Hedging an Equity Portfolio - Term Paper Example

Hedging an Equity Portfolio 0 Portfolio Setup The portfolio set up chosen was for 12 June 204. The price data was 1000 for index and futures for this particular date. It was selected as the preferred portfolio setup because it gives a good base for calculation of the various swap, derivatives, and options and futures for hedging purposes. This will help the finance manager plan appropriately for the company in the future and the long run. This was done by using price data for index futures of a preferred date like 12th June 2014 to come up with the portfolio setup. b. From the units of FTSE 100 index, the calculated units of FTSE 100 index will equivalent to the managers birthday multiplied by 1000. This can be calculated by taking the date of birth and multiplying it by 1000 as shown below 15/10/1991 = 15 x 1000 = 15,000 The calculation above indicates an appropriate setup that reveals the units the manager should give more preference when calculating the hedging ability of the company (Bhole & Mahakud, 2011). 2.0 Hedging Risk Faced By the Fund Manager and Application of Futures to Hedge It. Hedging is the process of limiting or qualifying a financial instrument by exception or condition. It may involve a strategy used in risk management as a way of offsetting or limiting any loss contemplated to be as a result of price fluctuations, currency exchange rates, price of commodities or the security exchange rates. It is seen as a perfect way of ensuring that financial risk are covered without taking a formal insurance policy. In the process of covering the risk, hedging uses various technologies to create equal forces acting in the opposite direction in a money market. Besides, hedging protects the financial capital of an organization from any loss that may arise from inflation during an investment. Moreover, the economic models that bear high yields like shares, bonds and note, the real estate sector and precious metals may be subjected to hedging to minimize any loss of value. During the process of hedging, the finance manager needs to take precaution over the following risk factors that may deter the success of any hedging strategy (Bhole, 2013). 2.1 Risks Related To Transaction Costs. Transaction cost has been a major barrier for many institutions, especially in international market investment. This has been facilitated by the fact that the expense of the operation depends on the nature and location of the market in the globe. The international market has for a long time charged high brokerage fees that scare several foreign investors. Moreover, the foreign investors are discriminated against by living extra charges, especially in the local markets. In most cases, such additional costs include taxes, levies, clearance fees, stamp duties and exchange fees 2.2 Currency Risks The currency volatility has posed a significant risk to investors seeking to get entry into the international markets. This has been a major challenge for retail investors who focus on getting direct entry to foreign markets without passing through ADRs. The retailers are forced to exchange their domestic currency into the currency denomination of the country they intend to invest in. The most volatile part of this venture is when a foreign stock is bought and held for one year. In the onset of selling the stock, the currency has to be converted again into a domestic currency at a prevailing exchange rate. Any fluctuation in exchange rate between these two transaction periods will mean that the retailer has to either incur loss or profit. The rate of exchange rates in future is uncertain and thus many investors are afraid of taking such risk to invest in foreign stocks. However, it is possible to eliminate this risk since a large percentage of the foreign stock return is affected by the return of the currency. Hedging the exposure of currency will work best for retailers in ensuring that the currency risk is eliminated. This, a careful selection of the correct product to be used is important in hedging currency risk. It is at this point that the application of option, forwards and currency futures comes in as a means of hedging currency risk. The challenge is the complexity associated with these financial instruments especially when it comes to an ordinary investor. Thus, a more user-friendly means that a reasonable investor can apply in hedging currency risk is currency ETF. It offers a better option given its user-friendliness, accessibility, and good liquidity. Besides, it is relatively simple as compared to the other complex methods. 2.3 Liquidity Risks Liquidity risk is the other risk that has posed significant challenges to the international markets. The most affected sector is the emerging market that has failed to survive the volatility of stock liquidity. This risk is associated with the draw back from selling stocks to the market immediately and order for sale is entered. Liquidity risk is a significant challenge because it is almost difficult to eliminate, unlike the currency risk. However, a normal investor may explore alternative means of safeguarding their investments from risks related to stock liquidity. Alternatively, the focus should be given to foreign investments that are illiquid or are prone to liquidity at the moment the investors intend to close their position. Also, an asset may be evaluated to ascertain its liquidity before a purchase is placed. A good example is the application of the bid-ask-spread of the stock over a certain duration before it is purchased. The assets that are not affected by liquidity will show a wider bid-ask-spread as opposed to the liquid stocks. Any stock that displays a narrow spread and a relatively higher volume that the rest indicates high liquidity. Thus, is possible to create a picture of the liquidity status of the stocks being traded in to reduce any risk related to liquidity (Redhead, 2012). 3.0 June or September Futures are Most Appropriate The future of June or September will be most suitable in this case and should be taken into consideration. This is because this is the period during which the rate of trading in the stock is lower, and thus the three risk related to hedging are at their minimum. Moreover, at this point it will be possible to reduce any form of financial loss that may result from any investment action taken in the international market. What makes the futures of June or September more appropriate is the time frame that it allows for the adjustment of the hedging process in the market. 