio of a call option as the stock price becomes infinitely large? —> The hedge ratio approaches one. As S increases, the probability of exercise approaches 1.0. N(d1) approaches 1.0. Egen: According to the Black-Scholes formula, what will be the value of the hedge ratio of a put option for a very small exercise price? —> The hedge ratio approaches 0. As X decreases, the probability of exercise approaches 0. [N(d1) –1] approaches 0 as N(d1) approaches 1. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Theories on the relationship between the future prices and expected future spot prices. (Hull, 121-123, BKM 685-687) Table of contents: (1) Defining the relationship (2) Short Introduction to the Three traditional theories (3) Modern Portfolio Theory. (1) The relationship between the future prices and expected future spot prices tell us how well the futures price forecast the ultimate spot price. We refer to the market’s average opinion about what the spot price of an asset will be at a certain future time as the expected spot price of the asset at that time. If the spot price is less than the futures price, the market must be expecting the futures price to decline, so that traders with short positions gain and traders wit long positions lose. If the expected spot price is greater, the reverse must be true, and therefore traders with long positions gain while those with short positions lose. (2) Three traditional theories have been put forth: the expectations hypothesis, normal backwardation, and contango. Today’s consensus is that all of these traditional hypotheses are subsumed by modern portfolio theory. The expectations hypothesis states that the futures price equals the expected value of the future spot price. Under this theory the expected profit to either position of a futures contract would equal zero. The expectations hypothesis resembles market equilibrium in a world with no uncertainty; if prices of goods at all future dates were currently known (which they are not), then the futures price for delivery at any particular date would equal the currently known future spot price for that date. It is a tempting but incorrect leap to then assert that under uncertainty the futures price should equal the currently expected spot rate. This view ignores the risk premiums that must be built into futures prices when ultimate spot prices are uncertain. Keynes and Hicks argued that, if hedgers tend to hold short positions and speculators end to hold long positions, the futures price of an asset will be below the expected spot price. This is because speculators require compensation for the risks they are bearing, and will trade only if they can expect to make money on average. Hedgers will lose money on average, but they are likely to be prepared to accept this because the futures contract reduces their risk. This is called the theory of normal backwardation. Although this theory recognises the important role of risk premiums in future markets, it is based on total variability rather than systematic risk. Contango is a polar hypothesis to backwardation and states that natural hedgers are the purchasers of a commodity, rather than the suppliers. It is clear that any commodity will have both natural long- and short hedgers. The strong side of the market will be the side that has more natural hedgers. The strong side must pay a premium to induce speculators to enter into enough contracts to balance the ’’natural’’ supply of short and long hedgers. (3) The three traditional hypotheses all envision a mass of speculators willing to enter either side of the futures market if they are sufficiently compensated for the risk they incur. The modern portfolio theory fine-tunes this approach by refining the notion of risk used in the determination of risk premiums. Simply put, if commodity prices pose positive systematic risk, futures prices must be lower than expected spot prices. Speculators with well-diversified portfolios will be willing to enter long futures positions only if they receive compensation for bearing that risk in the form of positive expected profits. The short position’s profit is the negative of the long’s and will have negative systematic risk. Diversified investors in the short position will be willing to suffer that expected loss to lower portfolio risk. The analysis is reversed for negative-beta commodities. 4. Derivative mishaps and the lessons to be learned: what lessons are primarily relevant to non-financial institutions? (Hull ch. 35.3) Table of contents: (1) Make Sure You Fully Understand the Trades You Are Doing (2) Make Sure a Hedger Does Not Become a Speculator (3) Summary. (1) Make Sure You Fully Understand the Trades You Are Doing: a simple rule of thumb is that if a trade and the rationale for entering into it are so complicated that they cannot be understood by the manager, it is almost certainly inappropriate for the corporation. One way of ensuring that you fully understand a financial instrument is to value it. If a corporation does not have the in-house capability to value an instrument, it should not trade it. In practise, corporations often rely on their derivatives dealers for valuation advice, which can be dangerous. (2) Make Sure a Hedger Does Not Become a Speculator: in order for this not to happen, clear limits to the risks that can be taken should be set by senior management. Controls should be put in place to ensure that the limits are obeyed. The trading strategy for a corporation should start with an analysis of the risks facing the corporation in foreign exchange, interest rate, commodity markets, etc. A decision should then be taken on how the risks are to be reduced to acceptable levels.Be Cautious about Making the Treasury Department a Profit Center: again, the treasurer might forget that the goal of a hedging program is to reduce risks, not to increase expected profits. The potential to make profits for the treasurer is limited, and improving the bottom line would only mean taking more risks. This can turn the treasurer into a speculator. (3) Summary: derivatives can be used for either hedging or speculation; that is, they can be used either to reduce risks or to take risks. A lot of big historical losses have occurred because derivatives were used inappropriately. Employees who had an implicit or explicit mandate to hedge their company’s risks decided instead to speculate. The key lessons to be learned from the losses is the importance of internal controls. Final exam 13.01.2017 1. Briefly explain the following words and expressions: a) Zero curve —> also known as, zero-coupon yield curve, is a plot of the zero-coupon interest rate against time to maturity. A common assumption is that the zero curve is linear between the points determined, as well is that it is horisontal prior to the first and last point. Ex: b) Repo —> Repurchase agreement. A financial institution that owns securities agrees to sell the securities for a certain price and buy them back at a later time for a slightly higher price. The financial institution is obtaining a loan and the interest it pays is the difference between the price at which the securities are sold and the price at which they are repurchased. The interest rate is referred to as the repo rate. c) iTraxx Europe —> Portfolio of 125 investment-grade European companies. Participants in credit markets have developed indices to track credit default swap spreads. Two important standard portfolios used by index providers are: CDX NA IG and iTraxx Europe (both portfolios of 125 investment grade companies in North America respectively Europe). These portfolios are updates on March 20 and September 20 each year. Companies that are no longer investment grade are dropped from the portfolios and new investment grade companies are added. ’’The indices are constructed on a set of rules with the overriding criterion being that of liquidity of the underlying credit default swaps (CDS)’’. ’’iTraxx is a group of international credit derivative indices that investors can use to gain or hedge exposure to the credit markets underlying the credit derivatives. The credit derivatives market that iTraxx provides allows parties to transfer the risk and return of underlying assets from one party to another without actually transferring the assets. These indexes allow market makers and active participants in the swaps market to take the other side of trades for a short period and provide liquidity in these markets. The iTraxx indices were developed to bring greater liqudity, transparency and acceptance to the credit default swap market. ’’. d) Gamma-neutral portfolio —> A portfolio with a gamma of zero. A gamma neutral portfolio can be created by taking positions with offsetting deltas. This helps to reduce variations due to changing market prices and conditions. A gamma neutral portfolio is still subject to risk, however. For example, if the assumptions used to establish the portfolio turns out to be incorrect, a position that is supposed to be neutral may turn out to be risky. Furthermore, the position has to be rebalanced as prices change and time passes.  