Why do we hedge the face value in Q52 and the market value in Q53? Q52 is for binary put options and Q53 is for credit spread forwards.
I think for the credit spread forward, it’s more about the fact that the Notional of the forward is $20M, than the face/market value. In this case the manager could have set the notional at $18M, but wants to hedge a drop in value below $20M. On the put option, it’s also a hedge against a drop, and the Strike is set at $1000. Again I think the manager could have bought an option with a strike at $107 (150/140). So I don’t believe it’s a market vs face - but more a matter of what value the manager chose to set the hedge at.
I thought these were two of the worst questions from the exam. I don’t know if these options really exist at all (and it they do, I can guarantee they are so thinly traded as to make them infeasible to use). I agree about the 20mm. I would have used $18mm, but the test of the questions said something about $20mm making it easy to decide.
hey i got these two wrong too 
I got these right - but probably by chance. And now I want to understand… Q52 - I have no issue: we have 14000 bonds and we want to hedge the entire portfolio, so we buy 14000 options. That is OK. Q53 - Here I have a serious issue. We have a market value of 20 M and we want to hedge against spread change. The thing is \*we have no information about the SPREAD DURATION\*. If we want to hedge the spread, we need to buy / sell contracts so that the \*spread duration\* comes to zero. Here the answer assumes that we buy credit spread forward contracts for the same \*notional value\*. Why? WHY ? THIS IS PUR NON-SENSE ! If spread duration is, say, 6, a change in spreads of 1% would impact the portfolio by -6%. "Dollar spread duration" is then 1.2 m. If we enter into the swap with a NP of 20 m$, we will get : 1% * NP * factor = 1% * 20 m * 3 = 0.6 m$. So we have covered only half of our spread risk. As the swap factor is 3 (given in the vignette) then with a spread duration of 6 we would need to hedge twice our portfolio value ! But the issue is : WE HAVE NO IDEA OF HOW MUCH IS THE SPREAD DURATION So we cannot answer the question. Would you agree? MH
yeah, but the question asked you for max loss on a particular contract—not the hedging strategy.
Good point but… if you want to calculate the max loss, you need first to calculate the NP of your forward… MH
But the issue is : WE HAVE NO IDEA OF HOW MUCH IS THE SPREAD DURATION So we cannot answer the question. Would you agree? Yes. I would agree 100% that enough info was not given.
It seemed pretty straightforward to me. They gave you the notional value ($20MM), the spread (209 basis points) and the risk factor (3). Multiply them together and you get the answer. The spread duration isn’t necessary. The formula on page 117 of book 4 is: Payoff = (Credit spread at maturity - Contracted credit spread) X Notional Amount X Risk Factor