Alternative Hedging Solutions for Equity Investment in the Current Oil Price Volatility - Case Study Example

Hedging Risks Name Affiliation Date PROPOSE ALTERNATIVE HEDGING SOLUTIONS FOR EQUITY INVESTMENT IN THE CURRENT OIL PRICE VOLATILITY  Introduction Within the asset owner world, risk management has become the most visible with risk hedging taking the center stage. Hedging is a technique intended to mitigate minimizing measurable financial risks in market transactions. Hedging is considered a type of insurance aimed at mitigating financial risks rather than eliminating them completely (Patrick, Martin & McGraw, 2015, p.42). It is considered as today’s crucial tool for management of risks by financial professionals in various roles and markets. Such markets have unique characteristics and share an important structure that allows risks to be managed using the same methods. Businesses tend to be exposed to many forms of systematic price risks which impact on the ability of the business to predict and plan for the future of the business in the most efficient and competitive manner (Patrick, Martin & McGraw, 2015, p.65). Hedging enables professionals in the field of finance to meet various risk management objectives through decreasing the volatility of cash flows and offsetting the fluctuations of interest rates so as to reduce price risk and default risk. Hedging tools and instruments compiles data, information and definitions needed by hedgers so as to consistently create stable and cost- effective hedging strategies. The following hedging instruments provide a substantial as well as a results- oriented approach to making informed decisions in risk management. The major tools for hedging include futures, forwards, options; index swaps and warrants (Patrick, Martin & McGraw, 2015, p.91). Futures Futures are an agreement between two or more parties to buy a product or a currency on a given future time and date at an agreed price. Future contracts help companies and corporations to offset the exposures of risks as well as limit them from any price fluctuations. The critical goal of an investor when using future contracts in the process of hedging is to offset completely their risks (Calamaro, Jean‐Paul, Kunal & Tahsin, 2009, p.55). Nonetheless, real life makes it impossible to offset risks completely; instead, financiers try as much as possible to neutralize risks as much as possible. For instance, if a commodity is to be hedged and that it doesn’t exist as a futures contract, then and investor will only buy a futures contract in another form but it should closely follow the movement of the initial commodity. Futures are traded in organized forms of exchanges such as LIFFE in London and UK, IMM in Chicago and SIMEX in Singapore. With futures contracts, cash exchanges hand on a daily basis during the contract life or any day that has seen a fluctuation in the contract price. The daily cash compensation in futures helps to eliminate default risks (Calamaro, Jean‐Paul, Kunal & Tahsin, 2009, p.70). A company that intends to make a purchase in the future for any item should invest in futures so as to hedge its position. Consider this example; Company Z understands that it will buy 20,000 ounces of silver in six months to come so as to accomplish an order. Assuming that the spot price for silver is set at $12/ounce and $11/ounce is set for the six- month future price. The company can buy the futures contracts and reduce its risk since it will be able to close the deal for only $11/ounce in six months (Lazo, et al. 2009, p.255). Options Options are agreements or contracts that give a buyer the right and not obligation to purchase and sell a fundamental asset at a given price on or before a certain given date. In insurance, as one insures a car or a house, options can be applied here so as to insure investments against a downturn. Options can be a good strategy for hedging especially in big organizations (Adrian & Tobias, 2007, p.87). Individual investors also benefit from options. Someone can take advantage of technological stocks as well as their upside and at the same time limiting any losses. Use of options restricts the downside and tat the same time one enjoys the full upside in the most cost-effective ways. Options are considered as the most flexible tool for hedging. An investor can buy a ‘call’ option which represents the obligation to buy an asset at a given price and be able to sell it at a particular price at a future date. An option is different from futures in that an option owner is not obliged to follow the procedures of the transaction given that the price in the market is more useful than the price of the option (Lazo, et al. 2009, p.251). Warrants Warrants are not commonly used especially in the United States but are still popular in other areas of the globe such as Hong Kong. They do still exist in the markets, so investors should have an understanding of how to assess and value them. Warrants are a high-return investment tool just like options. A warrant gives the warrant holder the right to purchase a crucial security at a given price and quantity at a future time (Calamaro, Jean‐Paul, Kunal & Tahsin, 2009, p.101). The security in the warrant is usually share equity and is always delivered by the issuing company but not the investor who holds the shares. Companies tend to include warrants as part of a new issue offering so as to attract investors into the purchase of the new security. Warranties also increase the confidence of shareholders in the stock given that the underlying security value increases with time. Index Return Swaps