Hedging Risk Exposure and Arbitrage - Term Paper Example

Hedging Risk Exposure and Arbitrage Introduction Investors focus on reducing the unpredictability of their investment spreading or hedging their funds across market, sectors, industries and regions continuum and against the risks that are un-diversifiable Gray & Malone, 2008, P. 86). There are various approaches used by investors to protect their investments or assets against possible risks. Investors hedge their stock across market/industries or sector or against market risk in order to maximize returns and decrease the risk (Bingham & Kiesel, 2004). The occurrences that have uniform effects on the entire stock market will not have any effects on portfolio after hedging. Some of the methods include hedging or diversification of risks (Madura, 2014). The investors should choose the best option cautiously not only to eliminate the risk but also to maximize revenue. This document evaluates put option as a hedging strategy in a simulation scenario. Hedging with the put option Hedging is concurrent acquisition and sale of two equivalent securities having different maturity period with the expectation of gaining from the consequent movements the price of those securities (Bouzoubaa & Osseiran, 2010, p. 78). The investors hold stocks with the expectation that at one point they will be able to sell the stock at a higher price to cover the transaction cost and other cost of holding the stock such as inflation cost (Bingham & Kiesel, 2004). The stocks are sold at a premium, but the sales may have to be delayed. The unit value of stock after price appreciation is equivalent to the marginal cost of holding that security. Anticipation of price increase in the stock value will result to an increase in the current price of the stock (Madura, 2014, p. 342). By hedging the stock investors commit to taking a minimum value of the stock and avoid making loss in case, the value of the underlying security goes below the future value of the contract. However, the hedger risk losing profit in case the value of the stocks exceeds the future contract value. It is imperative to note that the individual’s decision to hedge security does not affect the market condition because the investor transfers the risk to a willing speculator who buys a security. Also, when an investor purchases a security with anticipation that their prices will raise in the future that result in the transfer of risk from the seller to the buyer of the stocks (Madura, 2014, p. 242). However, investors accept risk premium in order to hedge their securities. The implication of risk premium is the fact that the investor has to sell securities at lower price that anticipated value of the underlying security in the future or has to tie up his or capital in order to purchase securities with anticipation of increase in future value of those securities (Gray & Malone, 2008. P. 96). A). Hedging and Price Risk Exposure The investors were able to hedge the firm’s exposure to the extent the allowable by the contract size. The contract size was 100 shares and the investor had ten put options thus it was possible to hedge the risk exposure of 1000 shares every day. However, the hedging of shares was only possible in the first six days of trading when the value price shares were declining, but afterwards, the price increase resulting to a premium intrinsic value of zero. Therefore, investors could not hedge the share risk exposure for the rest of the month when the price had no sign of declining. The risk exposure occurred during the first week of trading. B). Implementing of hedging strategies. The investors hedged the risk of shares through put option. “Put” option is an agreement in which the owner has the right to sell a stipulated quantity of underlying securities at a predetermined price and within a specified period (Chance & Brooks, 2009). The buyer of a put option anticipates the price of a security or asset will fall below the buying price before the end specified period. The hedging strategy involved exercising the put option by purchasing a premium of $1 per share for the allowable transaction size of 100 shares over transaction. The investors had ten put options thus the total number of shares hedged were 1000 every day. Therefore, investors bought a premium of $100 every day to protect their investments against decline in value. The bought premium increased the cost of holding shares besides the transaction costs. From the transactions, the investors were able to hedge only 13,000 shares every month for three months. The total cost of investment was reduced though hedging from $63,000 to $24,000. This resulted to a reduction in final portfolio from $2,000,000 (100,000*20) to $1,976,000. C). The gross profit or loss of the transaction Hedging of shares involved the premium cost of 10*100*1 =$1000 for each transaction. The transactions were conducted for 13 days every month from January to March with a total of $39,000. The total hedged value was (1000*6+1000*5+1000*4+1000*3+1000*2+1000*1)3 = 63,000. Therefore, gross profit from the hedging was 63,000-39,000 = $24,000. D). Net profit/loss The contract size is 100 and the total share value that can be hedged is 100*10 =$1,000 for the ten options. The investor should protect their shares from falling below their face value of $20. Assuming the