Calculating a Justified Price Multiple
A justified price multiple estimates the fair value of a price multiple... Read More
An investor’s principal can be put at risk by over-dependence on a counterparty. Moreover, the economic exposure of the fund can also be affected by counterparty failures. Therefore, investors are advised to evaluate the underlying counterparty risks when entering an ETF. Examples of counterparty risks are settlement risks and security lending.
ETFs, just like any other fund, may close. The underlying securities of the fund are sold, and then cash returns are made to the investors. Fund closures can be a result of regulations governing the funds, competition, corporate actions, creation of halts, and change in investment strategy.
Investors who do not understand the ETF’s inherent exposures and performance are likely to be at risk. Therefore, investors must evaluate the fund’s index methodology, as well as its portfolio construction approach. Investors who are most susceptible to this risk are the leveraged and inverse exchange-traded funds.
The leveraged products must reset their exposures daily to attain the expected return multiple for each day.
An ETF offers a 300% exposure to the S&P 500 Index with a net asset value of $150 and a notional exposure of $200. The one-day S&P 500 Index return is 10%. The ETF’s exposure and end-of-day net asset value are closest to:
Exposure to index = 3 times
Index return = 10%
$$ \text{Exposure} = $200+\left($200\times10\%\right)=$220 $$
$$ \text{End-of-day NAV}= ($150\times\left(1+3\times10\%\right)=$195 $$
Therefore, attaining 300% of the index’s daily performance for the next day requires a notional value exposure of \(($195\times3)\). The ETF must reset its exposure since there is only $220 in exposure. Therefore, the notional swap exposure is increased by \($585-$220=$365\).
Question
Consider an ETF that offers a 300% exposure to the benchmark index with a net asset value of $125 and a notional exposure of $140. The one-day S&P 500 Index return is 6%. The increase in the notional swap exposure is closest to:
- $442.50.
- $294.10.
- $295.90.
Solution
The correct answer is B.
Exposure to index= 3 times
Index return = 6%
$$ \text{Exposure} = $140+\left($140\times6\%\right)=$148.40 $$
$$ \text{End-of-day NAV}= ($125\times\left(1+3\times6\%\right)=$147.50 $$
The required notional value to attain 300% exposure for the next day is \(\left($147.50\times3\right)=$442.50\).
The notional swap exposure is thus increased by \($442.50-$148.40=$294.10\).
Reading 39: Exchange Traded-Funds, Mechanics and Applications
LOS 39 (g) Describe types of ETF risk.