Hedging an Equity Portfolio\ - Assignment Example

Portfolio setup

By using the price data from figure 1 below, the date chosen is 20 June 2016, which consequently is the last month in the on the diagram.

Figure 1

Price data which includes index and fixtures showing the portfolio date

(Bloomberg, 2016)

Portfolio size

The formula below illustrates how the size of the portfolio has been computed:

Units of the FTSE 100 index held in the portfolio = date of birth x by 1000 times. Therefore, the portfolio size is (insert your date of birth) x 1000 = (Insert figure here)

Pros and Cons

There are several advantages and disadvantages associated with using the put option to hedge the scenario presented in this report as compared to using futures only. According to Poddig (2012, pp.32-33), hedging using options involves developing a contractual relationship between two or more parties who include a buyer and a seller. There are two main types of hedging options that are the call option and the put option. A call option gives fund managers the right to buy a specified stock at a given price on or before a particular date. However, the put option gives fund managers the right to sell stocks at a specific price on or before a given date. The hedging option discussed in this report is the put option, which mainly focuses on the buyer’s right to sell stock at a given price. Diagram 2 below shows a multi-asset scenario put option that the fund manager can use to manage the fund manager’s scenario.

Diagram 2

Multi-asset scenario put option

(Bloomberg, 2016)

Below are the advantages and disadvantages of using a options based strategies.

Advantages

Cost efficiency

The put option hedging approach will offer considerable cost savings for the fund manager’s portfolio. This is because, unlike using futures only, options have a greater leveraging power (Poddig, 2012). The fund manager can obtain a put option that mimics a stock position that is almost identical, but at a lesser price.

Low risk

Djoko (2013, pp.32-33) notes that there were scenarios where buying options may be riskier than owning equities; however, there were also times whereby fund managers could use hedging options to reduce these risks. Therefore, it depends on how managers apply hedging options to their specific scenarios. Options will be less risky for the fund manager than fixtures because they often require less financial investments when compared to equities. According to Murphy (2012, pp.12-23), options offer a more dependable way to hedge a portfolio, making them much safer than futures.

Higher Potential Returns

Another advantage of using options over fixtures is that they have a higher rate of return on investments. This is mainly because they provide more strategic investments alternatives, are more flexible than fixtures, and also offers the fund manager with more choices for recreating other positions (Murphy, 2012)

Disadvantages

There are several cons associated with an option-based hedging plan. First, unlike futures, options often require a business to pay a specific amount of premium. Another challenge the fund manager is likely to experience when using an option-based hedging plan is the varying net prices. The net prices in the options are not fixed, as compared to fixtures; hence, it is difficult to estimate the return on investment both in the short term and in the long run. An option based hedge is also more likely to attract high brokerage fees, unlike fixtures.

Zero cost collar

Murphy (2012, pp.12-23) defined a zero cost collar as a short term hedging strategy whose main objective is to counterbalance the volatility risk of a business by buying a floor and a cap at a derivative price. The zero cost collar can be applied in the fund manager’s scenario to help protect the existing stock positions at little or no cost. This is because premiums paid for the put option can be balanced off by the premiums received (Stepien, 2012). Diagram 3 below illustrates how a zero cost collar could be used in the fund manager’s scenario using current options prices.

Diagram 3

Current option prices

(Bloomberg, 2016)

From diagram 3 above, the current put option price is £5500. This report assumes that the fund manager holds 100 shares, and wishes to hedge these shares should the stock market take a dive. At the same time, the fund manager wants to continue holding these shares because they are projected to appreciate in the next 7 months. A zero cost collar can be set up and applied in this case scenario. The costless collar can be set by writing 1 year JUN '30 60 LEAPS calls for £ 500 while at the same time use the profits from the call sale to purchase another 1 year JUN '30 50 LEAPS put for £ 500.

Therefore, if the stock prices were to converge at £ 700 during the expiration date, the fund manager’s maximum profit could be capped as he or she becomes obliged to sell the shares at the strike price of £ 600. The profits for 100 shares would be £ 100,000. However, if the stock price fell, the loss would be zero because the protective put option enables the fund manager to still sell the shares at an average price of £ 500. Nonetheless, if the stock price remains unchanged at £ 500, while the net loss remains at zero, the fund manager will lose 1 year’s worth of premiums of £ 50,000, which would have been collected were it not for the protective put option played on the purchase of the shares. In summary, a zero cost collar can be applied in the fund manager’s scenario to help protect the existing stock positions at little or no cost (Kritzman, 2009).

