Derivatives and Risk Management - Constructed Response Set - James King - CFA® Level III

Summary

The video discusses a case study on derivatives and portfolio management strategies. James King, a risk management advisor, works with the Davidson Foundation and Cambria University Endowment to implement strategies using futures contracts. The first strategy aims to convert the foundation’s portfolio into a synthetic cash position using equity futures. The second strategy seeks to adjust the portfolio’s beta to be less volatile than the benchmark. The video also covers bond futures contracts for a new contribution and discusses derivatives to lock in a US risk-free rate for the endowment. Various calculations are performed to determine the number of contracts required for each strategy.

Takeaways

• 😀 The Davidson Foundation holds a portfolio of Canadian equities valued at 140 million CAD, with a portfolio beta of 1.1 compared to the S&P 500 benchmark.
• 😀 The first strategy involves converting the portfolio's total value into a synthetic cash position using futures contracts to reduce exposure to Canadian equities temporarily.
• 😀 To execute strategy 1, the number of equity futures contracts needed to be sold is calculated by adjusting the portfolio’s beta to zero, requiring the sale of approximately 1,993 contracts.
• 😀 Strategy 2 focuses on reducing the portfolio's beta to 10% less volatile than its benchmark, targeting a beta of 0.9. This results in the sale of approximately 362 equity futures contracts.
• 😀 The third question involves a bond futures strategy where the foundation receives a CAD 22 million contribution in 90 days. The number of bond futures contracts needed is approximately 133.
• 😀 For strategy 1, the portfolio's exposure is adjusted by using the futures beta, contract price, and multiplier to calculate the short position required to achieve a synthetic cash position.
• 😀 Strategy 2 involves reducing portfolio beta to 0.9 to achieve a less volatile position compared to the benchmark, involving the sale of futures contracts to adjust the portfolio's market exposure.
• 😀 The foundation's objective in strategy 2 is to temporarily adjust the portfolio's risk profile by selling equity futures contracts to achieve a desired beta reduction.
• 😀 The Cambria University endowment aims to lock in a rate of return equal to the US risk-free rate, requiring the sale of S&P 500 index futures contracts without any currency hedging.
• 😀 To lock in the US risk-free rate, derivatives positions are adjusted by selling S&P futures, and no currency hedging is needed, as doing so would lead to earning the Canadian risk-free rate instead.

Q & A

What is the main objective of the Davidson Foundation in this case study?

The main objective of the Davidson Foundation is to reduce the portfolio's exposure to Canadian equities temporarily due to the belief that these equities will underperform over the next quarter. This is achieved by using derivatives to create a synthetic cash position.

How does the Davidson Foundation plan to adjust its portfolio using derivatives?

The Davidson Foundation plans to execute Strategy 1 by using equity futures contracts to take a short position equivalent to the value of the portfolio (140 million CAD), thus converting the portfolio into a synthetic cash position.

What is the role of beta in the Davidson Foundation’s strategy?

The beta represents the portfolio's exposure to market risk in relation to the S&P index. In this case, the portfolio has a beta of 1.1, and the strategy involves using derivatives to offset the exposure to the equity market by targeting a beta of zero, which would result in a market-neutral position.

What does Strategy 2 aim to achieve for the Davidson Foundation?

Strategy 2 aims to temporarily adjust the portfolio's beta to be 10% less volatile than its benchmark, which in this case is the S&P 500 index. The target beta for this strategy is set at 0.9, which will help reduce the portfolio's volatility without completely eliminating market exposure.

How many equity futures contracts would the Davidson Foundation need to sell to execute Strategy 1?

To execute Strategy 1, the Davidson Foundation would need to sell approximately 1,993 equity futures contracts. This is based on the portfolio value of 140 million CAD, a target beta of zero, and the formula provided, which factors in the futures contract price, beta, and multiplier.

How does the number of futures contracts required change between Strategy 1 and Strategy 2?

The number of futures contracts required for Strategy 2 is fewer than for Strategy 1. While Strategy 1 requires 1,993 contracts to convert the portfolio into a synthetic cash position, Strategy 2 requires 362 contracts to adjust the portfolio's beta to 0.9.

What factors influence the number of futures contracts needed to execute a strategy?

The number of futures contracts needed is influenced by the portfolio’s value, the target beta, the current portfolio beta, the futures contract price, the futures contract multiplier, and the beta of the futures contracts.

What is the purpose of the bond futures contracts in the case study?

The bond futures contracts are used to manage the pre-investment contribution of 22 million CAD, which the Davidson Foundation will receive in 90 days. The goal is to adjust the portfolio's exposure by using bond futures contracts to align with the desired risk profile for the incoming funds.

What is the key difference between the futures strategies in the Davidson Foundation case and the Cambria University Endowment case?

The key difference is that while the Davidson Foundation is using equity futures to manage exposure to Canadian equities, the Cambria University Endowment is focused on locking in a return equal to the US risk-free rate by using S&P 500 index futures, without altering its currency exposure.

Why does the Cambria University Endowment avoid hedging currency in its strategy?

The Cambria University Endowment avoids hedging currency because its objective is to lock in a rate of return equal to the US risk-free rate. Hedging the currency would expose the endowment to the Canadian risk-free rate instead, which is not the desired outcome.