Financial Derivatives Trading - Options, Futures, and Swaps - Coursework Example

Derivatives Trading work 2: Hedging an Equity Portfolio Insert (s) Derivatives Trading Coursework 2: Hedging an Equity Portfolio Hedging a. Explain the advantages and disadvantages of using options to hedge this scenario compared to using futures only. (10 marks) There are a number of potential advantages and disadvantages of using option based hedging in the scenario presented in the case study as compared to using future based hedging only. Generally, in a financial setting, hedges are investments that are usually undertaken by companies or individuals to reduce or mitigate the risks in another existing investment. Both options and futures have been widely used in regulating asset prices particularly in ensuring the price to be paid or to be received for a particular asset (Hull and White, 2007, p.297). However, the use of options has different types of payoffs as compared to when only futures are used. Advantages One of the likely advantages of using option based hedging in the scenario presented in the case study as compared to using future based hedging only is that options provide a comparatively high level of hedge protection at less cost compared to futures based hedging. This is particularly attributed to the high number of available options that enable buyers or sellers to tailor their option hedge in a manner help controls the leverage versus stock ratio of their hedging as well as cover the specific sectors or stocks of the market. On the other hand, hedging with futures normally entail using the currency futures such as by purchasing the currency futures for a particular currency that one will need in the future in order to hedge future payables. In this regard, using an option based hedging would give the equity funds manager the right as opposed to an obligation to buy or sell a particular asset for a given price at any given time during the contract while using a future contact provides the manager with an obligation to purchase a particular asset or sell it a given future date before the expiration period. Disadvantages Despite the numerous advantages that using options to hedge this scenario would present to the trust fund manager as compared to using futures only, options based hedging has a few potential limitations particularly with regard to the issue of expiration date. For example, long term options are often expensive while short term options are likely to expire before the company may need any hedge protection (Merton, 2003). Additionally, in comparison to futures based hedging, the existence of a large number of options is also a serious disadvantage as it increases the likelihood for one to pick a wrong option even after making a correct forecast. The Hedge as Described by the Formula As described by the formula, hedging is primarily based on the principle that both cash prices and future prices often tend to increase or decline together. The fundamental difference between option based hedging and future based hedging is particularly based on the different obligations that they place on the buyers or sellers. For example, hedging with options involves using limited term contracts to enable individuals or companies to sell or buy certain securities at a particular fixed price until a given expiration date. Finally, in the scenario presented in the case study, the use of options as a hedging will allow the equity funds manager to effectively trade against individual stock indexes and exchange trade funds while call options. b. Explain and discuss how a zero cost collar could be used in this scenario. Give an example using current options prices. (20 marks) A zero cost(cashless) collar could be used in case scenario by combining the purchase of a put option together with the sale of a call option but at a relatively lower floor price. This is particularly important as it will enable the company to put a cap on the sales of the call options in the event that the stock prices fail thereby helping offset the cost of put option. According to Black and Myron (2013), zero cost collar is an important option based hedge agreement designed that is normally characterized by the purchase of a protective put equal to the price of a derivative (popularly known as a cap and a floor) in order to offset the volatility risk. Additionally, the strategy of using zero cost(cashless) collar in the above scenario could be critically important particularly if the equity fund manager strongly believes that the stock prices is likely to continue gaining value. The other important benefits that using a zero cost collar could provide in the presented scenario include providing an opportunity for the investment company to create a floor level as opposed to paying for an upfront cap and providing benefits from the falling prices. c. Confirm your result using the OSA (Option Scenario Analysis) function on Bloomberg. Show a screen cast of the function 32) Hedge position (10 marks) The confirmation of the results based on the OSA (Option Scenario Analysis) function on Bloomberg shows that the use of a zero cost collar in the hedge strategy is important as it can would allow the company to hedge costlessly while at the same time maintaining its potential for making profit in the same position as shown in the figure below: Figure 1.3: Function 32 hedge positions d. Show and explain, using the functions 33) Scenario Matrix and 35) Multi-Asset Scenario, the effect of your hedge on the profit and loss of your portfolio in different Market scenarios. Show screen casts of your results. (10 marks) Figure 1.4: Function 33 Scenario Matrix e. The use and limitations of the Black-Scholes Option Pricing Model. (20 marks) The Dark Scholes model is utilized to ascertain a hypothetical call value (overlooking profits paid amid the life of the choice) utilizing the five key determinants of an alternatives value: stock value, strike value, unpredictability, time to lapse, and short-term (hazard free) intrigue rate. According to many experts, the Dark Scholes model can also be utilized to compute the hypothetical cost of European put and call choices, disregarding any profits paid amid the choices lifetime. While the first Dark Scholes model did not look into the impacts of profits paid amid the life of the alternative, the model can be adjusted to record for profits by deciding the ex-profit date estimation of the basic stock. An increment in interest rates will drive up call premiums and this puts premiums to reduction. To comprehend why, you have to consider the impact of interest rates when contrasting an alternative position with essentiality of owning the stock. Since it is much less expensive to purchase a call alternative than 100 shares of the stock, the call purchaser is willing to pay more for the choice when rates are moderately high, since he or she can put the distinction in the capital needed between the two positions. At the point when interest rates are consistently tumbling to a point where the Federal Reserve Stores objective is down to around 1.0% and fleeting interest rates accessible to people are around 0.75% to 2.0% (like in late 