CMFAS M6a Quiz Key Note Set 2

In portfolio management, hedging is used to:

• Smoothen cashflows;
• Simplify financial planning;
• Reduce working capital requirements;
• Allow for more efficient product pricing; and
• Manage inventory more efficiently

Once a decision to hedge is taken, the investor can develop the hedge program by considering the following factors:

1. Risk exposure – Evaluate the risk exposure in assets and liabilities (by group, by maturity or profit centre).
2. Objective – Set hedge objective in terms of the acceptable risk level or tolerance1.
3. Hedgeability – Determine hedgeability using price correlation analysis (and cross hedges2, if necessary).
4. Hedge vehicle – Determine the hedge instrument or vehicle, which should be an instrument with a high degree of correlation with the target security.
5. Target – Determine the target rate you want to lock in for the hedge (i.e. the rate or the price).

Futures and options are frequently used as hedging instruments. However, there are some limitations when using futures and exchange-traded options for hedging:

• Round number of contracts;
• Margin maintenance;
• Time horizon and expiry dates; and
• No exact hedge instrument.

A hedge can be constructed for currently held positions or anticipated ones. It can also be used for a known or unknown period of time.

Using futures to allocate assets can be more effective and less costly because:

• Brokerage costs for futures transactions are cheaper;
• Withmargining, the cash outlay is smaller and the transactions can be tailored to the user’s cash flowneeds;
• The transaction time is shorter as buyers and sellers are trading against the exchange as a counterparty;
• There is less impact on the market since the futures market is more liquid; and
• It is less disruptive to the whole portfolio management process

The main players in the futures markets are:
• Hedgers
• Speculators
• MarketMakers
• Proprietary Trading Firms
• Arbitrageurs
• PortfolioManagers
• Hedge Funds

Options are traded on a wide range of assets and securities, including equities, bonds, interest rates, currencies, commodities, futures and various financial indices. With product innovation and the globalisation of markets, there are now new categories of options, which include real estate, weather, market volatility and exchange traded funds.

Put option buyers have the right, without any obligation, to sell the underlying asset at the strike price. The put option seller is obligated to take delivery of the underlying asset at the strike price if the buyer chooses to exercise the option.

The key features of options are:
• Strike price (or exercise price) – the contracted price at which the buyer of a call option has the right to purchase the underlying asset, and the holder of a put option has the right to sell the underlying asset;
• Expiration date – options will lapse as they have a finite life; and
• Style – European-style options can only be exercised on the expiration date while American-style options allow holders to exercise their right at any time before expiration.

As a derivative product, the value and trading dynamics of an option are dependent on the price of the underlying asset. An option’s price consists of two parts: intrinsic value and time value.

Moneyness refers to the potential profit or loss from the immediate exercise of an option. It describes the relationship between the strike price of an option and the current trading price of its underlying security. Terms such as in-the-money (ITM), out-of-the-money (OTM) and at-the-money (ATM), describe the
moneyness of options.

There are six major factors which affect the price of equity options:
• Underlying share price
• Strike price (Exercise price)
• Time to expiration
• Volatility of underlying stock
• Current risk-free interest rates
• Expected dividends

The breakeven, maximum gain and maximum loss positions of trading options and executing various strategies can be understood by looking at the four basic option positions:

• Buying a call option (long a call option)
• Selling a call option (short a call option)
• Buying a put option (long a put option)
• Selling a put option (short a put option).

The Black-Scholes formula was the first widely used model for option pricing. The formula, it states that the value of an option is determined by six factors:

• Underlying share price
• Options strike price
• Time until expiration
• Implied volatility
• Dividend status
• Interest rates

Investors can execute the option trading strategies based on the market outlook:
• Neutral strategies (also called non-directional strategies) – employed when investor does not have a view on whether the underlying share price will rise or fall from its current price levels. The potential to profit does not depend on whether the underlying share price will go upwards or downwards.
• Bullish strategies – employed when investor expects the underlying share price to move upwards.
• Bearish strategies – employed when the options trader expects the underlying share price to move downwards

A bond option buyer has the right but not the obligation to buy or sell a bond at a pre-set price on or before the option’s expiration date. Long bond options positions allow the investor to participate in the bond market at his discretion instead of being forced to hold long bond positions. Investors with large bond portfolios can use bond options to hedge against interest rate movements.

