Hedging an Equity Portfolio - Coursework Example

Finance and Accounting Hedging an Equity Portfolio Contents Contents 2 Part A. 3 Portfolio Setup 3 Part B. 3 Hedging:- 3 Explain the advantages and disadvantages of using options to hedge this scenario compared to using futures only 3 Explain and discuss how a zero cost collar could be used in this scenario. Give an example using current options prices 4 Confirm your result using the OSA (Option Scenario Analysis) function on Bloomberg 5 Show and explain the effect of your hedge on the profit and loss of your portfolio in different market scenarios. Show screen casts of your result 6 Making reference to academic literature and recent events on financial markets, discuss the use and limitations of the Black-Scholes Option Pricing Model 8 Are there any additional risks and considerations to be taken into account when using options to hedge a portfolio in a situation like this. Discuss, making reference to academic literature 8 Part A. Portfolio Setup In case of portfolio set up we have chosen the date 3/7/2014. The size of the portfolio will be 22000 units of the FTSE 100 index as my birthday is 22/02/1991 thus the fund will hold 22 * 1000 = 22000 units of the FTSE 100 index. Part B. Hedging:- Explain the advantages and disadvantages of using options to hedge this scenario compared to using futures only We need to understand the concept of option and future before comparing them. Options are a type of contract which allows the holder the right but not the obligation to purchase or sell a security or asset or instrument at a before specified strike price on or before a specified date. Unlike the buyer, the seller has an obligation to complete the transaction as per the wishes of the option holder. Therefore since there is an doubt whether or not the holder will exercise his right or not the seller demands an option premium for his benefit which goes into his account whether or not the buyer exercises his option. The futures contract on the other hand binds the buyer for the exercise of the future for buying the asset at that specific price on that specific date and the seller too has to sell the asset/ security to the buyer on the specific date for the specific price by obligation. In this scenario, since there is a possibility of sharp correction in UK securities, the investors should go by options contract since they give the investors or the buyers the flexibility of obligation whether or not to purchase or sell the underlying securities. Here we can use option derivatives to hedge the portfolio and if we will gain profit if the market doesn’t fluctuate much. Explain and discuss how a zero cost collar could be used in this scenario. Give an example using current options prices Zero cost collars can be defined as a strategy which is created by buying a put and selling a call in the same underlying security so that the strike price of the call gives rise to the exact amount of profit to negate the loss in the put option, so that the underlying scenario leads to neither loss nor gain. This action or strategy is mostly used by the bullish traders or investors who anticipate always a rise or a hike in value of the underlying securities and thus the investors want to protect their position by offsetting the excessive rise in prices by putting a collar or a ceiling and simultaneously creating a put to offset the hike in prices leading to profit. The zero cost strategy is mostly carried out using LEAPS options (Long Term Equity Anticipation Securities). The profit of the zero cost collars can be calculated by using the formulae- Purchase price of the shares – strike price of the call whereas the minimum loss can be- stock price at the beginning- strike price of put-/+ net credit or debit on trade. In this given scenario where the market is anticipating correction, the zero cost collar can be used to protect the investors investment effectively since utilizing this strategy we can mitigate the losses completely and even if the investor is a bullish trader then the zero collar strategy can be used to even reduce the amount of price hike or value hike in the case of the afore mentioned underlying securities. We have taken the date on 3/7/2014. Thus we have shown the strike price, sell price of call and sell price of put of FTSE 100 index. Thus it can be seen that the investor will be helpful if invests by using the zero collar strategy. Confirm your result using the OSA (Option Scenario Analysis) function on Bloomberg We have 22000 units of FTSE 100 which we have invested in the call option and put option by using the zero collar strategy. Option strategy has been used here to hedge the risk of the portfolio and zero collar strategy has been used to mitigate the trading risk of option derivatives. As zero collar strategy states that we need to buy a put and sell a call thus at the strike price of 6850 we will sell 11000 units of call and will buy 11000 units of put. According to the option scenario analysis of FTSE 100, it has risen by 0.3% at 8:26 am. It has risen by 17.93 points to 6834.3. The main companies who were the gainers are Antofagasta Plc, Tullow Oil Plc and Fresnillo Plc (Bloomberg, 2014). From the above table it can be seen that the bid price of call option was 42 and the ask price was 43 and the last trading price was 36.50. We can trade at this price by selling 11000 units of call. The bid price of put was 34.50 and ask price of 36.00 and the last trading price was 37.00. Thus we can buy 11000 put at this price. Show and explain the effect of your hedge on the profit and loss of your portfolio in different market scenarios. Show screen casts of your result We have sold 11000 units of call option of FTSE 100. As a call option seller we have the obligation to sell and we can get the premium. We have sold the call option at 36.50. Thus the total price that we have sold for 11000 units is equal to 11000 * 36.50 = 401500. We have bought 11000 units of the put option. As a put option buyer we have right to sell but not the obligation to sell. We need to pay the premium to the put option seller. We have bought the 11000 units of FTSE 100 by using the put option at a price of 37.00. Thus the total buying price is 11000 * 37 = 407000. Now it can be seen that we have sold for 401500 amounts and we have bought for 407000 amounts. Now from the above table it can be seen that the call price has decreased and price of put has increased. Price of call has gone down to 24.50 and price of put has increased to 53.00. Thus we can see that we have gained through selling the call price because call price has gone down and we have sold it in higher price than 24.50. but if the call buyer will not agree in buying the call then we will get the premium only during the period of settlement because call