Financial Education

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.

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.

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.

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.

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.

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.

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.

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.

Investors wanting exposure to commodity prices in their portfolio can gain exposure either directly or indirectly.

Direct investment in commodities has traditionally taken the form of cash purchase of physical commodities such as metal, oil or agricultural products. The development of derivatives markets has resulted in most of the direct commodity transactions involving futures products. Direct investment obviously provides a direct link to commodity prices, but can require possession, storage, financing, insurance and transaction costs which are either paid directly or through the basis in the futures contract.

Indirect investment in commodities is typically manifest as buying the equities of a commodity producer such as a mining company. It does not provide a direct exposure to the commodity prices, in part because many producers uses hedges to control their own exposure.

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.