CMFAS M6a Key Note Set 3

Derivatives can be used to implement investment views and provide investors to access broader investment opportunities. Typical uses of derivatives include:
• Hedging or insuring against risk;
• Speculating, or adopting a view on the future direction of the market;
• Arbitraging, or taking advantage of price differentials between two or more markets to make a profit;
• Changing the nature of an asset or liability to meet specific needs that cannot be met from the standardized financial instruments available in the markets; or
• Creating synthetic positions without incurring the costs of buying or selling the underlying assets.

Futures markets are also a place where investors manage risk. Risks are reduced because market prices are transparent and readily available,therefore participants know howmuch they need to buy orsell. For consumers and buyers of commodities, hedging with futures helps to reduce the final cost to consumers by lowering the risk of manufacturers raising the prices of key supplies due to the volatility in the spot market. Business managers and financial investors also use suitable futures contracts as part of their planning to reach their investment objectives.

Futures have several differences compared to other financial instruments:
1. Value – The futures contract itself has no inherent value and is determined by movements in the price and underlying value of some other asset or commodity.
2. Lifespan – Futures have a finite life and an expiration date. Unlike shares or tangible commodities like gold, which can exist forever, futures contracts cease to exist after they expire. Hence, the market direction and time horizon are important considerations for the futures investor.
3. Trading Objectives – Futures traders employ sophisticated strategies, and the outcomes depend on the relationships between different contracts positions. Futures can be used to protect an underlying investment positions as well to make outright bets on the direction of the market.
4. Leverage – The use of leverage is an important aspect of the futures investor’s investment strategy and trading decisions (although various other forms of financing are available for investing in other financial instruments and assets).

1.Delivery or Hold to Expiry

2. Offset Position

3. Roll Position

This model says futures prices are just expected spot prices of an asset in the future. If there are more traders who expect the futures price of an asset to rise in the future than those who expect it to fall, the current futures price of that asset will be positive.
The theory suggests that it is not the relationship between the cash market price and the futures price that is relevant, but the relationship between the expected spot price on the date of expiry of the contract and the futures price that is.

The index is an arithmetic average of current prices. The magnitude of the price per share of a security influences the index. This is not regarded as a correct portrayal of the marketplace as a small-cap company with a high share price could impactthe indexmore than a big-cap company with a low share price. Examples include the American Dow Jones Industrial Average and the Japanese Nikkei 225 Index.

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 tolerance.
3. Hedgeability – Determine hedgeability using price correlation analysis (and cross hedges, 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).

This impacts the intrinsic value of the option. The lower the exercise price, the higher the price of a call option, all other factors being equal. For a put option, the higher the exercise price, the higher the put option value. An option’s premium (intrinsic value plus time value) generally increases as the option becomes deeper in-themoney. It decreases as the option becomes more deeply out-of-the-money.

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

The demand for structured products has grown due to the:
• Low interest rate environment, which motivates investors to look for extra yield;

• Extreme volatility in the financial markets driven by geopolitical and economic uncertainty, which has led to a greater desire by investors for structured products which are partially or fully principal guaranteed. These
products are designed to preserve the principal amount against negative returns due to volatile or bear markets, as well as offer upside participation; and

• Marketing efforts by banks and financial advisors, as their wealth management businesses expanded to private banking clients and High Net Worth individuals

A structured product is created to meet specific needs that cannot be met by the standardized financial instruments available in the market. It can be used as an alternative to a direct investment, as part of the asset allocation process to reduce the risk exposure of a portfolio, or to profit from the current market trend. A structured product also increase the efficiency of a portfolio by catering to diverse risk-return profiles, if there is a wide variety of financial instruments in the portfolio.

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.
For example, fund restrictions could include the proportion of the fund that may be invested in equities and fixed, proportion that may be invested in investment grade and non-investment grade bonds, or limits on the amount that can be invested in a particular issuer given the liquidity of the securities

Principal risk relates to the likelihood that the principal component of the investment product may suffer a loss. This could be caused by adverse movements in the price of the underlying assets due to market volatility and credit factors. As a result, the structured product issuer may have problems fulfilling its obligations in making the principal repayment to the investor on  maturity

In the event of a credit default, there are 2 ways to settle the CDS contract:
i. Physical settlement – The bank, being both the seller of the CDS and issuer of the CLN, pays the CDS buyer the principal amount of the CDS in cash and receives a debt obligation (i.e. a bond) of the reference entity that is now in default. In this scenario, the CLN investors end up owning the bond of the reference entity, which would have a value determined by the market.
ii. Cash settlement – The bank pays the CDS buyer the difference between the par value and market price of a specified debt obligation of the reference entity, typically determined in an auction. In this scenario, the CLN investors will bear a loss equivalent to that difference.

there are differences between ETFs and ETNs:
i. An ETF holds a proportional stake in the financial products that the ETF tracks, offering instant diversification. When investor buy an ETF, they are investing in a fund which holds multiple assets. An ETN is a debt instrument, backed by the creditworthiness of the issuer;
ii. ETFs do not have fixed maturity and investors can buy or sell ETFs just like stocks on an exchange. ETNs have maturity dates. When an investor holds an ETN until the maturity date, he/she receives a one-time payment based on the performance of the underlying asset, index or strategy. If the investor wishes to liquidate the position sooner, he/she can sell the ETN on the exchange;
iii. Tax treatment of ETFs and ETNs can be different. For ETNs, investors are taxed only when they sell their position. It may vary for ETFs, especially for commodity ETFs that hold futures and leveraged funds; and
iv. As ETFs are investment funds, regulations require that they must have a trustee, who is independent from the fund manager. ETNs are issued by banks and there is no regulatory requirement for a trustee, although some ETNs do have them.

