Archive for the 'Derivatives' Category

Credit Exposures for Derivative Contracts

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Posted on 29th November 2008
Under: Derivatives, Futures, Investing in Commodities, Options, Portfolio Management, Risk Management, Swaps | No Comments »

Using Derivatives to Hedge Different Types of Credit Risk

There are three primary types of credit risk:

  • Default risk is the chance the issuer will fail to meet its obligations
  • Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
  • Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

Posted on 24th June 2008
Under: Derivatives, Fixed income investments, Futures, Investing in bonds, Portfolio Management | No Comments »

Information Content of the Option Volatility Skew

Deep out-of-money options tend to trade with higher implied volatility than near-money options, a phenomenon known as the volatility skew. In the October 2007 Journal of Futures Markets, Doran, Peterson and Tarrant extend this observation to ask whether the implied volatility skew becomes more positive immediately prior to a market spike or more negative immediately prior to a market crash.

They find that at the short end of the term structure, the skew does give information regarding an impending crash. There is less information conveyed from positive skew. Further along the term structure, information content from volatility skew is weak.

Posted on 5th May 2008
Under: Derivatives, Economic Analysis, Investment Returns, Options, Research | No Comments »

Combination Hedges

Financial futures markets typically use one instrument to hedge a position. For example, a 10-year note future might be used to hedge a position in 10-year Treasury securities. However, such hedges can often be imperfect due to the structure of futures markets. A futures position can be satisfied by delivery of a wide range of bonds, and the cheapest to deliver (CTD) option may have qualities that differ significantly from the bond being hedged.

In the January/February 2008 Financial Analysts Journal, Lawrence Morgan addresses this issue and provides an example: in February 2007, the 10-year T-note was yielding 4.625%, but the CTD for the June 2007 10-year note futures was the 4.25% November 2013 note – a 7 year instrument.

Morgan examines whether combination hedges, made by combining two hedging instruments, would provide a better match. Leschhorn (2001) developed and tested an approach for the German bond market in which the weights of the two hedging instruments were determined by their yield differentials. Morgan notes that this approach can frequently result in unstable hedge ratios.

Morgan extends the analysis to combination hedges weighted by option-adjusted and non-option adjusted modified durations, and finds that in general option-adjusted modified duration weighted combination hedges performed best.

Posted on 5th March 2008
Under: Active Management, Derivatives, Fixed income investments, Futures, Hedge Funds, Investing in bonds, Investment Returns, Performance Measurement, Risk Management | No Comments »

The Role of Derivatives in Rebalancing

Whether to rebalance a portfolio depends on the costs associated with rebalancing and the reduced tracking error resulting from doing so.  Research has demonstrated strategies to minimize transaction costs for a given level of tracking error, resulting in similar performance at lower cost relative to naive strategies observed in practice.

In the September/October 2007 Financial Analysts Journal, Brown, Ozik and Scholz demonstrate a derivatives-based strategy that offers significantly lower cost at the expense of being more difficult to design. This is due to the fact that the transaction costs and tracking error of such a synthetic strategy depend both on the cost of trading the derivatives and the length of time the derivatives are held.

Posted on 12th January 2008
Under: Asset Allocation, Derivatives, Futures, Investment Returns, Portfolio Management, Research, Risk Management | No Comments »

Managing Credit Risk Associated With Derivative Contracts

Derivative contracts are agreements between two parties to pay a cash flow or series of cash flows based on the value of some underlying instrument. Whenever one of the counterparties is owed a cash flow that party faces credit risk: the chance that the other party will fail to honor its obligation. There are a number of ways firms dealing with a large number of derivative contracts can manage this risk.

Position limits are simply pre-set guidelines on how much exposure can be allocated to a given party. The limits could be in dollar terms, a percentage of the notional value of total contracts, or based on other factors (such as allocating a higher limit to more trusted parties.)

Certain futures contracts are periodically “marked to market,” a process by which the interim differences in value are settled before the contracts expire. The associated mark to market payments are smaller and more frequent, reducing the credit risk compared to a single large payment at the end of the contract. The most one party could lose is the change in value during the time since the last mark to market.