Option Scenario Analysis

The option scenario analysis in Bloomberg provides investment managers with a function that enables them to predict the value of a portfolio after a given period of time (Samudhram, 1999, pp.8-18). Figure 4 below shows some of the changes in values of the portfolio that has the potential of affecting security values such as, interest rates.

Diagram 4

Potential changes in portfolio

(Bloomberg, 2016)

There are several ways of confirming the results when using the option scenario analysis. This report has used the standard deviation approach of monthly returns to establish the total value that would be expected of the portfolio. There are 5 components in the option scenario analysis that have played a key role in verifying the results in this report, they include the current price of the stock; the type of option; time left to expiration; volatility of the stock and the dividend rate. From the results, the current price of the stock was £5500, while the option type was both a put and a cut as can be seen in diagram 3. The time left until expiration was only 1 year; however, the volatility of the stock was very low when compared to others. And finally, the dividend yield was 4.736 percent for both the put and the cut option. The option scenario analysis in Bloomberg confirms the results in this report and also consciously presents different alternatives that the fund manager can exploit for future investments (Han, 2015).

Impact of the hedge on the portfolio

This section of the report aims at discussing some of the effects of an option based hedge on the fund manager’s portfolio in different market scenarios. Diagram 5 below is a screencast of the put option based hedge after it has been applied to the portfolio.

Diagram 5

Put option hedge applied to portfolio

(Bloomberg, 2016)

From diagram 5 above, profit is limited by the sale of the LEAPS call. However, maximum profit is attained after the price of the stocks converges above the strike price of the short call. Therefore, the hedge options yield a profit for the portfolio. The basic formula applied for computing profit is:

Maximum profit = the short call (Strike price)-the purchase price of the underlying stock- brokerage commissions paid.

Therefore; the maximum profit achieved from the hedge option = the strike of the underlying short call (Shao, 2003, pp.7-12).

Option based hedging can add a level of safety to the portfolios offshore investment; however, investing in such markets can have a direct impact on foreign investments, and the fluctuations could have a significant impact on risks (Vaysman, 2003).

Black-Scholes Option Pricing Model

The Black-Scholes Option Pricing Model is mainly used to compute the price of European call and put options and ignores dividends that have been paid during an option’s lifetime. Recent events such as the 2009 global recession have been attributed to the flawed use of the Black-Scholes Option Pricing Model (BSOP) (Samudhram, 2009). The BSOP model has one major limitation as it cannot be used with other styles such as the American trading techniques that are used in most parts of the world. This is because the model only computes the option price individually until expiry. The model fails to take into consideration the steps, which could have the possibility of early returns such as in the American option. According to Samudhram (1999, pp.8-18), underlying models of variation and instruments of derivatives continue to gain popularity; however, it is important for the fund manager to be aware of limitations. This will ensure the fund manager makes informed trading decisions and avoids mistakes that would otherwise be very costly.

The model is widely used to calculate the prices of an option. For example, the fund manager in the case scenario discussed in this report may decide to call a stock. The manager would then reserve the right to purchase a specific number of shares of a given stock at a given period of time. The exercise price is also called the strike price, and the manager has to establish the fair price to charge for the option. The Black-Scholes formula plays a key role in offering the price for the option in regard to their quantities (Gupta, 2013).

Samudhram (2015, pp.12-31) notes that stock prices rarely showed any lognormal returns on investment as depicted by the Black-Scholes model because distributions in the real world are normally skewed. Research has suggested that this discrepancy leads to underpricing and overpricing of options when using the Black-Scholes. Therefore, the fund manager might expose himself to significant losses if he follows the Black-Scholes model blindly. Samudhram (2015, pp.11-21) suggests that several preventative measures that fund managers could take to mitigate the adverse effects of volatility in the market. One of the most effective measures is buying when the volatility in the market is lower and selling when the volatility is higher (Chincarini, 2004).

In summary, price movements in the FTSE 100 index are predictable and there is no correlation between market segments. For example, the impact of the 2009 economic recession was correlated to the housing bubble that leads to the collapse of the entire market (Nikolaos, 2003). However, these developments could not be accounted for in the Black-Scholes model.

