Hedging an Equity Portfolio - Essay Example

? Hedging an Equity Portfolio Insert Insert Grade Insert Insert A1. Derivatives traded on exchange markets that may include currency futures and options and swaps are usually limited. Moreover, the foreign market activities have a vulnerability of being highly hindered by the presence of exchange controls and other regulations. As a result, of this hindrance, market players are constantly adopting to adjustments that will enable a dynamic approach in risk management of foreign exchange (Hull 2012). Consequently, elements of risk management like cross-hedging have come up. This tool is used in the reduction of risks in the event that expected cash flows are dominated in a low value currency. A good example is that of two companies trading on different markets at international level. The company with an obligation to take a long position may opt to protect its currency using a stronger foreign one also referred to as a currency hedge. This is because the derivative instruments on such currencies may be nonexistent. However, cross hedging capabilities may depend on various factors. First is the degree in which the spot and futures currencies are negatively or positively correlated. Secondly, this also depends on the level of accuracy of the estimated risk-minimizing cross-hedge factors. In addition, time is an important factor in this process and therefore the capability of cross hedging depends on the stability of the optimal cross hedge proportions over a given duration or period of time. Moreover, this also depends on the potential risk reduction from portfolio cross-hedging. A hedger is any individual or institution that minimizes the variance of expected monetary returns on a currency spot position with regards to a position in the currency’s corresponding future contract. There are various reasons for hedging in a financial set up. First is for the purposes of managing volatility in cash flows. Secondly, hedging is important for the purposes of checking the market value of an organization’s shares. Hedging is also used for the purposes of managing volatility in accounting earnings. In addition, the management of balance sheet accounts and ratios can also benefit from hedging. For fund managers, performance information with regards to their hedging activities should be provided without restrictions or resistance from the fund manager. This is because funds may avoid reporting because of poor results. Such funds usually have below average returns in comparison to other funds and in addition, omitting them may result in an upward bias. On the other hand, there might be other funds that have become very successful as a result of growth in areas that they may not have actually wished to attract new investments. These funds may also decide to leave the database for a very different reason. Tentatively, their performance is likely to be superior to that of the average fund. Whereas there might be difficulties in attaining accurate estimates of these two effects, it is believed that the reported returns are usually biased upwards. Secondly, hedge fund databases have a limitation of reporting data only on funds still in existence or those that are new and rapidly growing. Funds that are no longer active are usually eliminated from the database. This practice in turn leaves an upward bias to performance statistics. This is because funds that are closed are likely to be poorly performing. Another type of bias can be referred to as the instant history bias. This occurs when a fund is included on the database for the first time and is therefore permitted to backfill its historical records. This type of bias could be estimated through the calculation of the average of the returns since introduction and later comparing them to the average returns since the fund joined the database. There are different hedge fund styles that are applicable in the financial markets today. Generally, hedge funds are not strictly regulated investment components that engage the use of a wide range of investment approaches. They posses relatively fewer investment restrictions and they can take short positions, use leverage and derivatives. The different types of hedge funds are characterized by its specific style or strategy. The following discussion briefly outlines the most common forms of hedge funds in financial market settings. First are the convertible arbitrage funds that invest in convertible securities. These securities employ both single-security and portfolio-hedging strategies. As a result, fund managers usually take a position in the convertible and hedge out the stock price risk. The second type is dedicated Short Bias funds. Short-biased managers invest mostly in short equity positions either directly or through derivatives. In addition, there are emerging markets. These funds invest in emerging markets with less developed economies and aim to profit from market growth or economic conditions. On the other hand, equity market neutral funds use quantitative strategies to profit from pricing inefficiencies among securities while hedging away market risk. There are also event-driven strategies that aim to profit from corporate events related to particular companies. Subcategories of event-driven strategies include merger arbitrage, distressed securities, and corporate actions. Merger Arbitrage is also another type of strategy. In this strategy, the fund aims to profit from mergers and acquisitions by buying shares of the target and in some cases going short the bidder's shares. Another is the Short Equity Long or short funds reduce risk by taking long positions in securities the manager thinks are undervalued and short positions in securities the manager believes to be overvalued. A2. Generally, the procedure for hedging involves a five-step process as indicated by Plaehn (2013). The first step is to identify a suitable stock market that will reflect the best composition of the portfolio. In this case, the company should be able to look at other companies that have same portfolios with it in the stock