Delta = the rate of change of the price of a derivative with the price of the underlying asset. Delta is the incremental price change in a derivative, for a one percent move in the underlying security. A delta of 0.54 for a call would mean that if the underlying asset would trade up by one point, you would make about 54 cents per option contract on this trade. The delta for a put is always negative, because an increase in stock price is obviously not good for buyers. In the aforementioned case the delta for the put would be -0.46 (1-0.54). Meaning, you would lose 46 cents per option contract. Gamma = the rate of change of delta with respect to the asset price. Gamma is an always positive number for both calls and puts, and its really the rate of change of delta. Both gamma and delta are constantly moving with the stock prices in the market. For a gamma of about 0.10 in the underlying security (in this case the aforementioned call), the delta could change by an additional 10 cents. So if the underlying call goes up by 1 point, we could make in this particular instance for the call options about.54 cents. And if it goes up another 1 point, we could make another.54 + 0.1. If it a put 0.46 - gamma, in this case -.46 -0.11 = -0.57 e) Embedded option —> An option that is a part of another instrument. It is a feature of a financial security that lets issuers or holders take specific actions against the other party at some future time. Examples: callable bonds and convertible bonds. Some swaps contain embedded options as well. Accrual swaps are swaps where the interest on one side accrues only when the floating reference rate is within certain range(which either remains fixed or is reset periodically). Cancelable swaps is a ’plain vanilla’ interest rate swap where one side has the option to terminate on one or more payment dates. Terminating a swap is the same as entering into the offsetting (opposite) swap. Sometimes compounding swaps can be terminated on specified payment dates. On termination, the floating-rate payer pays the compounded value of the floating amounts up to the time of termination and the fixed-rate payer pays the compounded value of the fixed payments up to the time of termination. These are called Cancelable Compounding Swaps. Compounding swap = A compounding swap is an interest rate swap in which interest, instead of being paid, compounds forward until the next payment date. Compounding swaps can be valued by assuming that the forward rates are realised. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) Oversight by large institutional investors or creditors is one mechanism to reduce agency problems. Why don’t individual investors in the firm have the same incentives to keep an eye on management? —> Even if an individual shareholder could monitor and improve managers’ performance, and thereby increase the value of the firm, the payoff would be small, since the ownership share in a large corporation would be very small. For example, if you own 10 000€ of Ford stock, and can increase the value of the firm by 5%, a very ambitious goal, you benefit only 500€. In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake in making sure that the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm. b) Explain carefully why liquidity preference theory is consistent with the observation that the term structure of interest rates tends to be upward sloping more often than it is downward sloping? —>If long-term rates were simply a reflection of expected future short-term rates, we would expect the term structure to be downward sloping as often as it is upward sloping. (This is based on the assumption that half of the time investors expect rates to increase and half of the times rates to decrease). Liquidity preference theory argues that long term rates are high relative to expected future short-term rates. This means that the term structure should be upward sloping more often than it is downward sloping. c) Give an intuitive explanation why the early exercise of an American option becomes more attractive as the risk-free rate increases and volatility decreases? —> The early exercise of an American put is attractive when the interest rate earned on the strike price is greater than the insurance element lost. When interest rates increase, the value of the interest earned on the strike price increases making early exercise more attractive. When volatility decreases, the insurance level is less valuable. Again this makes early exercise more attractive. d) What is meant by the gamma of an option position? What are the risks in the situation where the gamma of a position is large and negative and the delta is zero? —>The gamma of an option position is the rate of change of the delta of the position with respect to asset price. For example, a gamma of 0.1 would indicate that when the asset price increase by a certain small amount delta increases by 0.1 of this amount. When the gamma of an onion writer’s position is large and negative and the delta is zero, the option writer will lose significant amounts of money if there is a large movement (either an increase or decrease) in the asset price. e) If the stock price falls and the call price rises, what has happened to the implied volatility? —>Implied volatility has increased. If not, the call price would have fallen as a result of the decrease in stock price. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Active bond management strategies. Discuss the sources of profit and the strategies. (BKM, 16.4). Table of contents: (1) The Potential Value of Active Bond Management? (2) Bond Portfolio Strategies According to Homer and Liebowitz (3) The Four Bond Swaps (4) Summary (1) Broadly speaking, there are two sources of potential value in active bond management. The first is interest rate forecasting, which tries to anticipate movements across the entire spectrum of the fixed-income market. If interest rate declines are anticipated, managers will increase portfolio duration and vice versa. The second source of potential profit is identification of relative mispricing within the fixed-income market. An analyst, for example, might believe that the default premium on one particular bond is unnecessarily large and therefore that the bond is underpriced. These techniques will generate abnormal returns only if the analyst’s information or insight is superior to that of the market. (du vet nåt som marknaden inte vet). It is worth noting, though, that interest rate forecasters have a notoriously poor track record. (2) Homer and Liebowitz coined a popular taxonomy of active bond portfolio strategies. They characterise portfolio rebalancing activities as one of four types of bond swaps. In the first two swaps, the investor typically believes that the yield relationship between bonds or sectors is only temporarily out of alignment. When the aberration is eliminated, gains can be realised on the underpriced bond. The period of realignment is called the workout period. (3) The substitution swap is an exchange of one bond for nearly identical substitute. The substituted bonds should be of essentially equal coupon, maturity, quality, call features, sinking fund provisions, and so on. This swap would be motivated by a belief that the market has temporarily mispriced the two bonds, and that the discrepancy between the prices of the bonds represents a profit opportunity. The intermarket spread swap is pursued when an investor believes that the yield spread between two sectors of the bonds market is temporarily out of line. (arbitrage opportunity). The rate anticipation swap is used when investors believe that rates will fall, and they swap into bonds of longer duration. Conversely, when rates  are expected to rise, they will swap into shorter duration bonds. And finally the pure yield pickup swap is pursued not in response to perceived mispricing, but as a means of increasing return by holding higher-yield bonds. When the yield curve is upward-sloping, the yield pickup swap entails moving into longer-term bonds. This must be viewed as an attempt to earn an expected term premium in higher-yield bonds. We can add a fifth swap, called the tax swap, which simply refers to a swap which exploits some tax advantage. For example, an investor may swap from one bond that has decreased in price to another if realization of capital losses is advantageous for tax purposes. (4) Active bond management consists of interest rate forecasting techniques and inter market spread analysis. One popular taxonomy classifies active strategies as substitution swaps, inter market spread swaps, rate anticipation swaps, and pure yield pickup swaps. 4. Management of credit risk (counterparty risk) for exchange traded futures and futures traded in the OTC markets. Discuss the workings of the main methods for mitigating the risk of loss for an investor on the derivative transactions in case of default of the futures contract counterparty? (Hull, 2.4-5, 23.8) Table of contents: (1) Central Counterparties (2) Bilateral Clearing Over-the-counter markets are markets where companies agree to derivatives transactions without involving an exchange. Credit risk has traditionally been a feature of OTC derivatives markets. (1) In an attempt to reduce credit risk, the OTC market has borrowed some ideas from exchange- traded markets…CCPs are clearing houses for standard OTC transactions that perform much the same role as exchange clearing houses. Members of the CCP, similarly to members of an exchange clearing house, have to provide both initial margin and daily variation margin. Like members of an exchange clearing house, they are also required ro contribute to a guaranty fund. Once an OTC derivative transaction has been agreed upon between two parties A and B, it can be presented to a CCp. Assuming the CCP accepts the transaction, it becomes the counterparty to both A and B. For example, if the transaction is a forward contract where A has agreed to buy an asset from B in one year for a certain price, the clearing house agrees to i) Buy the asset from B in one year for the aged price, and ii) Sell the asset to A in one year for the agreed price. It takes on the credit risk for both A and B. Central Counterparties = Established by exchanges to facilitate transfer of securities resulting from trades. For options and futures contracts, the clearinghouse may interpose itself as a middleman between two traders. (2)Those OTC transaction that are not cleared through CCPs are cleared bilaterally.In the bilaterally-cleared OTC market, two companies A and B usually enter into a master agreement covering all their trades. This agreement often includes an annex, referred to as the credit support annex or CSA, requiring A or B, or both, to provide collateral. Collateral agreements in CSAs usually require transactions to be valued each day. Collateral significantly reduces risk in the bilaterally cleared OTC market. Resten se: Final exam 15.01.2016 Final exam 16.12.2016 1. Briefly explain the following words and expressions: a) Eurobond —>A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond. b) Systemic risk —> OBS! inte samma som systematisk risk. Risk of breakdown in the financial system, particularly due to spillover effects from one market into others. c) Intermarket spread swap —> is pursued when an investor believes that the yield spread between two sectors of the bonds market is temporarily out of line. (arbitrage opportunity). For example, if the current spread between corporate and government bonds is considered too wide and is expected to narrow, the investor will shift from government bonds into corporate bonds. If the yield spread does in fact narrow, corporates will outperform governments. …Of course, the investor must consider carefully whether there is a good reason that the yield spread seems out of alignment. For example, the default premium on corporate bonds might have increased because the market is expecting a severe recession. d) Hedge ratio —> The ratio of the size of a position in a hedging instrument to the size of the position being hedged. When the asset underlying the futures contract is the same as the asset being hedged, it is natural to use a hedge ratio of 1.0. This is the hedge ratio we have used in the examples considered so far. For instance, a hedger’s exposure was on 20 000 barrels of oil, and futures contracts were entered into for the delivery of exactly this amount of oil. e) Protective put —> Purchase of stock combined with a put option that guarantees minimum proceeds equal to the put’s exercise price. A put combined with a long position in the underlying asset. For example, buying a European put option on a stock and the stock itself. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) What is meant by a ’’bottom-up’’ investment style? Give three disadvantages of this investment style. —> In this process, the portfolio is constructed from the securities that seem attractively priced, without as much concern for the resultant asset allocation. Such a technique (1)can result in unintended bets none or another sector of the economy. For example, it might turn out that the portfolio ends up with a very heavy representation of firms in one industry, (1)from one part of the country, or with (3)exposure to one source of uncertainty. However, a bottom-up strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities. (FACIT) With a “top-down” investing style, you focus on asset allocation or the broad composition of the entire portfolio, which is the major determinant of overall performance. Moreover, top-down management is the natural way to establish a portfolio with a level of risk consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top-down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market. With a “bottom-up” investing style, you try to benefit from identifying undervalued securities. The disadvantage is that you tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with your level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, your analysis may be incorrect, in which case you will have fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy. b) A bond has a current yield of 9% and a yield to maturity of 10%. a) Is the bond selling above or below par? b) Is the coupon rate more or less than 9%? —> a) If the yield to maturity is greater than the current yield, then the bond offers the prospect of price appreciation as it approaches its maturity date. Therefore, the bond must be selling below par value. b) The coupon rate is less than 9%. If coupon divided by price equals 9%, and price is less than par, then price divided by par is less than 9%. c) Which are the five rules of duration? —> (1)The duration of a zero-coupon bond equals its time to maturity. (2) Holding maturity constant, a bond’s duration is lower when the coupon rate is higher. (3) Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity. Duration always increases with maturity for bonds selling at par or at premium to par. (4) Holding other factors constant (ceteris paribus), the duration of a coupon bond is higher when the bond’s yield to maturity is lower. (while a higher yield reduces the pv of all of the bond’s payments, it reduces the value of more-distant payments by a greater proportional amount. Therefore, at higher yields a higher fraction of the total value of the bond lies in its earlier payments, thereby reducing effective maturity). (5) The duration of a perpetuity: (1+y)/y d) The party with a short position in a futures contract sometimes has options as to the precise asset that will be delivered, where the delivery will take place, when delivery will take place, and so on. Do these options increase or decrease the futures price? —>These options make the contract less attractive to the party with the long position and more attractive to the party with the short position. They therefore tend to reduce the futures price. e) a) Why is an American call option on a dividend-paying stock always worth at least as much as its intrinsic value? b) Is the same true of a European call option? —> An American call option can be exercised at any time. If it is exercised its holder gets the intrinsic value. It follows that an American call option must be worth at least its intrinsic value. A European call option can be worth less than its intrinsic value. Consider, for example, the situation where a stock is expected to provide a very high dividend during the life of an option. The price of the stock will decline as a result of the dividend. Because the European option can be exercised only after the dividend has been paid, its value may be less than the intrinsic value today. 3., & 4. Se: Final exam 15.12.2017 Final exam 15.01.2016 1. Briefly explain the following words and expressions: b) Zero curve —> Also known as, zero-coupon yield curve, is a plot of the zero-coupon interest rate against time to maturity. A common assumption is that the zero curve is linear between the points determined, as well is that it is horisontal prior to the first and last point. Ex: b) Repo —> Repurchase agreement. A financial institution that owns securities agrees to sell the securities for a certain price and buy them back at a later time for a slightly higher price. The financial institution is obtaining a loan and the interest it pays is the difference between the price at which the securities are sold and the price at which they are repurchased. The interest rate is referred to as the repo rate. c) Margin call —> A request for extra margin when the balance in the margin account falls below the maintenance margin level. d) Gamma- neutral portfolio (412-413 Hull) —> A portfolio with a gamma of zero. A gamma neutral portfolio can be created by taking positions with offsetting deltas. This helps to reduce variations due to changing market prices and conditions. A gamma neutral portfolio is still subject to risk, however. For example, if the assumptions used to establish the portfolio turns out to be incorrect, a position that is supposed to be neutral may turn out to be risky. Furthermore, the position has to be rebalanced as prices change and time passes. e) Embedded option —> An option that is a part of another instrument. It is a feature of a financial security that lets issuers or holders take specific actions against the other party at some future time. Examples: callable bonds and convertible bonds. Some swaps contain embedded options as well. Accrual swaps are swaps where the interest on one side accrues only when the floating reference rate is within certain range(which either remains fixed or is reset periodically). Cancelable swaps is a ’plain vanilla’ interest rate swap where one side has the option to terminate on one or more payment dates. Terminating a swap is the same as entering into the offsetting (opposite) swap. Sometimes compounding swaps can be terminated on specified payment dates. On termination, the floating-rate payer pays the compounded value of the floating amounts up to the time of termination and the fixed-rate payer pays the compounded value of the fixed payments up to the time of termination. These are called Cancelable Compounding Swaps. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) Compare two yields for a (default-free) zero coupon bond: the stated yield to maturity and the realised compound yield to maturity. Is the realised compound yield higher, lower or are the yields the same? Why? —> (higher) Realized yield is the actual return earned during the holding period for an investment, and may include dividends, interest payments, and other cash distributions. The term may be applied to a bond sold before its maturity date or dividend-paying security. Generally speaking, the realized yield on bonds includes the coupon payments received during the holding period, plus or minus the change in the value of the original investment, calculated on an annual basis. realized compound return Yield assuming that coupon payments are invested at the going market interest rate at the time of their receipt and rolled over until the bond matures. b) Why does a loan in the repo market involve very little credit risk? —> A repo is a contract where an investment dealer who owns securities agrees to sell them to another company now and buy them back later at a slightly higher price. The other company is providing a loan to the investment dealer. This loan involves very little credit risk. If the borrower does not honor the agreement, the lending company simply keeps the securities. If the lending company does not keep to its side of the agreement, the original owner of the securities keeps the cash. c) Suppose that the spot price of the euro is currently $1.30 and the futures price is $1.33. Is the interest rate higher in the US or the euro zone? —> Arbitrageurs should buy euro short future d) Explain carefully how the value of credit default swap is calculated? (Hull, p 524-525) —> Example: two parties enter into a 5-year CDS on March 20, 2019. Assume that the notional principal is 100 million and the buyer agrees to pay 90 basis points per annum for protection against default by the reference entity, with payments being made quarterly in arrears. If the reference entity does not default, the buyer receives no payoff and pays 22.5 basis points (a quarter of 90 basis points) on 100 million on June is , 2015, and every quarter thereafter until March 20, 2020. The amount paid each quarter is 0.00225 * 100,000,000, or $225,000. If there is a credit event, a substantial payoff is likely. Suppose the buyer notifies the seller of a credit event on May 20, 2018 (2 months into the fourth year). The regular quarterly, semiannual, or annual payments from the buyer of protection to the seller of protection cease when there is a credit event. However, because these payments are made in arrears, a final accrual payment by the buyer is usually required. In our example, where there is a default on May 20, 2018, the buyer would be required to pay to the seller the amount of the annual payment accrued between March 20, 2018, and May 20, 2018 (approximately $150,000), but no further payments would be required. CDS = A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy. e) Give two reasons that the early exercise of an American call option on a non-dividend paying stock is not optimal. The first reason should involve the time value of money. The second reason should apply even if interest rates are zero. —>Delaying exercise delays the payment of the strike price. This means that the option holder is able to earn interest on the strike price for a longer period of time. Delaying exercise also provides insurance against the stock price falling below the strike price by the expiration date. Assume that the option holder has an amount of cash K and that interest rates are zero. When the option is exercised early it is worth ST at expiration. Delaying exercise means that it will be worth max (K ST ) at expiration. When answering the following two essay-type questions, start with a table of contents! 10p +10p 􏰂 3. Arguments for and against hedging in non-financial companies. (Hull, 3.2). Table of contents: (1) Introduction (arguments for) (2) Arguments for (3) Arguments against (4) End (1) Most nonfinancial companies are in the business of manufacturing, or retaining or wholesaling, or providing a service. They have no particular skills or expertise in predicting variables such as interest rates, exchanges, and commodity prices. It makes sense for them to hedge the risks associated with these variables as they become aware of them. The companies can then focus on their main activities — for which presumably they do have particular skills and expertise. By hedging, they avoid unpleasant surprises such as sharp rises in the price of a commodity that is being purchased. (2) OBS de här e financial koska shareholders In practise, many risks are left unhedged. One argument is that the shareholders can, if they wish, do the hedging themselves. Though, this assumes that shareholders have as much information as the company’s management about the risks faced by a company. The argument also ignores commissions and other transactions costs. These are less expensive per dollar of hedging for large transactions than for small transactions. Hedging is therefore likely to be less expensive when carried out by the company than by individual shareholders. Also, the size of futures contracts makes hedging by individual shareholders impossible in many situations. It is easier for a shareholder to create a well-diversified portfolio, and might this way avoid many of the risks faced by a corporation. This might mean that the company hedging would be unnecessary. (3) If hedging is not the norm in a certain industry, it may not be worth for a company to use hedging. Competitive pressures within the industry may be such that the prices of the goods and services produced by the industry fluctuate to reflect raw material costs, interest rates, exchange rates, and so on. In this case, a company can expect its profits margins to be roughly constant, no hedging needed. In fact, an effect of hedging in an environment like this would actually be a fluctuation of profit margins. An example could be hedging in the jewellery industry. If the price of gold were to go down, economic pressures will tend to lead to a corresponding decrease in the wholesale price of jewellery, leaving the profit margin of an unhedged company unaffected. In extreme conditions a hedged company, however, could find its profit margin having become negative. (4) Hedging reduces risk for the company, however it is important to remember that it is unknown wether it will increase or decrease the company’s profits. It all depends on in which way the price of the underlying asset evolves. Before hedging, a treasurer should confirm that all senior executives within the organisation fully understand the possible outcomes of a decision to hedge. 4. Credit risk mitigation techniques in derivatives trading. What kind of clauses are used in derivative trading contracts to mitigate counterparty credit risk? Explain how they work. (Hull 23.8). (sidan 558 pdf) Table of contents: (1) Netting (2) Haircut (3) Downgrade trigger (1) There are a number of ways banks try to reduce credit risk in bilaterally cleared transactions. One of them is netting, which is the ability to offset contracts with positive and negative values in the event of a default by a counterparty or for the purpose of determining collateral requirements. Suppose a bank has three uncollaterlized transactions with a counterparty worth +$10 million, + $30 million, and -$25 million. If they are regarded as independent transactions, the bank’s exposure on the transactions is $10 million, $30 million, and $0 for a total exposure of $40 million. With netting, the transactions are regarded as a single transaction worth $15 million and the exposure is reduced from $40 million to $15 million. (2) Collateral agreements are important way of reducing credit risk. Collateral can be either cash (which earns interest) or marketable securities. The market value of the latter may be reduced by a certain percentage to calculate their cash-equivalent for collateral purposes. The reduction is referred to as a haircut. Derivatives transactions receive favourable treatment the event of a default. The non defaulting party is entitled to keep any collateral posted by the other side. Expensive and time-consuming legal proceedings are not usually necessary. (3) Another credit risk mitigation technique used by financial institutions is known as a downgrade trigger. This is a clause the Master Agreement stating that if the credit rating of the counterparty falls below a certain level, say BBB, the bank has the option to close out all outstanding derivatives transactions at market value. Downgrade triggers do not provide protection against a relatively big jump in a company’s credit rating (e.g. from A to default). Moreover, they work well only if relatively little use is made of them. If a company has many downgrade triggers with its counterparties, they are likely to provide little protection to those counterparties. Netting = the ability to offset contracts with positive and negative values in the event of a default by a counterparty or for the purpose of determining collateral requirements. Haircut = discount applied to the value of an asset for collateral purposes. Downgrade trigger = a clause in a contract that states that the contract will be terminated with a cash settlement if the credit rating of one side falls below a certain level. Final exam 17.12.2015 1. Briefly explain the following words and expressions: a) Financial intermediary —> A bank or other financial institution that facilitates the flow of funds between different entities in the economy. b) Par yield —> The coupon on a bond that makes its price equal to the principal. c) Intermarket spread swap —> Switching from one segment of the bond market to another, from Treasuries to corporates, for example). d) Hazard rate —> Measures probability of default in a short period of time conditional on no earlier default. e) Dynamic hedging (403, 405-408, 418). —> A procedure for hedging an option position by periodically changing the position held in the underlying asset. The objective is usually to maintain a delta-neutral position. (Hull. s 403) ’’It is important to realise that, since the delta of an option does not remain constant, the trader’s position remains delta hedged (or delta neutral) for only a relatively short period of time. The hedge has to be adjusted periodically. This is known as rebalancing. In our example, by the end of 1 day the stock price might have increased to $110. An indicated by figure 19.2, an increase in the stock price leads to an increase in delta. Suppose that delta rises from 0.60 to 0.65. An extra 0.05 * 2,000 = 100 shares would then have to be purchased to maintain the hedge. A procedure such as this, where the hedge is adjusted on a regular basis, is referred to as dynamic hedging. It can be contrasted with static hedging, where a hedge is set up initially and never adjusted. Static hedging is sometimes also referred to as ’hedge-and-forget’’’. (Sold 2 000 options, delta 0.6 —> buy 0.6*2 000 = 1 200 shares). Delta neutral = Delta neutral is a portfolio strategy utilising multiple positions with balancing positive and negative deltas so that the overall delta of the assets in question totals zero. ’’…we can say that options can be valued by setting up a delta-neutral position and arguing that the return on the position should (instantaneously) be the risk-free interest rate’’. 