A currency or foreign exchange option is a contract which grants the option buyer the right, but not the obligation to buy or sell a predetermined amount of foreign currency at a fixed exchange rate on or before a specified date. Currency options are structurally similar to currency futures contracts. Currency options can be used for speculative purposes or to hedge an existing currency exposure.

Structured warrants are issued by third party financial institutions based on various underlying instruments such as:
• Individual stocks
• Equity indices
• Investment funds
• Commodities

Some of the exotic warrant structures include:
• Index Warrants
• Currency Translated Warrants
• Basket Warrants
• Yield Enhanced Securities
• Commodity Warrants
• Foreign Exchange Warrants

Structured warrant issuers appoint designated market-makers (DMMs) to make a market and provide liquidity for the structured warrants that have been issued. Structured warrants trade and settle like ordinary shares and company warrants listed on SGX-ST.

Based on their individual market views, investors can take positions using various available warrant and warrant-related securities to achieve their investment objectives. This would include:
• Neutral view – Yield enhanced security;
• Bullish view – Call warrant purchase, convertible bond, index linked note; or
• Bearish view – Put warrant purchase.

The term “wrapper” refers to the legal form in which a structured product is offered to the end investor.
Structured products are usually wrapped as:
• Structured Deposits
• Structured Notes
• Structured Funds
• Structured Investment-Linked Policies (ILPs)

The key terms of a structured product using a zero plus option strategy are:

1. Reference Asset (or Financial Instrument) – The underlying financial instrument with which the performance of the structured product is linked;
2. Strike Price – The level of the underlying financial instrument / asset where participation in the performance of the underlying financial instrument kicks in;
3. Participation Rate – The percentage increase in the structured product’s return for every 1% upside performance of the underlying financial instrument; and
4. Fixing Date – The day where the closing level of the underlying financial instrument is used to determine the structured product’s pay-out at maturity.

The barrier event of the option can be triggered with respect to the underlying assets:
• Price level (for a particular stock or asset class);
• Index level (for a market related index);
• Exchange rate level (for foreign exchange options);
• Interest rate level (for fixed income options); or
• A numerical indicator or value that is to be computed by a specified formula for a customized product basket.

Structured products which employ the short option strategy include:
• Dual currency investments
• Equity linked notes
• Credit linked notes
• Bond linked notes
• Range accrual notes
• Accumulators
• Decumulators

For structured funds where the monies received are invested in financial assets and used as collateral for providing guarantees to companies, restrictions are normally included in the trust deed on the management of the assets. Such restrictions are usually put in place by the issuers themselves, and include portfolio diversification rules related to credit quality, types of financial instruments and the maximum proportions that can be invested in the different financial assets.

Before participating in structured product, the investor should consider the following factors:
1. Risk appetite of investor

2. Liquidity needs

3. Product risks

4. Product returns

5. Time horizon

A closed-end fund is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange. A closed-end fund stock represents an interest in a specialized portfolio of securities that is
actively managed by an investment advisor and which typically concentrates on a specific industry, geographic market, or sector.

A separate legal entity (from the asset management company) which manages and safekeeps investors’ securities. In some countries, the custodian is appointed by the trustee. The custodian is paid a fee for keeping “custody” of securities and their role may differ from a trustee, who has additional duties of safeguarding the investors’ interests and ensuring compliance with investment guidelines. The custodian and trustee should be independent from the fund manager.

Trackers are used to simply replicate the performance of their benchmark. On the other hand, structured funds:
• Can be used to realize various anticipated market views;
• Have variable levels of exposure that adjust systematically as markets change and optimized based on expectations for market direction and volatility; and
• Carry out adjustments and optimization to deliver the promised level of capital preservation and participation (if any) in the underlying asset.