Liquidity

A client hedges a physical inventory by selling futures. Prices then rise steadily for several weeks. Even though the hedge is doing exactly what it was meant to do, the client should be prepared for

1. A.a demand that she deliver the inventory at once in order to close the position.Wrong. Delivery obligations arise in the delivery period and not because the market has moved.
2. B.the exchange closing out her position as soon as the loss reaches the initial margin.Wrong. A margin call is issued first, and the response to it is what determines whether the position survives.
3. C.daily variation margin payments while the offsetting inventory gain stays unrealised.Correct. Only one leg of the hedge settles in cash each day, which is where the liquidity strain comes from.
4. D.no cash effect at all, since the inventory value offsets the futures position.Wrong. The offset is economic, and economics and cash flow are on entirely different timetables here.

Why: Futures positions are marked to market every day and losses are collected in cash through variation margin, while the offsetting gain on a physical inventory is unrealised until the goods are sold. The hedge is economically sound, but the two legs settle on completely different timetables, so a working hedge can generate a serious and sustained cash demand. Planning for that liquidity is part of putting the hedge on, and a hedger who cannot meet the calls will be forced to close the position at the worst possible moment. The mismatch disappears only when the physical side is finally sold.

A deferred variable annuity carries a guaranteed lifetime withdrawal benefit rider whose benefit base has grown well above the contract account value after a poor market. If the owner surrenders the contract outright, he receives

1. A.the benefit base less any surrender charge, since that is the amount the rider guarantees.Wrong. The rider guarantees a withdrawal stream, never a lump sum measured by the notional base.
2. B.the account value less any surrender charge, because the benefit base is only a calculation figure.Correct. The account value is the only amount actually held for the owner, so it is all a surrender can pay.
3. C.the greater of the benefit base and the account value, at the election of the contract owner.Wrong. No such election exists, because the guarantee is expressed only as periodic withdrawals.
4. D.the account value plus the rider charges paid, which are refunded when the rider is cancelled.Wrong. Those charges bought coverage that was in force throughout and are not returned on surrender.

Why: A guaranteed lifetime withdrawal benefit promises a stream of withdrawals calculated from a notional benefit base, not a pool of money the owner can take in one piece. The account value remains the only amount actually held for the owner, so a surrender pays that value less any applicable charge and the benefit base simply disappears. This is why the rider is worth something only to an owner who intends to hold the contract and take the withdrawals as designed. An owner who might need the whole balance is paying a rider charge for a guarantee he cannot reach.

A client retiring next year tells her adviser that her time horizon is therefore one year. The adviser should explain that

1. A.she is right, since the accumulation period ends when the salary stops arriving.Wrong. Accumulation ends but the money still has to last, which is what the horizon measures.
2. B.her horizon runs for as long as the portfolio must support her, which is her remaining lifetime.Correct. The horizon is defined by how long the assets must work, not by the date the salary stops.
3. C.her horizon is now indefinite, so the allocation should be as aggressive as tolerance permits.Wrong. An open-ended horizon does not remove the need to fund the next few years of withdrawals.
4. D.horizon stops mattering once withdrawals begin, with liquidity governing in its place.Wrong. Liquidity governs the near-term spending and horizon still governs the decades funding it.

Why: Retirement ends the accumulation period but not the investment horizon, which runs for as long as the portfolio has to support the client and, where a survivor or a legacy is involved, longer still. A client with decades of spending ahead needs the portfolio to keep growing through most of that period, so treating the retirement date as the end point produces an allocation far too conservative to last. What the retirement date does introduce is a liquidity requirement for the first few years of withdrawals, which is met by reserving that money rather than by de-risking everything. The two considerations coexist, which is why near-term spending and long-term funding are held in different pools.

A client with a twenty-year horizon and no liquidity needs asks whether he should hedge his equity portfolio against a decline over the coming year. The most useful fiduciary response is that

1. A.he should hedge, because a smaller loss is always preferable to a larger one.Wrong. It ignores that the hedge is paid for out of the return the client is depending on.
2. B.he should hedge, because his portfolio is large enough that the premium is immaterial.Wrong. The premium scales with the exposure, so a larger portfolio buys no relief from the cost.
3. C.hedging is unnecessary because equity markets recover from every decline within a year.Wrong. No such assurance exists, and the argument collapses the first time one does not.
4. D.a hedge costs return every year it is held, and a long horizon is itself what absorbs a one-year decline.Correct. It weighs a certain recurring cost against a risk the structure of his situation already handles.

Why: A hedge is paid for out of the return the portfolio is relied upon to produce, so it has to earn its place against what it actually protects. A client with two decades ahead and no requirement to sell has time as his defence against a one-year decline, and paying a premium to remove a risk his horizon already absorbs converts a temporary paper loss into a permanent cash cost. The analysis changes entirely where a real liquidity need falls inside the hedged period, or where a decline would cause the client to abandon the plan, since that behavioural risk is permanent in a way the market decline is not. Size of portfolio is not the test, because the premium scales with the exposure.