2., 3., & 4. Se: Final exam 19.12.2019 Final exam 14.01.2015 1. Briefly explain the following words and expressions: a) Repo b) Strip bonds —> Zero-coupon bonds created by selling the coupons on Treasury bonds separately from the principal. Coupon stripping into separate zero-coupon bonds. (Hull, s.109) ’’Investment banks have developed a way of creating a zero-coupon bond, called a strip, from a coupon-bearing Treasury bond by selling each of the cash flows underlying the coupon-bearing bond as a separate security’’. c) Protective put d) Hazard rate e) Cross hedging —> Hedging an exposure to the price of one asset with a contract on another asset. (Hull, s.58) ’’Cross hedging occurs when the asset underlying the futures contract is not the same as the asset whose price is being hedged. Consider, for example, an airline that is concerned about the future price of jet fuel. Because jet fuel futures are not actively traded, it might choose to use heating oil futures contracts to hedge its exposure. The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure. When the asset underlying the futures contract is the same as the asset being hedged, it is natural to use a hedge ratio of 1.0’’. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p c) What are the main differences between typical forward contracts and typical future contracts? Describe at least four out of six typical differences. (Hull, 2.11). d) Explain carefully why the futures price of gold can be calculated from its spot price and other observable variables whereas the futures price of copper cannot. (Hull, 5.5). —> Gold is an investment asset. If the futures price is too high, investors will find it profitable to increase their holdings of gold and short futures contracts. If the futures price is too low, they will find it profitable to decrease their holdings of gold and go long in the futures market. Copper is a consumption asset. If the futures price is too high, a strategy of buy copper and short futures works. However, because investors do not in general hold the asset, the strategy of sell copper and buy futures is not available to them. There is therefore an upper bound, but no lower bound, to the futures price. e) Explain why margins are required when clients write options but not when they buy options. (Hull 9.4). —> When an investor buys an option, cash must be paid up front. There is no possibility of future liabilities and therefore no need for a margin account. When an investor sells an option, there are potential future liabilities. To protect against the risk of a default, margins are required. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Types of traders in derivative markets. (Hull ch. 1.6-1.9) Table of contents: (1) Hedgers (2) Speculators (3) Arbitrageurs The broad categories of traders can be identified: hedgers, speculators, and arbitrageurs. (1) Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable. Hedging can be made using forward contracts or using options. Forward contracts are designed to neutralise risk by fixing the price that the hedger will pay or receive for the underlying asset. Option contracts, by contrast, provide insurance. They offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favourable price movements. Good outcomes become very good, while bad outcomes result in the whole initial investment being lost. Unlike forwards, options involve the payment of an upfront fee. (2) Speculators use derivatives to bet on the future direction of a market. Speculating can be done using futures or options. These are similar instruments for speculators, in that they both provide a way in which a type of leverage can be obtained. Since a futures contract obligates the holder to buy or sell an asset at a predetermined delivery price during a specified future time period, the potential loss as well as the potential gain is very large. When options are used, no matter how bad things get, the speculator’s loss is limited to the amount paid for the options. (3) Arbitrageurs are a third important group of participants in futures, forward, and options markets. Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets. A simple example would be if the same stock trades simultaneously on two different markets for two different prices. An arbitrageur would buy the lower-priced share, and obtain a risk-free profit by selling it on the other market for a higher price. Though, transactions costs would probably eliminate the profit for a small investor. A large investment bank, however, faces very low transactions costs in both the stock market and the foreign exchange market. 4. Passive bond management. Discuss what is meant by passive management, the main classes of strategies, the main purposes of them, and main drawbacks or limitations. Table of contents: (1) Introduction (2) Bond-Index Funds (3) Immunisation (4) Cash Flow Matching and Dedication - solution to immunisation problems? (5) Other Problems with Conventional Immunisation (1) Passive managers take bond prices as fairly set and seek to control only the risk of their fixed- income portfolio. Two broad classes of passive management are pursued in the fixed-income market. The first is an indexing strategy that attempts to replicate the performance of a given bond index. The second broad class of passive strategies is known as immunisation techniques; they are used widely by financial institutions such as insurance companies and pension funds, and are designed to shield the overall financial status of the institution from exposure to interest rate fluctuations. Although indexing and immunisation strategies are alike in that they accept market prices as correctly set, they are very different in terms of risk exposure. A bond-index portfolio will have the same risk-reward profile as the bond market index to which it is tied. In contrast, immunisation strategies seek to establish a virtually zero-risk profile, in which interest rate movements have no impact on the value of the firm. (2) In principle bond market indexing is similar to stock market indexing. The idea is to create a portfolio that mirrors the composition of an index that measures the broad market. The first problem that arises in the formation of an indexed bond portfolio is the fact that these indexes include thousands of securities, making it quite difficult to purchase each security in the index in proportion to market value. Moreover, many bonds are vey thinly traded, meaning that identifying their owners and purchasing the securities at a fair market price can be difficult. The second problem is that bonds are both continually dropped from the index as their maturities fall below 1 year, as well as new bonds that are issued are also added to the index. In other words, the securities used to compute bond indexes constantly change. Moreover, the fact that bonds generate considerable interest income that must be reinvested complicates the job of the index manager even more. Since this is virtually impossible, a stratified sampling or cellular approach is often pursued. First, the bond market is stratified into several subclasses, for example Treasury, Mortgage-backed, Yankee… Next, the percentages of the entire universe (the bonds included in the index that is to be matched) falling within each cell are computed and reported. Finally, the portfolio manager establishes a bond portfolio with representation for each cell that matches the representation of that cell in the bond universe. In this way, the characteristics of the portfolio in terms of maturity, coupon rate, credit risk, industrial representation, and so on, will match the characteristics of the index, and the performance of the portfolio likewise should match the index. (3) In contrast to indexing strategies, many institutions try to insulate their portfolios from interest rate risk altogether. Generally, there are two ways of viewing this risk. Some institutions, such as banks, are concerned with protecting current net worth or net market value against interest rate fluctuations. Other investors, such as pension funds, may face an obligation to make payments after a given number of years. These investors are more concerned with protecting the future values of their portfolios. Many banks and thrift institutions have a natural mismatch between asset and liability maturity structures — liabilities primarily consisting of short-term and low duration deposits owed to customers, whereas assets compose largely of outstanding commercial and consumer loans or mortgages, which are of longer duration and more sensitive to interest rate fluctuations. A pension fund may also have a mismatch between the interest rate sensitivity of the assets held and the present value of its liabilities. (…the duration of fund investments tends to be shorter than the duration of its obligations, which makes