Hedging of a Portfolio through the Use of Index Futures Contracts - Case Study Example

Hedging of a portfolio through the use of “index futures contracts” SUMMARY The “Nairobi Stock Exchange, NSE” is the chief stock exchange in Kenya. It is a subscribed member of “The African Stock Exchanges Association”. The stock exchange works in joint-cooperation with “the Uganda Securities Exchange” and the “Dares Salaam Stock Exchange” and including cross-listings of diverse equities. The “NSE 20-share Index” has been operational since 1964. It measures performance of “20 blue-chip companies” which have got very strong essentials and that register consistent positive financial returns (Chance and Brooks 2009). This report considers 8 shares included in the index as follows: E. A. Cables’ Ltd, Carbacid-Investments Ltd, ‘E. A. Breweries Ltd’, Kengen Ltd, Sameer Africa, Unga-Group Ltd, Mumias-Sugar Co. Ltd, and Bamburi-Cement Ltd. Introduction Hedging is basically a concept through which an investor can have assurance that losses from his investment in the share market are minimized whenever the stock market declines. It can be achieved through the use of “index futures contracts” This report documents a $ 10,000,000 portfolio that consists of E. A. Cables’ Ltd, Carbacid-Investments Ltd, ‘E. A. Breweries Ltd’, Kengen Ltd, Sameer Africa, Unga-Group Ltd, Mumias-Sugar Co. Ltd, and Bamburi-Cement Ltd. This investment is made in the manner shown in the table that follows: Type of shares Symbol Total investment Beta E. A. Cables’ Ltd CABL 2,400,000 1.4 Carbacid-Investments Ltd CARB 2,100,000 1.3 ‘E. A. Breweries Ltd’ EABL 1,700,000 1.0 Kengen Ltd KGEN 1,400,000 1.2 Sameer Africa FEAL 1,100,000 0.7 Unga Group Ltd UNGA 800,000 0.8 Mumias-Sugar Co. Ltd MSCL 300,000 0.9 Bamburi-Cement Ltd BAMB 200,000 1.1 The beta of this portfolio will be found by calculating the summation of weighted average of the respective betas of the given shares in the portfolio. That is, (2,400,000/10,000,000) * (1.4) + (2,100,000/10,000,000) * (1.3) + (1,700,000/10,000,000) * (1.0) + (1,400,000 /10,000,000) * (1.2) + (1,100,000/10,000,000) * (0.7) + (800,000/10,000,000) * (0.8) + (300,000/ 10,000,000) * (0.9) + (200,000/10,000,000) * (1.1) = 1.137 The beta of this portfolio is greater than 1. This means that the portfolio is highly volatile and that the price movements of the shares keep changing on daily basis. This obviously heightens the need of the investor to take necessary measures to cushion against the uncertainty of the future price of the shares by engaging in an index futures contract (Scheidler 2007). This is usually caused by a change in the portfolio beta which results from a change in any of its individual shares. For instance, assume that the market is currently in equilibrium (that is, expected return = required return) and thus the KGEN Stock is fairly priced at $5 per share. If a press release indicates that a major product liability suit has been filed against Kengen Ltd, as a result investors immediately adjust their risk assessment. In essence, a portfolio’s beta is basically the “weighted sum” of the given individual share betas in the accordance of their respective proportions of investment made in the said portfolio. Portfolio beta generally describes the “relative volatility” of individual share portfolio, entirely taken, as calculated by the betas of the individual shares making up the portfolio. When the beta of a portfolio is equal to one it is a clear indication that the volatility of the portfolio reflects the wider market situation. Similarly, a beta which is more than one will indicate a greater volatility thus indicating that there is a high tendency of the movement of the price of the shares being volatile than the wider market considered as a whole. Whereas a portfolio beta that is less than one will show a lower volatility (Kolb and Overdahl 2006). Portfolio beta is generally incorporated in the “Capital Asset Pricing Model, CAPM”. “Futures contract” is a contract between 2 parties that are engaged in the exchange of a particular share for the price agreed now (futures price) but whose delivery will occur at a named future date -delivery date. The party that agrees to buy shares in a future date (long futures contract) usually has the hope that the price of the share is likely to increase whereas the party that agrees to sell his shares in future (short futures contract) usually has the hope that the price of the share is likely to come down. However this contract does cost anything to enter and it merely shows the position that each party takes (either long or short futures contract position). Futures contract will generally specify an exchange that will normally take place in a future date and the purpose of making this exchange in the future is to try to minimize the probable risk that either of the parties to the contract might default. The exchange will therefore require that both the buyer and the seller should put a cash margin (an initial amount). The futures price will keep changing on a daily basis and hence the discrepancy in the price that was agreed in advance and the futures price as per that time should also be settled daily. Since there are two margin accounts, an exchange will be drawing cash from the margin account of one party and crediting that amount to the margin account of the other party. This process will definitely lead to each party having the proper daily profit or loss. Therefore, during the delivery date, the cash amount that will be exchanged cannot be the price that was specified in the contract, it will be the “spot value” because any loss or gain has already been previously settled by marking to market. Note that the futures contract’s parties must execute the contract they entered on the specified delivery date. In this case the seller will deliver the share to the buyer and the buyer must pay for the shares at the spot value of those shares. The profit or the loss whichever the case is the disparity in the futures prices. Share valuation Common stock holders expect to be rewarded through the receipt of periodic cash dividends and or an increasing or at least non-declining share value. Like current owners, prospective owners and also share analysts frequently estimate the