BLN is also a ‘yield enhancement’ structured product. The payout of a CLN depends on whether there is a credit event on the reference entity while the payout of a BLN is depends on the price of a bond. Besides a default, the bond price can be affected by other credit events such as credit downgrades,  widening spreads and volatile interest rates. A BLN investor may end up owning a bond even if no credit default has occurred in the reference credit / bond.

By contrast, structured funds are different as they:
• Aim to replicate the underlying asset or to provide a synthetic return linked to the underlying asset of the fund by incorporating derivatives. Allocation is typically static or rule-based and the investment view can be long, short or market neutral.
• Involve exposure to a wider variety of risks which including credit or  counterparty risk, equity market risk, foreign exchange risk, interest rate risk, market volatility risk, political risks and any combination of these risks. There may also be further risks due to additional counterparties such as correlation risk. Counterparty risk is more present in structured funds as compared to traditional mutual funds.

The roles of the fund manager include:
• Managing the assets of the CIS in line with the defined investment objective and within the investment restrictions as stated in the offering document;
• Preparing the semi-annual accounts, annual accounts, semi-annual report and annual report. These reports are to be furnished to the trustee so that the trustee can have them audited before dissemination to the unit holders; and
• Taking responsible for the creation and the redemption of units.

A trust deed is a legal document that sets out the terms and conditions governing the relationship between investors, the fund manager and the trustee. It describes the investment objectives of the fund, and the obligations and responsibilities of the fund manager and trustee.
The trustee is independent of the fund manager and acts as the custodian of the fund’s assets. The trustee ensures that the fund is managed according to the trust deed to minimise the risk of mismanagement by the fund manager.

The NAV per share of each class within each structured fund is generally made available by the Administrative Agent. The fund issuer might arrange for the publication of NAV in one or more leading financial newspapers where the funds are distributed to public and may notify the relevant stock exchanges in cases where the shares of the fund are listed. NAV can also be accessed at sources like Bloomberg, Reuters and the website of the fund issuer using the fund ISIN or name.

Full replication is where an ETF would hold all assets underlying an index in the exact proportion with the index. This ETF will directly hold all constituents within the index to replicate the performance of an index. The returns of the ETF’s portfolio, after expenses, will be passed on to investors according to the number of ETF units held.

In the creation and redemption process, an ETF will be required to acquire or dispose of underlying index securities in order to mimic the performance of the index. If the underlying index securities are illiquid and thinly traded, the availability of underlying will decrease, causing the bid-ask spread 3 of the underlying to widen. The failure of the creation and redemption will cause ETF units to be traded at a premium or discount, and consequently, the tracking error will increase.

The key differentiating factor between ETFs and the other popular fund formats, such as mutual funds and closed-end funds, is that ETFs offer investors two sources of liquidity:
• Primary liquidity via the creation and redemption process; and
• Secondary liquidity through the trading of shares on exchange.

Individual investors and portfolio managers using the core-satellite approach often use ETFs as the core portfolio. ETFs can also be used for tactical  reasons, such as gaining exposure to a specific market rapidly while searching for specific securities to invest in. They can be used to provide for thematic exposures (for example, selected dividend-paying stocks).

As ETFs are passive instruments, they aim to replicate the performance of the underlying index one to one. As such, the ETF’s performance should be similar to the benchmark index. One of the main advantages of replicating an index through swaps is that the tracking error risk of the ETF, before fees, is passed to the swap counterparty. As such, swap-based ETFs have been embraced by investors who want to minimize the tracking error of the ETF versus the benchmark.

Tracking errors refer to the disparity in performance between an ETF and its underlying index. Tracking errors can arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index, index replication costs resulting from liquidity and ownership restrictions on the underlying, cash drag, and the structured ETF manager’s replication strategy. In general, tracking error is lower for synthetic replication than physical replication ETFs. It could also be greater for ETFs which have benchmarks that have inherently higher volatility, such as emerging markets.

a) Physical replication – ETFs that invest directly in the underlying assets may be exposed to counterparty risk if the ETF engages in securities lending of the funds’ assets. The ETF may suffer losses if the borrowers default or fail to honour their contractual commitments.
b) Synthetic replication – Synthetic ETFs are exposed to counterparty risk of the swap dealers and derivative issuers. The ETFs may suffer losses if any of the dealers/issuers default or fail to honour their contractual commitments. ETFs which make use futures are also exposed to basis risk and roll risk.

To mitigate this risk, regulators and securities exchanges could put in place the following measures:
• Circuit Breakers – Systems in cash and derivative markets that trigger trading halts;
• Shock Absorbers – These are systems in the trading infrastructure that slow down trading when markets experience significant volatility but it does not halt trading completely; or
• Limits – Session or daily price limits can be imposed to limit price volatility without slowing or halting trading activity.

Basis risks arise because of several factors:
• The asset, whose price is to be hedged, may not be exactly the same as the asset underlying the futures contract;
• The hedger may be uncertain about the exact date when the asset will be bought or sold;

• The hedge may require the futures contract to be closed out well before its expiration date; and
• The size and unit of measurement of futures contracts may not correspond with the size of the underlying hedged position. As a result, a position may be under-hedged or over-hedged.

Trading in currency / foreign exchange options is risky as the notional value involved is extremely large. Furthermore as the foreign exchange market is open round the clock, every day except weekends, traders need to be able to monitor their positions or risk being caught out by fast moving events.  Managing counter party risk is especially important if one has a position in an OTC currency option, as option contracts are fulfilled by actual delivery of the currencies.