Practice - Heights Case Scenario
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Last updated
Ford Tryon is a portfolio manager with Washington Heights, LLC, a hedge fund that invests in equities and fixed-income securities in both cash and derivative instruments. Heights markets itself as a go-anywhere fund that can exploit opportunities across asset classes and geographies. The recent increase in financial market volatility has opened several new opportunities for Tryon to exploit. He has four new trade ideas to discuss with his team, which includes James Bennett, his trader, and Wright Park, an analyst.
Tryonâs first trade is to hedge the interest rate exposure in a US$10 million corporate bond portfolio that has a modified duration of 7.5 years. Although Park is comfortable with the credit exposure of the individual bond positions, Tryon believes interest rates will increase and erode the total return of the portfolio. He proposes hedging the portfolio using Treasury bond futures with a contract size of US$100,000, a price of US$144.20, a modified duration of 8.3 years, and a conversion factor of 0.7455.
The number of Treasury futures contracts Tryon needs to hedge the interest rate exposure in the corporate bond portfolio is closest to:
Tryon and Bennett discuss their views on emerging market equities. The fund has no exposure to EMs, but they believe that imminent resolution of current global trade tensions will benefit valuations in the near term.
They want to use the futures market to express their positive view, because it would take time for Park to do the necessary research and for Bennett to trade the US$10 million they would allocate to this sector.
Bennett suggests a cash equitization strategy using futures on the BOVESPA, the Brazilian equity index, which historically has had a 1.15 beta to the broader EM, compared with his 1.0 target EM beta.
Bennett gathers data for the BOVESPA futures contract, whose underlying is the BOVESPA Index. The contract price is R$104,465, with a multiplier of 1 and a BRL/USD spot rate of 4.20.
The number of BOVESPA futures contracts Tryon would have to buy to express the view on emerging markets is closest to:
10m
104465 * 1.15 = 120,134.75
10m / 120134.75 = 83??
wrong, should be 10 * 4.2 / 120134.75 = 83 * 4.2 ~= 450
need to convert the currency
Tryon is long several equity positions based on event-driven ideas that, over the next few quarters, are expected to have double-digit returns.
He is concerned, however, that the equity market may decline as a result of lower corporate earnings. He believes investors are complacent as reflected in the historically low level of the volatility index (VIX). He wants to establish volatility exposure as a tail hedge for his holdings and notices the VIX futures curve is in contango. Tryon evaluates three potential trades to establish his hedge:
Trade 1: Go long back-end month futures contracts on the VIX Index, with a gross notional equal to the portfolio market value.
Trade 2: Sell a rolling series of out-of-the-money put options on VIX futures.
Trade 3: Go long a variance swap, with vega notional equal to the potential equity portfolio loss.
Which trade is Tryon most likely to implement to establish his equity market hedge?
Solution
C is correct. Variance swaps have a valuable convexity featureâas realized volatility increases (decreases), the positive (negative) swap payoffs increase (decrease)âwhich makes them particularly attractive for hedging long equity portfolios. Because the volatility curve is in contangoâthat is, higher volatility is priced into the curveâTrade 1 is likely to experience roll-down losses as the futures price converges or is âpulled downâ to the spot price. Trade 2 would benefit from a decrease rather than an increase in volatility; an alternative trade in the options space would be to buy call options to hedge the portfolio.
A is incorrect. Trade 1 is likely to experience roll-down losses as the futures price converges or is âpulled downâ to the spot price.
B is incorrect. VIX put options would be bought to profit from an expectation that volatility will decrease because of stable equity market conditions.
Swaps, Forwards, and Futures Strategies Learning Outcome
Demonstrate the use of volatility derivatives and variance swaps
The fund owns 10,000 shares of Inwood Industries, Inc., which is currently trading at US$100.00. Bennett believes that Inwoodâs next five quarterly earnings reports will miss consensus estimates but, longer term, there is value in the equity given the companyâs strong backlog of new products. The shares are very illiquid to trade, so Tryon wants to hedge the position over this time frame without selling the shares. Park suggests three total return equity swaps for Tryon to consider.
Question
Which type of total return swap is Tryon most likely to use given his view on Inwood stock equity? Buy a one-year:
Solution
A is correct. Equity swaps that have a single stock as underlying can be cash settled or physically settled. If the swap is cash settled, on the termination date of the contract, the equity swap payer will pay (receive) the equity appreciation (depreciation) in cash. Because Bennett believes the stock may temporarily decline in price, he would want to hedge the position by receiving any depreciation in price. If the swap is physically settled, on the termination date, the equity swap receiver will receive the quantity of the single stock specified in the contract and pay the notional amount. Because Tryon wants to keep the shares, a cash-settled total return payer swap is an appropriate strategy that hedges the equity position in Inwood.
B is incorrect. The swap receiver would establish a long position in Inwood that does not hedge the current holding.
C is incorrect. âPhysically settledâ does not fit Tryonâs strategy because he wants to hold the Inwood position.
Swaps, Forwards, and Futures Strategies Learning Outcome
Demonstrate how equity swaps, forwards, and futures can be used to modify a portfolioâs risk and return
Not accurate
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