The Difference between Hedging Downside Loss via Futures and via Options - Coursework Example

Portfolio management is not a gambling business. Even when everyone involves in it with an intention to maximize profits, nobody would indulge in it recklessly to risk the assets in possession in a fluctuating market. Therefore, an investment strategy necessarily includes methods to insure the asset against the fluctuations of the market. Hedging is a strategy designed to decrease risk and pay for it with an accompanying and comparable decline in return. It is a strategy for those in a long position seeking to allocate risk differently and listed put options are one means to accomplish the hedge. Hedging can be considered a source of financing for post-loss investment opportunities. Hedging has other dimensions besides financing the post-loss investment; it addresses the asset substitution and under investment problems, reduces the probability of insolvency, permits more effective managerial compensation contracts, and may help reduce tax liabilities when tax functions are convex. In nutshell hedging, is 1 - Taking a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change. 2 - A purchase or sale of futures as a temporary substitute for a cash transaction which will occur later. (http://www.cme.com/edu/ai/trdwthr/weatherbackground11784.html) For example, let us take the example of a hedger. A soybean grower must plan production based on some idea of a market price. There are, however, no guarantee against the decline of soybean prices once planting has begun. If prices drops once production is under way, future sale proceeds of soybeans may not be enough to cover the production cost, thus putting in jeopardy the financial health of the grower. Hedging can protect the farmer against this type of price uncertainty. Very similar is the case of weather derivatives. Weather derivatives cover low-risk, high probability events, while weather, insurance typically covers high-risk, low-probability events, as defined in highly tailored or customized policies. For example, a company might use a weather derivative to hedge against a winter that forecasters thought would be 5 Fahrenheit warmer than the historical average (a low risk, high probability event) since the company knows its revenues would be affected by that kind of weather. However, the same company would most likely purchase an insurance policy for protection against damages caused by a flood or hurricane (high-risk, low-probability events.) (http://www.cme.com/edu/ai/trdwthr/weatherbackground11784.html) In the example of the soybean grower, by locking in a floor price through the purchase of a soybean put option, the grower would for example, at least know that no matter where the future market price of Soybeans is at harvest time, He/she will be able to sell the soybeans at the strike price. Of course, to establish this future price floor, the grower must pay a premium to purchase the put options, but this cost can be priced into production at the outset like any other cost of production. An owner of an asset will loose mosey when the price of the asset falls. Value of a put option rises when the asset price falls. What happens to the value of a portfolio containing both the asset and the put when the asset price falls Clearly, the answer depends on the ratio of assets to options in the portfolio. If the ratio is equal to zero, the value rises, whereas if the ratio is infinity, the value falls. Somewhere between these two extremes is a ratio at which a small movement in the asset does not results in any movement in the value of the portfolio. Such a portfolio is risk free. The reduction of risk by taking advantage of such correlations between the asset and the option price movements is called hedging. This is the one example how options are used in hedging. Call options can also be used for hedging. When using put options to hedge, various strike prices exist for an option on a specific stock index and for a specific expiration date. For example, put options on the S & P 500 index may be available with strike prices of 1760, 1800, and 1840 and so on. The higher the strike price relative to the prevailing index value, the higher the price at which the investor can lock in the sale of index. However, a higher premium must be paid to purchase put options with a higher strike price. From a hedging perspective, this simply illustrates that a higher price must be paid, to be "insured" (or protected) against losses resulting from stock market downturns. An option is a contractual agreement between two parties to exchange a commodity at a specified price on a future date. However unlike forward and futures contracts, despite the option to fix a price for later use to limit losses and hedges, the fixed price is necessary, if it is better to use prices currently available in the spot market. In fact, an option gives the holder the right to do something, but the holder does not have to exercise this right. (Hull, J.C., 2001). This is the main difference between option contracts and forward/futures contracts, in which the holder is obliged to buy or sell the underlying commodity. Note that there is no cost to enter into forward/futures contracts, while there is a premium associated with the cost of acquiring an option contract. If the return distribution for the underlying security is symmetrical with a wide dispersion, hedging the portfolio with futures gradually draws both tails of the return distribution curve in towards the middle, and the mean return shrinks back somewhat towards the risk less rate. A full hedge draws both tails into one place and puts all of the probability mass at the risk less rate. Hedging with futures generally affects both ends of the return distribution curve equally. One of the main differences between options and futures is that options can affect one tail more dramatically than the other, so the distribution becomes quite skewed. Another key difference between the purchases of options versus single stock futures is the issue of margin. Option contracts on equities are not marginable and must be paid for in full when purchased long in an account. This differs of course from the purchase of single security futures, which are purchased on margin that is your good faith deposit for the performance of the contract. When you purchase an option contract, you are buying that contract and not entering into a forward agreement, therefore the full value of the contract must be paid for in advance. The ability to use margin for purchasing single security futures allows more flexibility for short-term speculators who have limited investment capital. Not only does option trading provide a cheap and effective means of hedging one's portfolio against adverse and unexpected price fluctuations, but also it offers a tremendous speculative dimension to trading. The difference between hedging downside loss via futures and via options lies in the trade-offs made to eliminate the downside risk. In a futures hedge, the hedger gives up upside potential, but does not have to pay a premium for the hedge. In an options hedge, the hedger gives up a premium, but gets to keep the upside potential. Overall, single security futures have similarities and differences; however, these tools can be used in conjunction to compliment qualities that are unique to each of the two. By implementing strategies that involve the use of both single security futures and listed equity options, new avenues for profitable speculation and accurate hedging activities can find their way into every investor's portfolio. Sources Grossman, S. and Zhou, Z. (1993) Optimal investment strategies for controlling drawdowns. Mathematical Finance Hartmann, M.A., and D. Khambata, 1992. Emerging stock markets' investment strategies of the future, The Columbia journal of world Business. Hull, J.C., (2001) Fundamentals of Options and Futures Markets, Prentice Hall, Upper Saddle River. Weather background www.cme.com/trading/prd/env Read More