funds vulnerable to interest rate declines). The lesson is that funds should match the interest rate exposure of assets and liabilities so that the value of assets will track the value of liabilities whether rates rise or fall — in other words, the financial manager might want to immunise the fund against interest rate volatility. Fixed-income investors face two offsetting types of interest rate risk: price risk and reinvestment rate risk. Increases in interest rates cause capital losses but at the same time increase the rate at which reinvested income will grow. If the portfolio duration is chosen appropriately, these two effects will cancel out exactly. When the portfolio duration is set equal to the investor’s horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations. For a horizon equal to the portfolio’s duration, price risk (the sale value of the bond) and reinvestment risk (accumulated value of the coupon payments) are precisely offsetting. That is, when interest rates fall, the coupons grow less than in the base case, but the higher value of the bond offsets this. When interest rates rise, the value of the bond falls, but the coupons more than make up for this loss because they are reinvested at the higher rate. However, one must remember that the coupon bond has greater convexity than the obligation it funds. Hence, when rates move substantially, the bond value exceeds the present value of the obligation by a noticeable amount. Therefore, as interest rates and asset durations change, a manager must rebalance the portfolio to realign its duration with the duration of the obligation. Moreover, even if interest rates do not change, asset duration will change solely because of the passage of time. Of course, rebalancing of the portfolio entails transactions costs as assets are bought or sold, so one cannot rebalance continuously. (4) If we follow the principle of cash flow matching we automatically immunise the portfolio from interest rate risk because the cash flow from the bond and the obligation exactly offset each other. Cash flow matching on a multiperiod basis is referred to as a dedication strategy. In this case, the manager selects either zero-coupon or coupon bonds with total cash flows in each period that match a series of obligation. The advantage of dedication is that it is a once-and-for-all approach to eliminating interest rate risk (no need for rebalancing). Though, cash flow matching is not more widely pursued because of the constraints that it imposes on bond selection. Also, sometimes cash flow matching is simply not possible. For example, to cash flow match for a pension fund that is obligated to pay out a perpetual flow of income to current and future retirees, the pension fund would need to purchase fixed-income securities with maturities ranging up to hundreds of years. (5) If the yield curve of a bond is not flat, then the definition of duration must be modified and instead calculated with the appropriate spot interest rate for each cash flow. Moreover, even with this modification, duration matching will immunise portfolios only for parallell shifts in the yield curve, which is quite unrealistic to find. ’’…If the obligation was immunised, why is there any surplus in the fun? The answer is convexity. The coupon bond has greater convexity than the obligation it funds. Hence, when rates move substantially, the bond value exceeds the present value of the obligation by a noticeable amount. Final exam 17.12.2015 1., 2., 3., &4. Se: Final exam 19.12.2019 Final exam 16.01.2014 1. Briefly explain the following words and expressions: b) Current yield —> A bond’s annual coupon payment divided by its price. Differs from yield to maturity. For example, for an 8% 30-year bond currently selling at 1 276,76€, the current yield would be 80/1276,76 = 0,0627 or 6,37%, per year. c) Debenture bond —> (Or unsecured bond) is a bond not backed by specific collateral. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p Se Final exam 13.01.2017 When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Which are the three main methods for calculating the default probability for publicly traded debt (bonds), and why do the different methods produce different estimates on default probability? (Hull ch. 23). Table of contents: (1) Historical Default Probabilities (2) Estimating Default Probabilities From Bond Yield Spreads (3) Using Equity Prices to Estimate Default Probabilities (1) Rating agencies typically create tables showing the default experience during for certain bonds during a time period, say 20 years. The probability of a bond defaulting during a particular year can be calculated from the table. It is often seen, that for investment-grade bonds, the probability of default in a year tends to be an increasing function of time. This is because the bond issuer is initially considered to be creditworthy, and the more time that elapses, the greater the possibility that its financial health will decline. For bonds wit a poor credit rating, the probability of default is often a decreasing function of time. The reason here is that, for a bond with a poor credit rating, the next year or two may be critical. The longer the issuer survives, the greater the chance that its financial health improves. (2) Another way of estimating default probabilities is to look at bond yield spreads. A bond’s yield spread is the excess of the promised yield on the bond over the risk-free rate. The usual assumption is that the excess yield is compensation for the possibility of default. The benchmark risk-free rate used by bond traders is usually a Treasury rate. The default probabilities estimated from historical data are usually much less than those derived from bond yield spreads. The difference between the two was particularly large during the credit crisis. This is because there was what is termed a ’’flight to quality’’ during the crisis, where all investors wanted to hold safe securities such as Treasury bonds. The prices of corporate bonds declined, thereby increasing their yields. The credit spread on these bonds increased and calculations gave very high default probability estimates. (3) Looking at tables with historical default probabilities, we are relying on the company’s credit rating. Unfortunately, credit ratings are revised relatively infrequently. This has led to some analysts to argue that equity prices can provide more up-to-date information for estimating default probabilities, which one can do using the Black-Scholes-Merton formula. 4. Se: Final exam 19.12.2019 Final exam 20.12.2014 1. Briefly explain the following words and expressions: b) Liquidity premium —> The amount that forward interest rates exceed expected future spot interest rates. c) Total return swap —> A swap where the return on an asset such as a bond is exchanged for LIBOR plus a spread. The return on the asset includes income such as coupons and the change in value of the asset. e) ABS CDO —> Asset-Backed Security, Collateralized Debt Obligation. An instrument where tranches are created from the tranches of ABSs. ’’…Finding investors to buy the senior AAA-rated tranches of ABSs was usually not difficult, because the tranches promised returns that were very attractive when compared with the return on AAA-rated bonds. Equity tranches were typically retained by the originator of the assets or sold to a hedge fund. Finding investors for mezzanine tranches was more difficult. This led to the creation of ABS of ABSs. Many different mezzanine tranches are put in a portfolio and the risks associated with the cash flows from the portfolio are tranches out in the same way as the risks associated with cash flows from the assets are tranches out in regular ABSs. The resulting structure is known as an ABS CDO or Mezz ABS CDO. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) What is the relationship between securitisation and the role of financial intermediaries in the economy? What happens to financial intermediaries as securitisation progresses? (BKM 1.3). —> Securitisation leads to disintermediation; that is, securitisation provides a means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. As securitisation progresses, financial intermediaries must increase other activities such as providing short-term liquidity to consumers and small business, and financial services. b) Explain carefully why liquidity preference theory is consistent with the observation that the term structure of interest rates tends to be upward sloping more often than it is downward sloping? (Hull 4.17) —> If long-term rates were simply a reflection of expected future short-term rates, we would expect the term structure to be downward sloping as often as it is upward sloping. (This is based on the assumption that half of the time investors expect rates to increase and half of the time expect rates to decrease). Liquidity preference theory argues that long term rates are high relative to expected future short-term rates. This means that the term structure should be upward sloping more often than it is downward sloping. (Liquidity preference theory = theory that the forward rate exceeds expected future interest rates). c) Give an intuitive explanation of why the early exercise of an American option becomes more attractive as the risk-free rate increases and volatility decreases? (Hull 10.13). —> The early exercise of an American put is attractive when the interest earned on the strike price is greater than the insurance element lost. When interest rates increase, the value of the interest earned on the strike price increases making early exercise more attractive. When volatility decreases, the insurance element is less valuable. Again, this makes early exercise more attractive. d) If the corn harvest today is poor, would you expect this fact to have any effect on today’s future price for corn to be delivered (post harvest) two years from today? Under what circumstances will there be no effect? (BKM 20.19) —> If a poor harvest today indicates a worse than average harvest in future years, then the futures prices will rise in response to today’s harvest, although presumably the two-year price will change by less than the one-year price. The same reasoning holds if corn is stored across the harvest. Next year’s price is determined by the available supply at harvest time, which is the actual harvest plus the stored corn. A smaller harvest today means less stored corn for next year which can lead to higher prices. Suppose first that corn is never stored across a harvest, and second that the quality of a harvest is not related to the quality of past harvests. Under these circumstances, there is no link between the current price of corn and the expected future price of corn. The quantity of corn and the price in one year will depend solely on the quantity of next year’s harvest, which has nothing to do with this year’s harvest. e) If the stock price falls and the call price rises, what has happened to the implied volatility? (BKM, 18.23). —> Implied volatility has increased. If not, the call price would have fallen as a result of the decrease in stock price. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Se: Final exam 19.12.2019 4. Derivative mishaps and the lessons to be learned: what lessons are primarily relevant to financial institutions? (Hull ch. 35.2). (Non-financial och all traders finns sen tidigare). Table of contents: (1) Monitor Traders Carefully (2) Separate the Front, Middle, and Back Office (3) Do Not Blindly Trust Models (4) Be Conservative in Recognising Inception Profits (5) Do Not Sell Clients Inappropriate Products (6) Beware of Easy Profits (6) Do Not Ignore Liquidity Risk (7) Beware When Everyone Is Following the Same Trading Strategy (8) Do not Make Excessive Use of Short-Term Funding for Long-Term Needs (9) Market Transparency Is Important (10) Manage Incentives (11) Never Ignore Risk Management (1) Monitor traders carefully: All traders — particularly those making high profits — should be fully accountable (of the trades they make). It is important for the financial institution to know whether the high profits are being made by taking unreasonably high risks. It is also important to check that the financial institution’s computer systems and pricing models are correct and are not being manipulated in some way. (2) Separate the front, middle, and back office: The front office in a financial institution consists of the traders who are executing trades, taking positions, and so forth. The middle office consists of risk managers who are monitoring the risks being taken. The back office is where the record keeping and accounting takes place. Some of the worst derivatives disasters have occurred because these functions were not kept separate. (3) Do not blindly trust models: Some of the large losses incurred by financial institutions arose because of the models and computer systems being used. If large profits are reported when relatively simple trading strategies are followed, there is a good chance that the models underlying the calculation of the profits are wrong. Similarly, if a financial institution appears to be particularly competitive on its quotes for a particular type of deal, there is a good chance that it is using a different model from other market participants, and it should analyse what is going on carefully. To the head of a trading room, getting too much business of a certain type can be just as worrisome as getting too little business of that type. (4) Be conservative in recognising inception profits: When a financial institution sells a highly exotic (nonstandard) instrument to a non-financial corporation, the valuation can be highly dependent on the underlying model. For example, instruments with long-dated embedded interest rate options can be highly dependent on the interest rate model used. In these circumstances, a phrase used to describe the daily marking to market of the deal is marking to model. This is because there are no market prices for similar deals that can be used as a benchmark. (5) Do not sell clients inappropriate products: It is tempting to sell corporate clients inappropriate products, particularly when they appear to have an appetite for the underlying risks. But this is shortsighted. (Also reputation-damaging). (6) Beware of easy profits: In general, transactions where high profits seem easy to achieve should be looked at closely for hidden risks. For example, investing in the AAA-rated tranches of the ABS CDOs that were created from subprime mortgages seemed like a fantastic opportunity. The promised returns were much higher than the returns normally earned on AAA-rated instruments. Many investors did not stop to ask whether the extra returns reflected risks not taken into account by the rating agencies. (7) Beware when everyone is following the same trading strategy: Financial engineers usually base the pricing of exotic instruments and other instruments that trade relatively infrequently on the prices of actively traded instruments. Par example: (i) A financial engineer often calculates a zero curve from actively traded government bonds (known as on-the-run bonds) and uses it to price government bonds that trade less frequently (off-the-run bonds); (ii) A financial engineer often implies the volatility of an asset from actively traded options and uses it to price less actively traded options; (iii) A financial engineer often implies information about the behaviour of interest rates from actively traded interest rate caps and swap options and uses it to price nonstandard interest rate derivatives that are less actively traded. These practises are not unreasonable. However, it is dangerous to assume that less actively traded instruments can always be traded at close to their theoretical price. In cases of for example a market shock liquidity becomes very important to investors, which means that illiquid instruments often sell at a big discount. (8) Do not make excessive use of short-term funding for long-term needs : It sometimes happens that many market participants are following essentially the same trading strategy. This creates a dangerous environment where there are liable to be big market moves, unstable markets, and large losses for the market participants. (9) Market transparency is important: All financial institutions finance long-term needs with short-term sources of funds to some extent. But a financial institution that relies too heavily on short-term funds is likely to expose itself to unacceptable liquidity risk. If investors lose confidence in the financial institution for some reason, it becomes impossible to get enough short- term funding, and the financial institution experiences severe liquidity problems. Many of the failures of financial institutions during the credit crisis (e.g. Lehman Brothers) were largely caused by excessive reliance on short-term funding. (10) Manage incentives: A key lesson from the credit crisis is the importance of incentives. The bonus systems in banks tend to emphasise short-term performance. Some financial institutions have switched to systems where bonuses are based on performance over a longer window, which doesn’t eliminate the problem, though. When loans are securitised, it is important to align the interests of the party originating the loan with the party who bears the ultimate risk so that the originator does not have an incentive to misrepresent the loan. One way of doing this is for regulators to require the originator of a loan portfolio to keep a stake in all the tranches and other instruments that are created from the portfolio. (11) Never ignore risk management: When times are good, there is a tendency to assume that nothing can go wrong and ignore the output from stress tests and other analyses carried out by the risk management group, which is exactly the wrong attitude to risk management. Securitisation = procedure for distributing the risks in a portfolio of assets. Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities(ABS). Final exam 15.01.2013 1. Briefly explain the following words and expressions: b) Eurodollars —>A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond. c) Marking to market —> The practice of revaluing an instrument to reflect the current values of the relevant market variables. ’’The traders working for banks should of course be free to use any procedures they like for determining the prices at which they are prepared to trade. However, transactions have to be valued daily for accounting and other purposes. This is referred to as marking-to-market the transactions. Accountants working for a bank aim to value a transaction at the ’exit price’. This is the current market price at which the bank could enter into an offsetting transaction. At any given time the exit price should be a price that clears the market (i.e. balances supply and demand). It should not depend on the funding cost of the bank holding the derivative. d) Theta —> The rate of change of the price of an option or other derivative with the passage of time. The theta of a portfolio of options is the rate of change of the value of the portfolio with respect to the passage of time with all else remaining the same. For a European call option on a non-dividend- paying stock, it can be shown from the Black-Scholes-Merton formula: where N’(x) e) Z-score —> Simply put, a Z-score (also called a standard score) gives you an idea of how far from the mean a data point is. A Z-score can be placed on a normal distribution curve. Z-scores range from -3 up to +3 standard deviations. In order to use a z-score, you need to know the mean µ and also the population standard deviation σ. If a Z-score is 0, it indicates that the data point’s score is identical to the mean score. A Z-score of 1.0 would indicate a value that is one standard deviation from the mean. Z-scores may be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean. 