buyer has no obligation to buy the option and as the call price has gone down to 24.50 thus he/she may not buy the call option. Then we will get only the premium. Now in case of put option it can be seen that the put price has gone up. It is known to us that put buyer gain from price going down. But here the price has gone up thus if we buy the put options then it will not be profitable for us thus we will not buy the put. We need to pay the premium to the put seller. Thus our total gain or loss will be the difference between premiums what we will get buy selling the call option and premium what we need to pay in case of buying the put option. If the premium of call option is higher than the premium paid for the put options then it will be profitable for us. The difference amount will be the profit. But if the premium of the put option is higher then the premium of the call option then the difference amount will be the loss what we need to bear. Thus our target will be to earn profit in our portfolio out of the settlement of the option derivatives. Making reference to academic literature and recent events on financial markets, discuss the use and limitations of the Black-Scholes Option Pricing Model The Black -Scholes options pricing model was propounded by Fischer Black and Myron Scholes. It is an analytical model used to find the underlying price of European option securities. The value of a European call option is calculated using the Black Scholes model using the formulae- C= SN (d1)- N(d2)Ke-rt where d1= {ln( S/K)+ (r +s2/2) t}/{s*t} and d2= d1-{s*t} , where, C is the call premium, S is the current stock price , t is the time until option expiration, K is the option striking price, r is the risk free interest rate, N is the cumulative standard normal deviation, e is the exponential term, S is the standard deviation and in is the natural log. The Black and Scholes options pricing model is used for finding out the values and prices of the European Call and Pot options. It does not include or consider any dividends distributed during the life of the option. The Black and Scholes model is based on certain assumptions and they are, the options are European options which are exercised at their maturity, no dividends are generally given out during the life time of the option, it is considered that the markets are efficient in nature, there is no presence of any commission, the risk free rate and the volatility of the stock is known and constant and it follows a lognormal distribution. Are there any additional risks and considerations to be taken into account when using options to hedge a portfolio in a situation like this. Discuss, making reference to academic literature It is known by all that financial market has various different risk factors and financial securities has various risk associated with it. There is no single strategy of investments which can mitigate the risk factors. Thus investors need to employ different investment strategies to hedge the risk factors. According to a study conducted by Fung Hsieh (2001), there are various hedging strategies are available in the market and the most popular strategies are “trend following” and “risk arbitrage”. Both the studies show the risk & return characteristics of the hedge funds to be non-linear and have stressed on the necessity of taking the options features in the hedge fund portfolio. According to Merton (1981), payoffs of the managed portfolios are needed to be monitored regularly in order to avoid the risk of loss in option trading. Dybvig and Ross (1985) have stated the importance of using option trading when the investor does not have vast information about trading in derivatives. Thus there are some risk factors in option trading such as risk of price fluctuation in call option and put option. Glosten and Jagannathan (1994) were the first to show that it is difficult to invest in option trading when the investor is not able point out the risk involved in the portfolio. Additional risks and considerations to be taken into account when using options to hedge a portfolio. Breeden and Litzenberger (1978) have stated that non-linear payoffs are very much important in option portfolio as it adds value to the portfolio and help to reduce the risk of loss. Harvey and Siddique (2000) have stated that the three factor model of Fama and French is important to drive skewness in the portfolio. The main motivation in using the option by the investors is to get liquid and regularly traded assets which have non-linear payoff that can be related to the market price to compute the return of the portfolio. Mitchell and Pulvino (2001) have shown that the risk arbitrage strategy having zero correlation during the up market condition will provide a positive return to the portfolio but on the other hand the positive correlations will provide negative returns during the market recession. Thus it can be said that it is true for all hedge fund indexes and regression specification can be used to have separate slope coefficients and intercepts when the market is going up and when it is below the return of median. Thus an investor needs to calculate all type of risk factors before using options to hedge a portfolio. Referencing:- Mitchell, M., and Pulvino, T., 2001. “Characteristics of Risk in Risk Arbitrage”. Journal of Finance. Harvey, C., and Siddique, A., 2000.”Conditional Skewness in Asset Pricing Tests”. Journal of Finance. Breeden, D., and Litzenberger, R., 1978. “Prices of State-Contingent Claims Implicit in Option Prices”. Journal of Business. Glosten, R., and Jagannatahn, R., 1994. “A Contingent Claim Approach to Performance Evaluation”. Journal of Empirical Finance. Dybvig, H., and Ross, S., 1985. “Differential Information and Performance Measurement Using a Security Market Line”. Journal of Finance. Merton, C., 1981. “On Market Timing and Investment Performance”. Journal of Business. Fung, W., and Hsieh, A., 2000a. “measuring the Market Impact of Hedge Funds”. Journal of Empirical Finnace. CBOE., No Date. HEDGING BASICS. [Pdf]. Available at : http://www.cboe.com/Institutional/hedge.pdf. [Accessed on June 3, 2014]. Intercontinental Excahnge., 2014. FTSE 100 INDEX OPTION. [Online]. Available at : https://globalderivatives.nyx.com/contract/content/29108/contract-specification. [Accessed on June 3, 2014]. Intercontinental Excahnge., 2014. JULY 2014 PRICES - 03/07/14. [Online]. Available at : https://globalderivatives.nyx.com/en/products/index-options/ESX-DLON?Class_type=O&Class_symbol=ESX&Class_exchange=DLON&ps=5&ex=T&md=. [Accessed on June 3, 2014]. Bloomberg., 2014. U.K. Stocks Climb as Antofagasta, Tullow, Fresnillo Gain. [Online]. Available at : http://www.businessweek.com/news/2014-07-03/u-dot-k-dot-stocks-climb-as-antofagasta-tullow-fresnillo-gain. [Accessed on June 3, 2014]. Read More