market. Secondly, it is important that there is a determination of the type of contract. This can be in the form of standard or mini contracts. In this case, the fund manager will need to employ the use of a standard contract. This is because the yield for the standard contract is likely to be higher in comparison to that of a mini contract. Third, it is important to calculate the amount of future contracts needed in hedging of the specified portfolio. The amount should be however close to the index of specified futures contract. This is for guarding against the risks associated with adjustments and fluctuations of prices. Next, it is important to sell futures contracts short. In so doing, the value of the stock is likely to decline while on the other hand, the value of sales benefits from such declines. This point is therefore sensitive for the success of the hedging process. Fund managers should therefore be careful so as to reap full benefits from their sold futures. Lastly, monitor the value of prices of the sold future contract and that of the traded stock index; on the other hand. Generally, as the index declines, the value of future options will increase to cater for loses in the portfolio. Having discussed how hedging using futures among other derivatives work, it is now important to look at the best way Euro Stoxx futures that are traded on EUREX can be hedged by the fund managers. This will be discussed in the section that follows. This discussion is based on the information that a European equity fund manager holds €100m in a portfolio comprising the largest European stocks and benchmarks the Euro Stoxx50 index. This index is currently 2695. As a result, they are highly concerned about the possibility of a sharp correction in European equity markets within the next three months and would therefore like an evaluation of their hedging choices. Additional information is also given as indicated below: Futures prices, volumes and open interest on 25th April 2013 Contract Expiry Price Volume Open Interest FESX Jun-13 2650 1,094,493 2,460,912 FESX Sept-13 2639 738 7,388 and also given the following Eurex - Euro Stoxx 50 Index Contract Details: Underlying: Euro Stoxx 50 Index Contract Size: 10 Eur = 1 Index point Quotation: Contract Is Quoted To One Decimal Place Minimum Price: 1 Tick = 10 Euro Contract Month: March, June, September, December Last Trading Day: Third Friday of the Month The amount of futures that the fund manager should be purchasing or selling therefore to hedge the company’s position can be determined as shown below: There are two case scenarios for this position. In case 1, purchase of FESX shall be as follows: Given; 10 Eur = 1 Index point Purchase of 2650 index points will lead to an overall increase in the value of future contract for the organization. This might prove quite useful given that it is ascertainable at the initial process given their relative prices are shown for the months of June and September 2013. On the second case, the organization needs to sell the available 2695 shares for the stated prices that may be subject to variations. The option of purchasing a future contract for the designated company shares is therefore viable in this case. The fund manager should therefore purchase the 2650 index shares. A3. However, the fund manager will be faced with a dilemma for purchasing either the June or September with regards to the risks associated with the two periods. For the June shares, the nature of hedging is a long one as opposed to that of September. The main issue however is that of the most applicable features which will yield the maximum benefits for the company. In the case of this company, the June feature contracts seem most viable because of a number of reasons and technicalities associated with hedging by the use of features. First, the index point shares have been predicted by the information supply to have the possibility of declining as at September 13th. As a result, it is important that the fund manager utilizes the futures for June because of the uncertainty created in the process. In addition, the long term hedging opportunity provided by the employment of June future contracts cannot be ignored by the company; given its fluctuating value of shares in the recent years. This is an opportunity for the improvement of this situation given the margin of returns that is likely to be obtained in the process. A4. Having identified the best options available for the fund manager in the different scenarios, it is important to highlight additional risks and considerations to be taken into account for using futures for hedging a portfolio identical to that of Euro Stoxx. First is the likelihood that prices may fluctuate before the maturity period of the traded future contract. This might be as a result of the prevailing economic conditions that may have an impact on say; interest rates or currency exchange rates. Secondly, it is important that the right number of shares be traded for the future contract if any meaningful gain is to be realized in the whole process. As a result, further research should be done on the financial markets to ensure that the trends are accurately captured (Kolb 2007). This analysis also relies on the value of a single portfolio that may not be suitable for future contracts of the company in future. It is therefore important that the contract is conducted within a restricted period as stated in the contract to avoid future inconsistencies. Lastly, it is important for the fund manager to be always in touch with the European financial market dealings so that sharp increases or declines in the value of portfolios have limited effects on the direction taken by the company when dealing with hedging by use of futures. Bibliography Hull, J., 2012. Options, Futures and Other Derivatives. New Jersey, Pearson Education Kolb, R., 2007. Futures, Options and Swaps. Chichester, Blackwell Publishing Plaehn, T., 2013. “How to Hedge with Stock Index Futures.” [Online]. Available at: http://www.ehow.com/how_6233199_hedge-stock-index-futures.html (accessed 5 June 2013). Read More