firm’s value. They choose to purchase the shares when they believe it to be undervalued (that is its true value is greater than its market price) and to sell it when they believe it to be overvalued (that is, its market price is greater than its true value). The table below shows the market situation of the shares under consideration in this report. Share’s Symbol Current price of the share Required return % (as at 1st April) Expected return % (by 30th June) CABL 3 13 14 CARB 2.5 11 12 EABL 1.4 12 14 KGEN 5 13 13 FEAL 2.0 14 13 UNGA 0.8 10 10 MSCL 1.9 12 11 BAMB 2.3 14 12 Current price of the portfolio (2,400,000/10,000,000) * (3) + (2,100,000/10,000,000) * (2.5) + (1,700,000/10,000,000) * (1.4) + (1,400,000 /10,000,000) * (5) + (1,100,000/10,000,000) * (2) + (800,000/10,000,000) * (0.8) + (300,000/ 10,000,000) * (1.9) + (200,000/10,000,000) * (2.3) = 2.57 Expected return for the portfolio (2,400,000/10,000,000) * (14 %) + (2,100,000/10,000,000) * (12 %) + (1,700,000/10,000,000) * (14 %) + (1,400,000 /10,000,000) * (13 %) + (1,100,000/10,000,000) * (13 %) + (800,000/10,000,000) * (10 %) + (300,000/ 10,000,000) * (11 %) + (200,000/10,000,000) * (12 %) = 12.88% Required return for the portfolio (2,400,000/10,000,000) * (13 %) + (2,100,000/10,000,000) * (11 %) + (1,700,000/10,000,000) * (12 %) + (1,400,000 /10,000,000) * (13 %) + (1,100,000/10,000,000) * (14 %) + (800,000/10,000,000) * (10 %) + (300,000/ 10,000,000) * (12 %) + (200,000/10,000,000) * (14 %) = 12.27% Market efficiency Economically rational buyers and sellers of shares use the assessment of shares’ risk and return to determine its value. In a competitive market with many active participants the interaction of many buyers (demanders of shares) and sellers (suppliers of shares) results in an equilibrium price and or market value for its shares. As new information becomes available, buyers and sellers use such information and through purchase and sales activities they create new equilibrium price for the share. Investors do require a specified return given the level of risk (portfolio beta) the required return which can be estimated using “capital asset pricing model” At each point in time shareholders estimate the expected return to be earned on a given share over a specified time period. The expected return can be estimated through the use of the formula: a) Expected return = expected benefit during the period/current price of the share. b) Required return, Kj = Rf + {bj * (Km – Rf)} Where; Kj = required return on a share / portfolio, j Rf = “risk free rate of return” bj = beta coefficient or index of a non-diversified risk for share j Km = “market return” the return or market portfolio of a share Whenever investors find that the expected return is not equal to the required return a market price adjustment will occur. If the expected return is less than the required return investors will sell the shares since it is not expected to earn a return commensurate with its risk. If the expected return were above the required return the prospective investors will buy the shares since they consider it to be a viable investment opportunity. Assumptions In this report however, the hypothesis of an efficient market which is the basic theory describing the behavior of an efficient market is not held and the assumptions made are; The portfolio is not at equilibrium meaning that it is not fairly priced and the expected return is not equal to the required return. At any point in time the share prices does not fully reflect the public information available about the firm and its shares and the investors react swiftly to the new information. Since shares in a portfolio are not fairly priced it follows that investors are in the business of trying to find and capitalize on mispriced shares (undervalued or overvalued) Both the business risk and the financial risk are assumed to remain unchanged over the two weeks period After tax cost are also considered relevant, that is, the cost of capital is measured on and after tax basis such that the declared dividend is not subject to other hidden deductions thus the investors will make their decisions from an informed position. It is usually not possible do hedging using futures contract of each share. as an alternative to buying a share future for all share held in a portfolio, the shareholder can make use of index futures (Powers and Castelino 1991). In using index futures, shareholder makes a calculated-bet on the likely level of the index on a specific future date. For instance, hedging CABL, this presently stands at $ 2,400,000. A shareholder can go into a futures contract say for 3 months prior to his sale. Therefore, if he gets into a contract by 1st April, the expiry date can be on 30th April, near month, 31st May, next month or 30th June, far month. The initial margin required to be made by the parties is 10%, the original investment is computed to 10% the price of contract. Therefore, it works out to $ 240,000. The shareholder at the delivery date of the futures contract will get the discrepancy between the amount of futures index on 30th June and the amount he selects for this futures contract, in this case $ 28,000. If a shareholder suspects his EABL stocks to rise he will buy the shares. But, in case the share price decreases, the shareholder will incur loss. He can, however take index futures, that has allowance of buying or selling the index on a pre-agreed future date for a specific price (Nicholas and Barbara 2000). Therefore, shareholder can buy futures of EABL, thus contracting sell EABL futures at $1,759,500 on 30th April. Hence if the exact shares he bought fail to have anticipated gain, his index-future will and thus curtailing any loss resulting from decline in share. REFERENCES Chance, D. M. and Brooks, R. (2009), Introduction to Derivatives and Risk Management. New Delhi: Cengage Learning. Kolb, R. W. and Overdahl, J. A. (2006). Understanding futures markets. New York: Wiley- Blackwell Nicholas, G. A. and Barbara A. (2000) Keys to investing in options and futures. New Delhi: Barron's Educational Series. Powers, M. G. and Castelino, M. G. (1991). Inside the financial futures markets. New York: John Wiley and Sons. Scheidler, M. (2007) Hedging a portfolio with Futures. Monaco: GRIN Verlag. Read More