4.0 The Number of Futures to Be Bought or Sold To Hedge the Position The number of futures to be bought or sold to hedge the position of the company depends on the nature of the futures. This is because they are the most used derivatives in the process of hedging risk. In this process, two parties agree on a certain purchase price of an assets to be conducted in future. This helps protect the investor against any risk associated with the transaction in case of price, the currency of other factors happens in future. This helps in offsetting any exposure to financial risk while limiting the potential loss from price fluctuation. Neutralizing the risk is more realistic in a situation where the asset is not available for a future contract. The determination of the futures to be used in hedging a risk takes into consideration the spot price of an asset, the anticipated future cost of that assets. The future price is considered as the value that the investor holds and can achieve at a current rate without incurring any extra cost at a later stage. If a company is uncertain of the future. Long term position is the best alternative. However, if the company is confident of the future, then the best option is the short term. Futures are important in ensuring that the uncertainty of prices is eliminated in the stock trade. The management should thus consider locking an item in the most preferred price so that any ambiguity concerning profits and expenses are eliminated. The process of calculating the number of futures to be used to hedge a risk takes the principle of the cash price and compare it with the future cost of an asset. This policy aims at offsetting the loss from one market dealing with money with the gains from another market dealing with future prices. This will help an investor to establish the level of price existing in a stock market thus increasing protection from any adverse price fluctuation. 4.1 Short Term Hedging Option Table 1: Confirmation of result using the OSA function on Bloomberg. Cash Market Futures Market Basis May Receives cash forward (July) bid at $1.18 Sells July stock futures at $1.28 -.10 July Sells cash stock at $1.15/gal in the spot Buys July stock futures at $1.20 -.05 Cash Market Futures Market Basis May Receives cash forward (July) bid at $1.20 Sells July stock future at 1.25 -.05 July Sells cash stock at $1.25 Buys July stock futures at $1.35 -.10 Change $.05 gain $.10loss .05 loss Confirmation of result using the OSA (Option Scenario Analysis) function on Bloomberg. Showing a screen cast of the function 32) Hedge position. This means that the equivalent to the hedge ration in OSA function is shown in the diagram below. Figure 1: Showing a screen cast of the function 32 Source: http//www. Bloomberg.com 4.2 Long Term Hedging Option On the other hand, an explanation with function 33 scenario matrix 35 multi-Asset scenario. The effect of the hedge on profit and loss of the portfolio in different market scenario is shown below. In a decreasing price scenario, it is expected that the long hedge applies futures that will cover all risk relevant to the investment. In this scenario, buying futures as opposed to cash will result into fall in prices. However when the purchase is made at a lower price, then it is possible to offset the loss in future by selling at a slightly higher price. Figure 2: function 33 scenario matrix 35 multi-Asset scenario. Source: http//www. Bloomberg.com Table 1: calculation of function 33 scenario matrix 35 multi-Asset scenario. In a market with increasing prices, the investor will hedge their stick while awaiting for the price increase. The only way of finding the correct futures to use is by buying the stocks in cash today at a lower price awaiting the future increase. The result will be a significant gain in the future market by locking the future sale prices in the choosing to buy in cash. Moreover weakening basis may lead to even better gains. Table 3 calculation of function 33 scenario matrix 35 multi-Asset scenario. Cash Market Futures Market Basis May Receives cash forward (July) offer at $1.15 Buys July stock futures at $1.25 -.10 July Buys cash stock at $1.20 Sells July stock futures at $1.35 -.15 Change $.05 loss $.10 gain .05 cent gain 5.0 The Use and Limitations of the Hedge Ratio The hedge ratio is the comparison of the value attributed to a whole position occupied by stock and the value that has been protected through a hedge process. Moreover, it may refer to a value of the contracts to be bought in future about the value of the commodities under hedging in the form of cash. Thus, hedging ratio represents the number of stocks sheltered from the risk of the exchange rate. The hedge ratio is used to minimize the risk that have been identified as common to the stock investment. It offers the best solution for investors in future contracts especially when the investor seeks to reduce the risk likely to be faced in the investment process. The limitation of the hedging ratio is that it is affected by market volatility. This was proved by an investigation of the future market of India to determine the relationship between time-invariant and hedges that vary with time. Moreover, the hedge ratio creates a lot of problems that lead to the complication of individual stocks during the financial crisis (Rendleman, 2002). 6.0 Additional Risks and Considerations to Be Taken into Account When Using Futures to Hedge a Portfolio in a Situation like This Some additional risk and considerations exist that needs to be given preference in the process of using futures to hedge on the profit and loss of the portfolio. Besides, the nature of market diversity has enabled the application of alternative methods to ensure no extra risk is incurred. In a portfolio of such magnitude. An example of such additional risk is the currency exposure that is an essential element of managing market risk. Currency exposure is critical I facilitating the capitalization of economies of scale and thus creating a concrete hedge for payments of foreign exchange. Another risk that may originate from the central treasury, frequency of currency turns is also potential risks. The module of SAP cash management and market risk from additional risk factors in the hedging process. Moreover, operational cash flow risk and risk related to financial transactions are shared in the hedging process. In rare cases, the risk associated with portfolio hierarchical node pose an additional challenge to investors in hedging process. Under the hierarchical node risk, factors such as counteract risk, risk associated with organization structure and operations, and interest are significant challenges in hedging (Hull, 2012). Bibliography Rendleman, R. J. (2002). Applied derivatives: options, futures, and swaps. Malden, Mass. [u.a.], Blackwell. Redhead, K. (2012). Financial derivatives: an introduction to futures, forwards, options and swaps. London, Prentice Hall. Bhole, L. M., & Mahakud, J. (2011). Financial institutions and markets: structure, growth and innovations. New Delhi, Tata McGraw-Hill. Bhole, L. M. (2013). ). Financial derivatives: theory, concepts and problems. New Delhi, Prentice-Hall of India. Elliott, R. J., & Kopp, P. E. (2005). Mathematics of financial markets. New York, Springer. http://www.myilibrary.com?id=133422. Hull, J. (2012). Options, futures, and other derivatives. Boston, Prentice Hall. Read More