2003), interest rates have a negligible impact on choice costs. All the best choice investigation models incorporate premium rates in their figurings utilizing a danger free premium rate, for example, U.S. Treasury rates. Interest rates are the basic figure figuring out if to practice a put alternative early. A stock put choice turns into an early practice competitor at whatever time the premium that could be earned on the returns from the offer of the stock at the strike cost is sufficiently vast. Deciding precisely when this happens is troublesome, since every individual has diverse open door costs, however it does imply that early practice for a stock put alternative can be ideal whenever gave the premium earned turns out to be adequately extraordinary (Heston, 2003, p.328). Basing on unpredictability Smiles and Surfaces, The one of the inaccurate supposition of the Dark Scholes zone is that the unpredictability of the basic is consistent. In the event that unpredictability is not a straightforward steady then maybe it is a more convoluted capacity of time and/ or the fundamental. Considering inferred unpredictability and instability grins, the standard approach to gauge unpredictability for a given underlying is to utilize the cost of a choice on that underlie. Assume a call alternative on the fundamental is effectively exchange, so the choices cost is promptly realistic. At that point, by applying a suitable alternative evaluating recipe in a sense in reverse we ascertain the yearly unpredictability that would need to be data into the alternative evaluating recipe to get that cost for the choice. In this way, we acquire the unpredictability suggested by the alternative value what is known as the inferred instability for the fundamental. Most subordinates markets show persevering examples of volatilities differing by strike. One of the greatest errors new choices brokers make is purchasing a call alternative with a specific end goal to attempt and pick a champ. As it would turn out, purchasing calls maps to the example youre accustomed to taking after as a value merchant: purchase low, offer high, in a specific order. Once in a while the basic stock moves in the normal course, yet the alternative doesnt, or even the other way around. Alternatives with distinctive strikes move diversely when the basic value climbs and down, furthermore as the alternative methodologies lapse. Is there any numerical approach to gauge what amount your alternative may move as the hidden moves? The answer is delta – it gives some piece of the motivation to how and why an alternatives value moves the way it does. There are various meanings of delta, yet the clarification that takes after is the essential one. Delta is the sum a hypothetical choices cost will change for a relating one-unit (point/dollar) change in the cost of the fundamental security – accepting, obviously, every single other variable are unaltered. On the other hand, Gamma is the sum a theoretical alternatives delta will change for a comparing one-unit (point) change in the cost of the hidden security. As it were, whether you take a gander at delta as the "rate" of your choice position, gamma is the "quickening". Gamma is certain when purchasing alternatives and negative when offering them. Dissimilar to delta, the sign is not influenced when exchanging a call or put. Gamma is most astounding for close term ATM strikes, and inclines off toward ITM, OTM, and far-term strikes. This bodes well in the event that you think it through: a choice that is ATM and near to termination has a high probability to quicken to the completion in either course. Limitations of the dark scholes The Dark Scholes model has one noteworthy constraint: it cant be utilized to precisely value choices with an American-style practice as it just ascertains the choice cost at one point in time - at close. It doesnt consider the progressions along the route where there could be the likelihood of right on time activity of an American choice. As all trade exchanged value alternatives have American-style exercise (i.e. they can be worked out whenever instead of European choices which must be practiced at close) this is a critical confinement. The exemption to this is an American approach a non-profit paying resource. For this situation the call is constantly justified regardless of the same as its European proportional as there is never any favorable position in practicing early. Different conformities are now and then made to the Dark Scholes cost to empower it to estimated American choice costs (e.g. the Fischer Dark Pseudo-American technique) however these just function admirably inside of specific points of confinement and they dont generally function admirably for puts. Unpredictability grins and surfaces can indicate specifically that instability is not a basic steady. It is more convoluted capacity of time and capacity of benefits, and in addition capacity of both. Unpredictability is difficult to gauge, watch or foresee, the established system is to model it stochastically. The upside of bounce inversion procedure is that depicts better the truth by both perspective, financial and factual time-arrangement. We have two issues with hop dispersion procedures, for example, the outlandish possibility to construct a hazard less portfolio and challenges with parameters gauge. The genuine feedback is the troubles with supporting. Because of the hop part, the business is fragmented, and the customary riskless supporting contentions are not pertinent here. Then again, it ought to be called attention to that the riskless supporting is truly a unique property of constant time Brownian movement, and it doesnt hold for the greater part of the option models. Indeed, even inside of the Brownian movement structure, the riskless supporting is outlandish if one needs to do it in discrete time. f. 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. (20 marks) There are a few additional risks of using dark scholes model. For example, the stock pays no profits amid the alternatives life .Most organizations pay profits to their offer holders, so this may appear a genuine constraint to the model considering the perception that higher profit yields evoke lower call premiums. A typical method for changing the model for this circumstance is to subtract the marked down estimation of a future profit from the stock cost. European activity terms are utilized European activity terms direct that the choice must be practiced on the close date. References Black, F., Myron S. 2013. The Pricing of Options and Corporate Liability. Journal of Political Economy, 81(3): 637-654 Cox, J.C. & Ross, S.A. 2006. The Valuation of Options for Alternative Stochastic Processes. Journal of Financial Economics, 7(3): 229-263 Heston, S.L. 2003. A Closed-Form Solution for Options with Stochastic Volatility with Application to Bond and Currency Options”, The Review of Financial Studies, 6(3): 327-343 Hull, J.C. and White, A. 2007. The Pricing of Options on Assets with Stochastic Volatilities”, Journal of Finance, 43: 281-300 Merton, R.C. 2003. Theory of Rational Option Pricing. Bell Journal of Economics and Management Science 4(1):141-183 Read More