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) Suppose housing pricing across the world double. i) Is society any richer after the change? ii) Are homeowners wealthier? iii) Is anyone worse off as result of the change? (BKM 1.6). —> i) No. The increase in price did not add to the productive capacity of the economy. ii) Yes, the value of the equity held in these assets has increased. iii) Future homeowners as a whole are worse off, since mortgage liabilities have also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will endure the damage. b) Explain the impact of adding a call feature to a proposed bond issue on: i) The offering yield and ii) The bonds expected life. iii) Describe one advantage and one disadvantage of including callable bonds in a portfolio. (BKM cfa 14.5). —> i) A call feature is required to offer a higher rate of promised yield in order to compensate the investor as the firm decides to call back the bond. The call back of the bond is done at a time when the interest rates are declining. Investors give such an option to the issuer only if they are in a position to buy the bond at an expected price reflecting the possibility of calling back. ii) The call feature reduces the expected life of the bond. If interest rates fall substantially so that the likelihood of a call increases, investors will treat the bond as if it will ’’mature’’ and be paid off at the call date, not the stated maturity date. On the other hand if rates rise, the bond must be paid off at the maturity date, not later. This asymmetry means that the expected life of the bond is less than the stated maturity. iii) The advantage of a callable bond is the higher coupon (and higher promised yield to maturity) when the bond is issued. If the bond is never called, then an investor earns a higher realised compound yield on a callable bond issued at par than a non-callable bond issued at par on the same date. The disadvantage of the callable bond is the risk of a call. If rates fall and the bond is called, then the investor receives the call price and then has to reinvest the proceeds at interest rates that are lower than the yield to maturity at which the bond originally was issued. In this event, the firm’s savings in interest payments is the investor’s loss. c) How were the risks in ABS CDOs misjudged by the market? (Hull 8.9). —> Investors underestimated how high the default correlations between mortgages would be in stressed market conditions. Investors also did not always realise that the tranches underlying ABS CDOs were usually quite thin so that they were either totally wiped out or untouched. There was an unfortunate tendency to assume that a tranche with a particular rating could be considered to be the same as a bond with that rating. This assumption is not valid for the reasons just mentioned. d) How should the Black-Scholes model be modified for valuing i) European stock index options, and ii) European stock options on a stock paying a known dividend of $D before the option expires? —> i) A stock index is analogous to a stock paying a continuous dividend yield, the dividend yield being the one on the index. e) Explain why risk neutrality can be assumed when valuing options? —>The price of an option other derivative when expressed in terms of the price of the underlying stock is independent of risk preferences. Options therefore have the same value in a risk-neutral world as they do in the real world. We may therefore assume that the world is risk neutral for the purposes of valuing options. This simplifies the analysis. In a risk-neutral world all securities have an expected return equal to risk-free interest rate. Also, in a risk neutral world, the appropriate discount rate to use for expected future cash flows is the risk-free interest rate. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Passive bond management strategies. (BKM, 16.3). Se: Final exam 14.01.2015 4. Arguments for and against hedging. (Hull, 3.2). Se: Final exam 15.01.2016 för non-financial och financial (del nummer2 med ’shareholders’) Final exam 20.12.2012 1. Briefly explain the following words and expressions: a) Asked Price —> The price that a dealer is offering to sell an asset. b) CDO —> A way of packaging credit risk. Several classes of securities (known as tranches) are created from a portfolio of bonds and there are rules for determining how the cost of defaults are allocated to classes. e) Credit contagion —> A tendency of a default by one company to lead to defaults by other companies. (Dominoeffekt). 2. Briefly (no more than 10 lines/answer) answer the following questions. Remember to explain your answers! 20p a) The party with a short position in a futures contract… b) …Put following in order of magnitude… c) …siphon off capital from… d) Consider a stock without dividend payments. Is the price of an American call option higher than the price of an otherwise European call option? Why or why not? —>An American option can be exercised at any time, whereas a European option can only be exercised at the expiration date. This added flexibility of American options increases their value over European options in certain situations. Thus, we can say American Options = European Options + Premium where the Premium is greater than or equal to zero. For standard American call options without dividends, there are several reasons why the call should never be exercised before the expiration date. First, for a given movement in an underlying asset, the profit from holding an in the money call is equivalent to the profit from holding the underlying asset. The call option, however, has the added benefit of protecting against the risk of a downward price movement below the strike price. Additionally, because of the time value of money, it costs more to exercise the option today at a fixed strike price K than in the future at K. Finally, there is an intrinsic time value of the option that would be lost by exercising the option prior to the expiration date. Hence, the price of an American and European call option without dividends should not diverge. The price of an American call option on an underlying asset that pays dividends, however, may diverge from its European counterpart. For an American call with dividends it may be beneficial to exercise the option prior to expiration. By exercising the call, the owner of the call will be entitled to dividend payments that they would not have otherwise received. This means that prior to dividend announcement American options must include a premium based on some distribution of an expected dividend. Once the dividend is announced, the premium must be adjusted again to account for this revised information. (harvard.edu) e) How CDOs are calculated —> 178, 221, 572-579 Intrinsic value = the intrinsic value of an option is defined as the value it would have if there were no time to maturity, so that the exercise decision had to be made immediately. When answering the following two essay-type questions, start with a table of contents! 10p +10p 3. Recent trends. According to BKM four important trends have changed the contemporary investment environment. Which are the trends and how have they changed the financial sector? (BKM ch. 1.7). (egen åsikt, tycker att 3.5 e relevantare än finanskrisen ur USAs perspektiv). OFÄRDIGT Table of contents: (1) Algorithmic Trading (2) High-Frequency Trading (3) Dark Pools (4) Bond Trading. The marriage of electronic trading mechanisms with computer technology has had far- ranging impacts on trading strategies and tools. Algorithmic trading delegates trading decisions to computer programs. High frequency trading is a special class of algorith- mic trading in which computer programs initiate orders in tiny fractions of a second, far faster than any human could process the information driving the trade. Much of the market liquidity that once was provided by brokers making a market in a security has been displaced by these high-frequency traders. But when high-frequency traders abandon the market, as in the so-called ash crash of 2010, liquidity can likewise evaporate in a ash. Dark pools are trading venues that preserve anonymity, but also affect market liquidity. We will address these emerging issues later in this section. (1) Well more than half of all equity volume in the U.S. is believed to be initiated by computer algorithms. Many of these trades exploit very small discrepancies in security prices and entail numerous and rapid cross-market price comparisons. (2)(initiate orders in tiny fractions of a second, seeks to find discrepancies in trading prices. Neg. Flash crash). ‘’We pointed out that one high-frequency strategy entails a sort of market making, attempting to profit from the bid-ask spread. Another relies on cross-market arbitrage’’. (må den snabbaste vinna och få bäst avkastning). ‘’ this has induced trading firms to ‘co-locate’ their trading centers next to the computer systems of electronic exchanges’’. The Flash crash (2010) = The crash was triggered by a multimillion-dollar selling order which brought the price down, from $317.81 to $224.48, and caused the following flood of 800 stop-loss and margin funding liquidation orders, crashing the market. (3) Dark Pools means a private securities exchange in which investors, typica