An equity index return swap entails a contract to swap two assets of cash flows between two parties on pre-specified dates over a contracted number of years. One party may agree to pay an interest payment which entails fixed rates based on LIBOR and the other party on the other hand could agree to pay the total return on an equity or equity index. Investors use swaps when they seek a straightforward way to get exposed to an asset class like an index or sector portfolio in a manner that is cost efficient (Lazo, et al, 2009, p.188). Dynamic managers utilize these swaps to efficiently increase and decrease their exposure to various markets over time. Fund managers seeking to have an exposure to an index make use of various options to take into account. They could first purchase the entire index such as the S&P 500. Using equity index swap becomes the best then. The manager can organize for an S&P 500 swap, and pay for it on a contracted interest rate. The fund manager in return receives the return on the S&P 500 index for the stipulated period of the swap, say five years. The capital gains and income distributions from the S&P 500 are received on a monthly basis by the fund manager. He/she then pays interests to the counterparty upon agreed rate. These equity swaps come with tax advantages as well (Calamaro, Jean‐Paul, Kunal & Tahsin, 2009, p.139). Investors can constitute a swap to distribute out capital gains over a determined number of years in return of fixed rate interest paying. Index return swaps are instrumental to the investors in tailoring the timing of investing events and gaining exposure to selected sectors or regions without commitments in purchasing shares in the index. The shortcoming is seen when the index performs against expectations and proves futile to get out of the swap (Lazo, et al, 2009, p.241). Innovation regressions and market index volatilities levels on oil price volatility. The standard deviation observed for each month are calculated as the monthly volatilities of σmkt,t, σP rod,t and σp, t using excess daily returns on the CRSP aggregate market index, excess daily returns on the datas tream oil producer index, and log of oil price changes calculated using the daily WTI index (Adrian & Tobias, 2007, p.192). Regressions of differences include controls for the lag of the level and change of both the dependent volatility and the independent volatility. Standard errors are Newey-West with 6 lags. The volatility of the oil prices is highly correlated with the volatility of the stock market. A difficult situation arises as it is hard to show whether the shocks to oil prices have no impact on aggregate stock returns. Nevertheless, if the response of the stock market to supply shocks is offset by its response to demand shocks, a rise in the volatility of either shock will result to an increase in the volatility in stock market (Lazo, et al, 2009, p.192). The volatilities of oil producer stock returns seem to have a minimal association with the volatilities of the oil price. Increases in the oil price volatilities are linked to the rises in aggregate market volatility without effect on the oil producer return volatility. This means that the returns of the oil producer are not correlated with a vital element of the changes in oil price (Adrian & Tobias, 2007, p.201). Commodity Risk Commodity price risk occurs when the market price is volatile due to the fluctuation of the price of a commodity. This type of risk affects numerous sectors of the market such as oil drilling companies, casino gaming and airlines. Price of a commodity is affected by seasonal changes, change in technology, politics and the current market conditions (Patrick, Martin & McGraw, 2015, p.146). Crude oil Due to the oversupply of crude oil that leads to falling of oil prices every day over the past year, a company that has heavily invested in oil drilling suffers from the commodity price risk. The profit margin of the company falls as well as it is still operating at the same cost but the prices of the crude oil are falling. The profits of the company decreases as well. Using futures or options by the company will be the best equity investment venture to operate on to hedge the risk and minimize the uncertainty of oil prices. The Brent or rather the global oil price averaged around $100/bbl for the 4th year in a row, it has fallen sharply towards the end of the year to close at around $55/bbl. There has been acceleration in the growth of the unconventional oil production growth in North America along with the weakening demand of oil by the Far East and Europe as a whole. This has weakened the balance between the supply and demand and the pressure of oil prices. The supply of oil from the non-OPEC producing countries has led to the surplus of oil evident in the market. In response to the oil crisis of 1973, energy became a famous tradable commodity (Calamaro, Jean‐Paul, Kunal & Tahsin, 2009, p.189). West Texas Intermediate (WTI) is a grade of crude oil used as a benchmark in oil pricing. WTI futures comprise the most actively traded energy product in the world. Options and WTI futures and trade on the NYMEX (Adrian & Tobias, 2007, p.144). Contracts for numerous months usually show a significant liquidity. Futures contracts are traded under the symbol CL and represent a thousand barrels of oil for Oklahoma with pipeline access to TEPPCO, Cushing, Cushing storage or Equilon Pipeline Company LLC Cushing storage. WTI principal futures contracts must meet certain minimum grade and quality standards. The WTI has $80.7 billion of outstanding futures contracts