put option value of $1 the premium value for the contract each month would be 1000* $1 every day for the three months. Assuming the investors traded for 13 days every months the total premium will be 1000*13*3 = $39,000. The transaction cost involved in hedging include $20 +20*13+ 1%*39,000 = $670*3 = $2,010. Therefore, total cost of hedging = $39,000 + $2,010 = 41,010. The loss of investment if no hedging was made would be 1000*6 +1000*5+ 1000*4 + 1000*3 + 1000*2 + 1000*1 = $21,000 per month 63,000 for three months. Therefore, the investors would lose $63,000 if they had not taken any action. By exercising hedging option, the investors could reduce get rid of the cost and make a net profit of $21,090 E). Arbitrage opportunities Arbitrage refers to concurrent Purchase and sale of stocks at a price that assures the seller of a fixed return at the time of completing the transaction at a future date (Madura, 2014, p. 428). The investors could apply both call options and put options in the transaction in order to maximize their returns and minimize loss. Calls and put options merged with underlying market situation offer investors a base value with prospects to capture upside moves (Bouzoubaa & Osseiran, 2010). The investors role is to ensure capture the arbitrage opportunity in order to hedge the risk of volatility and low prices of stock in the future. The “calendar spreads options” are determined by the stock’s value and the instability of spreads rather than price of the stock (Gray & Malone, 2008. P. 126). F). Other approaches Available for investors Call option (call in) is an agreement in which the investor is given the option to buy securities such as stock at fixed value within a specified time (Ranganatham, 2006). A call option provides the investor the right to “call in” or to purchase an asset and the investor benefits when price increases. The option gives the investor a financial gain when the price of the security increases. However, the option price includes premiums that are influenced by the number of spreads remaining to termination of that spread and the presumed volatility (Murphy, 2008, p. 46). This could enable the investors to make the best out of anticipated movement of the options price in relation to the principal market. The investors could make revenue by selling the shares at a price higher than the strike price. The investors have a guarantee of a higher price, but in case the price continues to expand in the future the investor does not enjoy huge market returns (Subramani, 2011, p. 458). Market neutral is applicable where the funds hedging manager opts to purchase long stocks and sell short stocks with focusing to reduce extensive market exposure (Gawron, 2007, p. 25). The investors can achieve this objective by investing an equal amount of funds on long and short stocks so that the overall impact of price changes neutralizes each other (zero net exposure). Alternatively, the investors can plan on the investment portfolio in order to achieve zero beta exposure (Subramani, 2011, p. 325). The loss generated by a portion of shares from short investments is neutralized by income from long in the security. The intention of the investor in market-neutral strategy is to get rid of any influence of market movements and to increase dependence on his/her capacity to select stocks with higher returns. Long or short hedging strategies are applicable within sector, industry, section or a specific stock (Biagini et al., 2013) The challenge of hedging portfolio risk using market neutral strategy is the inability of the fund’s manager to determine the actual risk associated with the portfolio at the time of making investment decisions (Chance & Brooks, 2009, p 523). In order for an investor to gain returns from the security he or should be able to predict the stock movements accurately and estimate the stock likely to yield greater returns among the investments options available (Biagini et al., 2013, p. 24) However, since there are many investors making similar decisions one has to outdo the rest in making analysis of the stock movements in order to achieve greater returns than the rest of the investors (Ranganatham, 2006) The investor would prefer to hedge risk downside risk where the price of securities is expect to continue declining for unknown future period. Tail risk occurs when the price of security falls more than three folds from its par value (International Monetary Fund, 2011). Hedging tail risk can be achieved by allocating the risk to other stocks to attain portfolio stability. Bibliography Biagini, F., Richter, A. & Schlesinger, H. (2013). Risk Measures and Attitudes. Springer Science & Business Media. Pp. 1-100 pages Bingham, N. H. & Kiesel, R. (2004). Risk-Neutral Valuation: Pricing and Hedging of Financial Derivatives. Springer Science & Business Media. Pp. 1-437. Bouzoubaa, M. & Osseiran, A. (2010). Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading. John Wiley & Sons. Pp. 46-392 Chance, D. & Brooks, R. (2009). Introduction to Derivatives and Risk Management. Cengage Learning. Pp. 72-672. Epstein, B. J. & Jermakowicz, E. K. (2008). Wiley IFRS 2008: Interpretation and Application of International Accounting and Financial Reporting Standards 2008. John Wiley & Sons. Pp. 1-1166 pages Gawron, G. A. (2007). 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