SA6 April 2016 Q1 (vi)

Discussion in 'SA7' started by radex, Jan 20, 2020.

  1. radex

    radex Member

    The question asks how the leverage ratio, of a portfolio comprising of long futures, changes with changing market conditions.

    According to me, in case of rising markets variation margin requirements reduce. Hence leverage increases... Since you get same exposure for reduced margins.

    However the solution states the opposite, ie, leverage ratio falls in rising markets.

    Can anyone explain the reason.

    Additionally can anyone also explain "cash drag", mentioned in the solution to the above question.

    Thanks
     
    Last edited by a moderator: Jan 20, 2020
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    Hi, I dont agree that rising markets would lead to falling margin. Margin accounts get boosted by profits when markets rise (you seem to suggest above that a rising market would lead to a falling margin account). So a rising market would see profits being dumped into the margin account, which would probably then be transferred into the portfolio account when the margin with the clearing house got overly large. So if we see "leverage ratio" as (fixed interest assets)/(total assets), then this will fall in rising markets. Markets fall and the investor has to sell existing assets to fund the margin account, then the ratio could rise quite sharply.
    I think "cash drag" refers to the fact that the investor will have to hold lots of cash in the asset portfolio to cope with the event of margin calls, rather than assume that the other assets can be sold in large quantities when required. This cash is not invested and therefore acts as a performance drag when markets are neither falling nor rising.
     
  3. radex

    radex Member

    Hi Colin

    Thanks for your answer! I am now able to understand the reasoning.

    I had confused myself with 'the balance in margin account' and 'margin requirement'.

    Also I had ignored to add MTM profits (transfers to portfolio account) to the denominator, thus reducing the leverage ratio.
     
  4. Irwin

    Irwin Made first post

    Good day Colin,

    I am still confused by this question. Where can I get additional information on the leverage ratio?

    thanks
     
  5. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    I suspect there will be loads of references to "leverage ratio" but 99.9% of them will be in contexts that are irrelevant to the one in the question. I dont think it is well defined term in the pensions world, although "leverage" is something that people talk about. My definition above is one that quantifies the impact of swap and repo leverage on a portfolios hedging properties and cash requirements, which is what the examiner tends to discuss when talking about leverage. But there is probably not one "official" definition of the leverage ratio for pension schemes. Sorry if this is not entirely helpful.
     

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