Risks associated with option-based hedging

There are additional risks and considerations that should be taken into account when using options to hedge a portfolio. According to Meindl (2007, pp.7-12), options usually obey the reward and risk ratio, whereby, the higher the potential reward, the higher the risk. Meindl (2007, pp.7-12) also notes that leverage was great when a portfolio was making money; however, it was worse when losing money because losses were multiplied. Many traders who have suffered from losses when trading using options often do so because they used too much leverage. Studies conducted by Vanderlinden (2002, pp.17-15) on options suggest that risks were more likely to be unlimited when portfolio managers sold their options. This is because short calls have unlimited risks attached to them. Vanderlinden (2002, pp.17-15) also notes that there is no limit to how much a share in a portfolio can rise. Therefore, the risk in a short put option is limited owing to the fact that their underlying price cannot drop below zero (Salkin, 2002).

Another consideration that should be made is that options are more complex than fixtures. It is easier to teach unskilled people about selling and buying shares; however, it is very difficult to teach someone about hedging options (Simonov, 2016). A solid basic education on options takes an average of 4 months at a minimum. It is also important to consider that some options available at the FTSE 100 index do not trade as often as they should, which in turn suggest that there might be little liquidity in the long run (Chang, 2000). According to Maurer and Valiani (2007, pp.7-12), lack of liquidity forces bid offers to spread all over the portfolio making it hard to make substantial amounts of profits. The fund manager should check the average daily volume to ensure the options are high enough to provide good returns on investments both in the short run and in the long run (Fan, 2012).

Reference List

Bloomberg 2016, Stock market prices graphics for FTSE 100 index. [online] Available at:< http://www.bloomberg.com/search?query=GM,%20Ford,%20Saab%20and%20Volcswyagen> [accessed 17 June 2016].

Chang, J., 2000. An International Asset Pricing Model with Time-Varying Hedging Risk. Review of Quantitative Finance and Accounting, 15(3), pp. 235-257.

Chardon, S., 2012. What is the ideal equities portfolio for hedging against an increase in oil prices? Investment Week, pp. 50.

Chincarini, L., 2004. Managing cash flow in sector portfolios: A hedging approach. Derivatives Use, Trading & Regulation, 10(1), pp. 27-45

Djoko, D.T., 2013. Performance Based Diversification How To Create a Multistrategy hedge fund? Journal of Applied Finance and Banking, 3(4), pp. 271-325.

Fan F., 2012. Optimal Portfolio Choices, House Risk Hedging and the Pricing of Forward House Transactions. Journal of Real Estate Finance and Economics, 45(1), pp. 3-29.

Gupta, M., 2013. Portfolio Hedging Through Options: Covered Call versus Protective Put. Journal of Management Research, 13(2), pp. 118-126. R

Han, L., 2015. Hedging International Foreign Exchange Risks via Option Based Portfolio Insurance. Computational Economics, 45(1), pp. 151-181

Kritzman, M., 2009. Optimal currency hedging in- and out-of-sample. Journal of Asset Management, 10(1), pp. 22-36.

Maurer, R. and Valiani, S., 2007. Hedging the exchange rate risk in international portfolio diversification. Managerial Finance, 33(9), pp. 667.

Meindl, P.J., 2007. Portfolio optimization and dynamic hedging with receding horizon control, stochastic programming, and Monte Carlo simulation, Stanford University.

Murphy, M., 2012. The Pros and Cons of Stock Buybacks; If done right, share repurchases can create more value for stockholders. But how often are they done right? Wall Street Journal (Online).

Nikolaos, G., 2003. Hedging Strategies Using LIFFE Listed Equity Options. Managerial Finance, 29(11), pp. 17-34.

Poddig, T., 2012. Hedge Fund Replication: The Asymmetric Way. The Journal of Alternative Investments, 15(1), pp. 68-84.

Salkin, G., 2002. Hedging option portfolios without using Greeks. Derivatives Use, Trading & Regulation, 7(4), pp. 362-385.

Samudhram, A., 2009, Nov 08. Scenario summaries for analysis. New Straits Times, 27.

Samudhram, A., 2015, Nov 08. Scenario summaries for analysis. New Straits Times, 27.

Shao, W., 2003. Hedging, information asymmetry and financing cost: Evidence from seasoned equity offering announcements. Concordia University (Canada).

Simonov, A., 2006. Hedging, Familiarity and Portfolio Choice. The Review of Financial Studies, 19(2), pp. 633.

Stepien, EY., 2012. International portfolios and currency hedging: viewpoint of Polish investors. Managerial Finance, 38(7), pp. 660-677.

Vanderlinden, D., 2002. Conditional hedging and portfolio performance. Financial Analysts Journal, 58(4), pp. 72-82.

Vaysman, S., 2008. An approach to scenario hedging. Journal of Portfolio Management, 24(2), pp. 83-92.