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STOCK PORTFOLIO HEDGINGWITH DERIVATIVES
STOCK PORTFOLIO HEDGINGWITH DERIVATIVES
Madalina Cojocaru PetrilaDarius Cipariu
Mentor: Professor Thomas KruegerJuly 15th , 2005
United States stock marketUnited States stock market
New York Stock Exchange (NYSE) - founded in 1792 and was named New York Stock & Exchange Board until 1863
National Association of Securities Dealers Automated Quotation System (NASDAQ) – an electronic stock exchange founded by the National Association of Securities Dealers (NASD)
United States Exchange IndexesUnited States Exchange Indexes
The Dow Jones Industrial Average - is the oldest and most watched index The NASDAQ Stock Market composite (IXIC) - is composed of all the stocks on the NASDAQ exchange – more than 5,000 firms
The Standard & Poor’s 500 Index (S&P500) – is a market weighted index - tracks 500 of the most representative companies based in the US selected upon size, liquidity and sector
Romanian stock marketRomanian stock market
Bucharest Stock Exchange was re-opened in 1995 and launched the first official index in September 1997: BET – Bucharest Exchange Trading index
Rasdaq Electronic Exchange was designed for filling the trading needs as a result of mass-privatization program and launched the first official index in July 1998: RAQ-C – Rasdaq Composite index
Stock PortfolioStock Portfolio
Steps in order to build a portfolio:
Setting the objective Setting the time horizon Choosing the stocks
Stock PortfolioStock Portfolio
Strategies for choosing the stocks: Buy and hold Market timing Growth Value GARP Income
Stock SelectionStock Selection
Fundamental analysis: Earnings per share Dividend Payout Ratio Return on EquityTechnical analysis: Chart patterns analysis
Stock portfolio protection with derivatives
Stock portfolio protection with derivatives
Risk of stock portfolio: price DECLINE in the stock market
Hedging: “Taking a position in a futures or option market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change.”
Position cash market: LONG Position in futures market: SHORT
¹ www.liffeweather.com/glossary.aspx
Stock portfolio protection with derivatives
Stock portfolio protection with derivatives
By using derivatives instruments a portfolio manager can preserve or improve the value of a stock portfolio.
Hedging: “Taking a position in a futures or option market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change.”
Risk: DOWNTREND in stock market Cash market position: LONG on stocksFutures market position: SHORT on stocks or indexOption market position: LONG PUT OPTIONS on stock or index
¹ www.liffeweather.com/glossary.aspx
Stock portfolio protection with derivatives
Stock portfolio protection with derivatives
Derivatives instruments used to protect a stock portfolio
Single stock futures - One Chicago, SMFCE
Equity Index futures - CME, CBOT
Single stock options - CBOE
Equity options - CBOE
Options on futures - CME, CBOT, SMFCE
Stock portfolio hedging with single stock futures
Stock portfolio hedging with single stock futures
Single stock futures contract : an agreement to deliver a certain amount of shares of a specific stock at the expiration date.
In the USA, over 200 stocks are traded at One Chicago.In Romania 19 stocks are traded at SMFCE.
Position cash market: LONG Position in futures market: SHORT
Stock portfolio hedging with single stock futures
Stock portfolio hedging with single stock futures
Example – Best Buy Co (BBY)
gain
loss
LONG BBY
(NYSE)
SHORT BBY
(One Chi)
BBY cash price
55 68
NYSE
LONG 1,000
BBY shares at $55 One Chicago
SHORT 10 BBY
contracts at $68
(1 futures = 100 shares)
Value of BBY shares ensured:
1,000 x $68 = $68,000
Stock portfolio hedging with single stock futures
Stock portfolio hedging with single stock futures
1 2 3 4
BBY price
at futures expiration date
Stock market
(NYSE)
Futures
(One Chicago)
Net result
(2+3)
BBY (NYSE)<$68
Assume BBY = $60
1,000*60
= $60,000 (68-60)*10*100
= $8,000
$60,000 + $8,000 =
$68,000
BBY (NYSE) = $68
1,000*68
= $68,000
(68-68)*10*100
= 0 $68,000 + 0=
$68,000
BBY(NYSE)>$68
Assume BBY = $75
1,000*75
= $75,000
(68-75)*10*100
= - $7,000
$75,000 – $7,000=
$68,000
Stock portfolio hedging withequity index futures
Stock portfolio hedging withequity index futures
The stock index futures contract has the same specifications as the single stock futures contract, the only difference arising from the underlying assets which is not a specific number of stocks, but a specific number of index units.
At the expiration date, all settlements are in cash because of the nature of the indexes (they are just abstract numbers and not physical items like agricultural commodities for example).
Stock portfolio hedging withequity index futures
Stock portfolio hedging withequity index futures
The principle of using stock index futures for hedging purpose is the same like in the single stock futures situation: a long position in the stock market will be offset by a short position taken in the stock index futures market.
Most traded indexes on the US futures markets:
S&P 500, DJIA, NASDAQ
Stock portfolio hedging withequity index futures
Stock portfolio hedging withequity index futures
The number of futures contracts that must be sold in order to hedge a stock portfolio is called hedge ratio and is computed by using the following formula:
Dollar value of portfolio
HR = * beta of portfolio
Dollar value of S&P 500
index futures contract
Stock portfolio hedging withequity index futures
Stock portfolio hedging withequity index futures
Number of SPX Sep 05 futures contracts needed to be sold in order to protect the $10,000,000 portfolio:
10,000,000
HR = * 1.1 = 36.72 (37 rounded).
250 x 1,198
Stock portfolio hedging withequity index futures
Stock portfolio hedging withequity index futures
1 2 3 4
S&P 500 value price at futures expiration
date
Stock market Futures Market Net result
(2+3)
S&P 500 < $ 1194
Assume
S&P 500 = 1,100
(decrease of 7,87%)
10m –
(10m * 7,87%) * 1.1
= $9,134,300
37 * 250 *
(1,198 – 1,100)
= $906,500
9,134,300
+ 906,500
= $10,040,800
S&P 500 = 1,194 $10,000,000 37 * 250 *
(1,198 – 1,194)
= $37,000
10,000,000
+ 37,000
= $10,037,000 S&P 500 > $ 1194
Assume
S&P 500 = 1,230
(increase of 3.015%)
10m* +
(10m * 3.015% * 1.1)
= $10,331,650
37 * 250 *
(1,198 – 1,230)
= - $296,000
10,331,650
- 296,000
= $10,035,650
Stock portfolio hedging withoptions
Stock portfolio hedging withoptions
Options give the buyer the right, but not the obligation to buy or sell the underlying asset at the strike price until the expiration date of the contract. The buyer must pay a premium to the seller of the option.
In this situation, the underlying asset means a stock, an equity index or a futures contract.
The best hedging strategy with options means to buy PUT options on single stock or equity index.
Stock portfolio hedging withPUT options
Stock portfolio hedging withPUT options
Number of Puts needed to be sold in order to protect the stocks purchased on the cash market is given by the
formula of hedge ratio:
Dollar value of portfolio 1
HR = * Contract value Delta
Delta is a specific element of options and shows how an option price changes for a given change in the underlying asset.
Thank youThank you