as of 3/10/2015. From the drop of WTI from $107.26 to ~$75, which is a sheer drop, a sound hedging tool is appropriate to ensure that returns are not lost from the price drop. It should be a tool that can provide a meaningful insight from a keen decision making framework in order to prepare for the future regardless of the market conditions (Patrick, Martin & McGraw, 2015, p.73). Warren Buffett quoted, “Risk comes from not knowing what you’re doing The hedging tool used should encourage activities that mitigate risk and truly meet the needs and objectives of the investor. No matter one is a consumer or a producer, the hedging strategy he/she prefers at $75 oil is not the same as the one he/she would prefer at $107. It is significant to note that the difference in price is less important than the speed at which prices change (Patrick, Martin & McGraw, 2015, p.81). Investors make billions of dollars on the opinions of the current state of oil. The Crude Oil WTI futures are the most actively traded commodity contracts on the market. The interest on crude oil has increased despite the fact that the drop of about 60% in the price of crude oil. Trading options is also a good strategy and is as easy as trading stock. The investor is first approved and puts money into the account and then logs in the account. He/she then searches for the oil index on the exchange-traded funds (ETF) by using its ticker. The investor then clicks on the “option chain” link where the number of the dates going into the future is available. The prices of the available contracts along with the future expiration date of the option he/she wants to purchase is availed there. This investment is great only if the investor is very certain that the price of oil will go up along with the date it will happen. The investor makes purchase with very little money up front and no cap on how much he/she can make. However, if the price of the oil does not rise above the preset buying price on the contract before the date on the contract, the investor definitely looses all his/her investment (Patrick, Martin & McGraw, 2015, p.92). Warrants are also good strategy as it gives the investor right to buy oil at a future low price. The investor can sell the oil at a higher price on the date of his/her contract. For instance, when oil is trading at $75 and the investor believes that the commodity will trade at say $107 by the end of September, after analyzing the current available option contracts, the investor sees that he/she will buy oil at $80 for the cost of $5 per contract. If the oil price hits the price target of the investor by the stipulated month, he /she will be able to buy oil at $80. The investor will be able to sell the oil at $107 a unit at the same time. He/she makes a $27 profit per contract. The greatest downside is that the investor looses all the invested money if the price of the oil does not increase to at least $107 in the amount of stipulated time in his/her contract (Patrick, Martin & McGraw, 2015, p.105). The investor can also buy the index instead if he/she cannot handle that kind of possible risk. The investor in this case buys the whole index at a specific price instead of buying contracts that expire. He/she logs into his/her brokerage account and searches for the particular oil ETF that he would prefer by using its ticker symbol. He/she then would click on the “trade” link and enters the order to buy the ETF. The investor here buys at the cost of a brokerage trade and he/she can sell it at anytime he/she wants. The investor makes money in the investment if the price of the oil goes up. However, if the price does not rise, the investor has dead money. The investor will have lost the option to invest in another opportunity that could have paid interest in that given time (Patrick, Martin & McGraw, 2015, p.121). Buying equity in an oil company rely on the oil market as well as the business itself. Both cases have linked monetary risks and the ability to get returns depends on the price of oil. This process is similar to buying index as above. Since the profits of the company grow, the investor will get a share of the profits if the company is well run through both capital appreciation and dividends too. The disadvantage is that they cannot get returns when the prices of the oil go down. The company will be forced to slash its dividends or even stop paying them altogether a situation that can push its stock price down and make the bad situation worse (Patrick, Martin & McGraw, 2015, p.149). The Crude Oil WTI futures are the most actively traded commodity contracts on the market. The interest on crude oil has increased despite the fact that the drop of about 60% in the price of crude oil and hence the best hedging tool over options, warrants and index swaps. Bibliography Patrick Cusatis, Martin Thomas & McGraw Hill., 2015. Hedging Instruments and Risk Management:) Hardcover . McGraw Hill Calamaro, Jean‐Paul, Kunal Thakkar & Tahsin Alam. 2009. “Tail Risk: Uncertainty and Hedges.” Deutsche Bank Quantitative Credit Strategy. Adrian & Tobias, 2007. “System vs. Liquidity Risk: Discussion.” Presentation for the International Association of Financial Engineers. Adrian, Tobias and Markus Brunnermeier, 2007. “Hedge Fund Tail Risk.” Research proposal Bacmann, Jean‐Francois and Gregor Gawron, 2004. “Fat tail risk in portfolios of hedge funds and traditional investments.” Working paper, RFM Investment Management. Bhansali, Vineer, 2008. “Tail Risk Management.” Journal of Portfolio Management, Vol. 34, No. 4 (Summer 2008) pp. 68‐75. 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