CFA Level II ExamPortfolio Management and Wealth PlanningEasy
A pension fund manager is concerned about a potential sharp decline in the equity market over the next three months. The fund has a significant allocation to a broad market equity index. To mitigate this short-term downside risk without liquidating the underlying equity holdings, the manager decides to use derivatives. Which risk management strategy would be most appropriate for this scenario?
- ASelling call options on the equity index.
- BEntering into a long equity index futures contract.
- CBuying put options on the equity index.
- DSelling credit default swaps (CDS) on the underlying equity components.
Show answer & explanationAnswer & explanation
Correct answer: C. Buying put options on the equity index.
Buying put options on an equity index provides the right, but not the obligation, to sell the index at a predetermined price (strike price). This strategy effectively hedges against downside risk, as the value of the put options increases if the index declines, offsetting losses in the underlying equity holdings. It allows the manager to maintain the equity exposure while limiting potential losses.
Why the other options are wrong
- A. Selling call options generates income but exposes the fund to unlimited upside risk if the market rises significantly, and does not hedge downside risk.
- B. Entering a long futures contract would increase the fund's exposure to the equity market, exacerbating losses if the market declines.
- D. Selling CDS hedges against credit risk of specific companies, not broad equity market downside risk.
Hedging with Put Options
Using put options to protect an investment against a decline in value. The put option gains value as the underlying asset price falls, offsetting losses in the asset.
- Provides downside protection while retaining upside potential (less the premium).
- Costs a premium, which is the maximum loss on the option position.
- Suitable for investors who want to limit losses but remain invested.
Memory trick: Derivatives: Your Financial Safety Net.