Collateral such as margin are required for many contracts. The margin is a small percentage of the notional value kept in escrow. Usually if the margin falls to a specific percentage of how much is actually owed, either more margin must be put up or the margin is paid out and the contract terminated.

Netting procedures are set up for most contracts so that if both parties owe something only the difference (the net payment) is made by the party owing the larger amount. This reduces the credit risk and causes it to apply only to the party owed the larger amount.

Traditional credit analysis techniques can be used to vet counterparties according to credit standards at the outset of a contract. However, if the contract is long-term in nature the credit quality can change during the contract life.

Finally, there are a number of credit derivatives that can be used to transfer specific aspects of credit risk to other parties willing to accept the risk.

Posted on 3rd January 2008
Under: Derivatives, Futures, Options, Risk Management, Swaps | No Comments »

Tactical Asset Allocation in Portfolio Management

Strategic allocation sets the investor’s long-term exposures to systematic risk. Tactical asset allocation (TAA) involves short-term adjustments to asset weights based on short-term predictions of relative performance.

While strategic allocations are revisited only periodically or when there is a change in the investor’s circumstances, TAA is an active, ongoing discipline. In effect, it is active management at the asset class level. It often takes place as an interim step between the strategic asset allocation and the actual asset class management decisions. Alternatively, the asset management can be set and a derivative overlay strategy used to alter the asset class weights tactically.

Tactical asset allocation is based on three principles:

  1. Market prices explicitly describe the returns available (either cash yield or a yield + growth formula)
  2. Relative expected returns reflect relative perceptions of risk
  3. Markets are rational and mean reverting

Tactical asset allocation frequently seeks asset classes where risk premia are well above normal levels in anticipation of mean reversion. This requires judgment, as the mean reversion process can take many years.

Posted on 20th December 2007
Under: Active Management, Asset Allocation, Derivatives, FInancial Planning, Futures, Institutional Investing, Investment Returns, Portfolio Management | No Comments »

Equitizing a Long-Short Portfolio

Skilled managers are likely to be able to identify stocks that are priced too high as well as those that are underpriced. Theoretically, this skill should be maximized by using a market-neutral (long-short) portfolio in which each long position is matched by a corresponding short sale. However, over the long term stock prices generally rise, and investors may wish to capture this general market exposure (beta).

One way to capture Beta while maximizing manager skill (alpha) is to equitize the market neutral portfolio by holding index futures contracts.

Posted on 19th July 2007
Under: Asset Allocation, Derivatives, FInancial Planning, Futures, Investing in Stocks, Investment Returns, Portfolio Management | No Comments »

Creating an Index Portfolio Using Index Futures

Rather than buying the stocks in an index individually, a fund can gain exposure to all of the stocks at once using either basket (program) trades or stock index futures. A single S&P 500 futures contract provides exposure to 250 times the value of the S&P 500, while the e-mini futures contract provides 50x exposure. These contracts are very liquid, so a fund can gain exposure with minimal transaction costs.

Furthermore, by using an exchange of futures for physicals, the fund can use the futures as a low-cost way to gain access to a fully replicated portfolio. This can be useful because an all-futures portfolio must be rolled over periodically as futures expire in order to maintain appropriate exposure.

Posted on 19th July 2007
Under: Asset Allocation, Derivatives, Futures, Investing in Stocks, Investment Returns | No Comments »

Creating an Index Portfolio Using Total Return Swaps

An equity swap is an agreement between two parties in which one agrees to pay the total return on an equity or equity index portfolio and the other party agrees to pay an interest payment (usually either a fixed rate or one based on LIBOR) or the return on a different equity or index portfolio.

Swaps can be an efficient way for portfolios to gain access to an index, as the cost of the swap may be lower than the transaction costs of replicating the portfolio.

Active managers may also use swaps as an efficient way of increasing/decreasing exposure to various markets over time.

Posted on 16th July 2007
Under: Asset Allocation, Derivatives, FInancial Planning, Investing in Stocks, Investing in bonds, Investment Returns, Portfolio Management, Swaps | No Comments »