Archive for the 'Futures' 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 »

Characteristics of Managed Futures Investments and Their Role in a Portfolio

Derivative markets are zero-sum games, with each long position offset by a corresponding short. As such, the aggregate return to all participants in the futures market is the risk-free rate, less any management fees. In order for managed accounts to earn a positive risk-adjusted return after fees implies other market participants who systematically earn less than the risk-free rate. This is possible because many participants in the futures markets are hedgers, who may be willing to accept the lower return as an insurance premium protecting them from outlying events.

Managed futures managers can also exploit mispricing opportunities that arise when certain contracts are not trading at the proper relationship to other contracts.

Even with limited return opportunities, managed futures may play a role in the portfolio due to a low correlation of returns with those of traditional investments such as stocks and bonds. The diversification benefits have been shown to accrue even for portfolios that include other alternative assets such as hedge funds.

The Sharpe ratios of portfolios that include managed futures dominate those that do not. However, the benefits may be specific to the investment vehicle, time period and strategy under consideration. Managers have been shown to demonstrate short-term persistence in returns and a manager’s beta relative to his benchmark is often a good indicator of future returns.

Since futures involve leverage and derivatives, particular consideration should be paid to risk management strategies.

Posted on 28th September 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Personal Finance | No Comments »

Types of Managed Futures Accounts

Managed futures investments are investments in commodities by professional managers using skill-based strategies. The strategies employed may be either systematic trading methods which usually are trend-following or discretionary strategies based on analysis and judgment of the manager.

Managed futures accounts are often classified according to market focus as either:

  • Financial – investing in financial and currency futures and options
  • Currency
  • Diversified – financial and physical commodities

Typically, managers are benchmarked to a group of managers employing a similar style. Investable benchmarks have also been established that rely on mechanical trend-following strategies. When comparing returns, it is important to understand that historical data is affected by survivorship bias.

Posted on 28th August 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Portfolio Management | 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 »

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 »

Components of Total Return for Investments in Commodity Futures

The total return for a commodity futures contract is made up of three components.

  1. Spot return represents the change in spot price of the underlying asset. Since commodities tend to have positive exposure to event risk, it can make up a significant portion of the total return.
  2. Collateral yield or collateral return arises because futures contracts do not require the entire cash position to be paid up front (only margin is due at the outset of the contract.) Collateral yield is the return earned by investing the remaining cash during the term of the contract.
  3. Roll yield or roll return is generated as contracts roll forward in time due to the necessary convergence of spot prices and futures prices. A downward-sloping term structure (which is known as backwardation) results in a positive roll yield, and an upward-sloping term structure (known as contango) results in a negative roll yield.

Posted on 28th January 2008
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio 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 »

Momentum Strategies in Commodity Futures Markets

In the June 2007 Journal of Banking and Finance, Miffre and Rallis compare strategies for investing in commodity futures based on short-term momentum and long-term reversal, based on a variety of formation and holding periods.

Momentum strategies based on selling past losers and buying past winners generated positive and significant returns in 13 of the 16 combinations of formation and holding periods, with a significant portion of that return being derived from short positions in the losers. These strategies generate positive alpha and have low correlations with the returns on equity or fixed income securities.

The reversal strategies do not exhibit consistent outperformance in this study.

Posted on 10th January 2008
Under: Futures, Investing in Commodities, Investment Returns, Momentum Strategies, Portfolio Management, Research | 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 »

Commodity Benchmarks

As with any asset class, investments in commodities should be compared with an appropriate benchmark for risk and return. A number of commodity indices are in wide use, which all attempt to replicate the returns available to holding long positions in commodities. The indices can vary widely in terms of composition (which commodities are included), weighting scheme, and purpose. It is important to choose an index that matches the investment practices being used.

Since a futures contract is a zero-sum game (every long position is offset by a corresponding short position) it is not possible to market-weight a futures index. Instead, weighting strategies range from judgment-based methods, to equal-weight, to weightings based on world production levels. The benchmarks typically offer representations of both spot return and total return.

Posted on 28th December 2007
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »