The Curious Schemer

42 Days left from Exam Day. Swaps. After this I will go through the last book’s examples and end of chapter questions only.

As everything else about derivatives in level 3, the overarching theme is about managing risks using derivatives. In particular, with the topic of swaps, we go a bit deeper than we did in level 2. In level 2, swaps are all about converting the cash flow you don’t want into the cash flow you want (of course by paying a bit for that convenience).

In level 2, after you’ve swapped your floating payment with fixed payment, you’re done. You’re hedged, end of story. But this is actually not true. When we swap a series of floating payment with fixed payment, we’re changing the duration of our portfolio. Meaning that while our cash flow problems might be solved, the value of the swap that we got into to solve this problem might erase some of the benefits, depending on the movement of the underlying asset.

But we’re getting ahead of ourselves here. First, let’s talk about duration.

What’s the duration of a floating rate note? Because the coupons will be regularly adjusted, the duration of the floating rate note is usually very low — the minimum is obviously zero, and the highest is the time between coupon payments. If we talk about semiannual coupons, then the maximum duration is 0.5, and the minimum is 0. The average duration is then 0.25.

The duration of a fixed rate note, on the other hand, is longer than that. For convenience, the CFA material assumes that the duration is 75% of the entire tenor. So for example a 2-year fixed rate note would have a duration of 1.5.

So now. What happens when a company converts receiving floating, to receiving fixed? Basically the company converts something that has a low duration, to something that has a much higher duration. The sensitivity of the market value against the change in interest rate becomes much higher as well. Does this matter? Of course it matters. But regardless, using swap to achieve this kind of thing is extremely popular.

The main reason would be the predictability of cash flow, which, depending on your business, might worth all the additional risks that’s inherent in this approach.

Let’s say we have a portfolio of USD 300mm, which is 80% stocks and 20% bonds. We know that in the next 3 months, the situation of the market is such, that we want to reduce the stock allocation and increase the bonds allocation, let’s say to 50-50, to benefit from the expected movement.

But let’s say we cannot really change the actual allocation. Perhaps because it’d be against the IPS. Perhaps because we have some illiquid assets and changing the allocation that much will move the market too much.

What can we do then? We can use futures to adjust our asset allocation without changing the actual allocation.

So let’s go through this example. Our current allocation is 240mm in stocks, and 60mm in bonds. Equal weights between them means that we want to have the equivalent of 150mm stocks and 150mm bonds in our portfolio. It’s the equivalent to converting 90 million of stocks into cash, and then invest that 90mm cash in bonds–except that we’re not actually doing that. We’ll be using futures. More precisely, we’ll be reducing the beta of 90mm stocks to 0 (that is, cash!) by selling stock futures, and use that 0 beta cash to achieve the target duration for 90mm bonds by buying bonds futures.

To walk through the example, let’s input some numbers as well:

• The price of stock index futures is 200k, with beta of 0.96
• The price of bonds futures is 105250, with duration of 7.2
• The beta of the stock is 1.1
• The bonds duration is 6.5, and we want to keep it for this new 90mm bonds as well

The number of stock futures contract:

Nsf = ((0 – 1.1) / 0.96) * (90,000,000 / 200k) = -515.63, or -516 contracts. Negative means sell.

The number of bonds futures contract:

Nbf = ((6.5 – 0) / 7.2) * (90,000,000 / 105,250) = 771.97, or buy 772 contracts.

This allows us to maintain the actual positions, but changing the effective allocation of our assets, by using the futures as appropriate.

I finished Fixed Income finally. And this week I’ve been reading about risk management, where CFA level 3 candidates learn about VAR (Value At Risk) approach of measuring risk.

CFA text is reasonably balanced about VAR. While the text says that VAR is the method of choice in the industry for measuring risk today, it also mentions the main drawback of VAR. Namely, while it tells you the probability of losing at least X amount of dollars within a timeframe (e.g.: 1 day, 1 week, 1 month, 1 year), it does not tell you how much you will end up losing.

That is, you can calculate VAR correctly, and still losing way, way more than what your minimum loss is, as calculated via VAR.

Let’s say for example, that the 5% daily VAR is 1 million USD. That means, in 1 day out of 20 days, it is expected that we’ll lose at least USD 1 million dollars.

Now, let’s say 200 days later, we go back and observe the result. It turned out that it really happened as expected: we lose more than USD 1 million 1 day out of 20. But instead of 1 million, the typical loss is 10 times as large (USD 10 million). Is the VAR calculation correct then?

YES.

And there lies the main weakness of VAR. It does not tell you how much loss you will experience. It only tells you that your minimum loss is X dollars, with Y% probability, over Z time period. You might be making USD100k every day for 19 days, and then losing USD50 million on the 20th day. And the VAR is still technically correct. Just that your company might not be there anymore (or at least your unit, and your job).

Nassim Taleb wrote further about the dangers of VAR here, and more recently, here. Interesting stuff! And of course, one book to read after this whole exam is over: Antifragile, by the same author

I’m still moving at a glacial pace. Work has been crazy this week, it’s really wake up, go to work, go home, work some more, and sleep. Your brain’s ability to absorb any material after 11.30PM? Let’s just say it’s a bit… comical.

I was planning to finish the fixed income material last week, and instead I’m barely finishing it this week. It’s amazing how fast a weekend passes by. The material is not something you can skim on–it’s tough material.

So what’s the plan now? No change. Still the same. Concentrate on examples and EOC from CFA text, and then use Schweser QBank to refresh memory. Retention will be a big issue, because — again, my work. I can go for a week without touching the material at all due to extreme deadline pressure.

I used to be stressed and got very cranky about this whole situation, but I think I have come to accept it now. Do my best, and see what happens. I shall go on!

I’ve changed my strategy. I’m no longer going to read the material cover to cover. Rather, I’m going to do all the examples and the end of chapter questions first. And then do the practice exams. This is going to be my strategy from this week until exam day.

Rather than writing the findings here, I’ve started writing them on a notebook. It’s actually NOT easy. After so many years out of school (I can’t remember the last time I was taking notes–even in high school I usually borrowed and copied a female friend’s notes, because her handwriting was very nice, and she took very detailed notes).

I still have 200 words to write, so instead of writing directly about CFA 2013 exam, I’d like to touch a bit about the plan after the exam. Remember that if I don’t pass this one, that’s it for me. So what next?

So many things! But for 2013 I only have two and only two topics to follow up after CFA:

1. Salih Neftci’s Principles of Financial Engineering. So far I’ve only managed to get to the first few chapters… but it’s absolutely golden. Finishing this would solidify my understanding of my business.
2. Mandarin! Not only for myself, but also for my daughter. I want to be able to lead by example — learning with her Mandarin and showing that her Dad can do it. I hope a couple of years of lead time that I have will allow me to compete against her sponge-like brain

That’s it for now. This week, I am planning to finish the Fixed Income part of the material. Next week, another read through the Equity part, and then derivatives (will leave alternative investment last, as usual). I hope there’s still enough time.

And actually, another one:

3. Blog regularly again. I missed the feeling of publishing a post that is well-researched, one that is well-done. I am fully aware of crappy my recent posts have been!

One week after change of plan.

On one hand, I’m going at a much faster speed than before, once the illusion that we’re-all-OK-because-we’re-writing-3-blog-posts-per-week has been shattered. On the other hand, I’m going much slower than I’d like.

Having a full-time job and a one year daughter doesn’t leave you much free time. Oftentimes the only time I can start reading the material is at 11PM… after she’s finally settled down and sleeping. By then, it doesn’t take a lot to knock me out all the way to 7AM the following morning, unfortunately.

I don’t know how to make it any better either. Especially not when the schedule at work is super tight. On Thursday, I had to stay up until 2AM. Hard to read the material, much less absorb anything, with this kind of schedule.

In any case. I will spend the next one week practicing problems for behavioural finance, fixed income, and equity. I hope that will help solidifying the concepts that I’ve been reading on this week. Only 11 weeks left. The week after, book 4, then practice, and then book 5, then practice some more.

Either way, as I mentioned earlier… I’m not going to make another attempt at CFA, regardless of the result this year. I don’t think passing level 3 is going to get me more money (if any!). There are other more practical activities that I must do — for example, proper management of my portfolio. Looking into property investment more seriously. Doing proper research of US and Indonesia equities, (is the bull market gonna be over? Should we buy now? Should we buy put now? All very interesting problems with direct monetary consequences).

Yes. The post this week is mostly whining. I am frustrated. We shall see how the coming week transpires. Hopefully going through the practice problems will help.