Financial Derivatives Trading: Options, Futures, and Swaps - Assignment Example

Hedging and Equity Portfolio

• (a) Portfolio Set-Up

Investment portfolio is simply the collection of assets. It is important that an organization considers one as it will enable them to spread the risks that are found in the stock markets. In other words, by using a portfolio, a firm or an individual avoids placing all of their stocks in a single bucket. A portfolio can be held by various things including individuals, financial institutions, a company, and a hedge fund. The design of a portfolio is based on the risk tolerance, investment goals, and time-frame that individuals have. In the present portfolio, I have chosen 06/16/16 as the date.

(b) Size of Portfolio

The size of this particular portfolio is as indicated below.

The value of the portfolio is 73,118 while the contract size of the same portfolio is 50.00 after it has been hedged. Indeed, the number of contracts in this portfolio is 38, which is what is hedged by the company. Therefore, the current portfolio has 38 stocks that are hedged in order to minimize risks.

2(a) Advantages and Disadvantages of Options

Options are one of the methods used by investors to hedge. Essentially, options are like an insurance policy that an investor takes against a slump. There are numerous potential advantages that characterize options. According to research, options are very flexible. They allow one to transact any sort of prospective move within the primary security (Hull et al. 2013, p. 24). One can use options even when they think that there is going to be a downside, the shares are going to double or even when they think that the shares are going to remain unchanged. In essence, the usage of options permits one to engage in trade as long as they possess a view. Options can also offer the company remarkable leverage as well as returns in the region of 100% and even more (Fugaza & Nicita 2013, p. 24). The company can, in turn, utilize this leverage in an intelligent manner.

In addition, the usage of options can reduce the risk exposure for the company. In as much as CFDs and futures guarantee leverage, the company may be exposed to prospective open-ended losses when it decides to use them. Whereas using numerous options stratagems may allow comparable leveraged profit potential, they are also characterized with controlled risks. Options may offer the company an opportunity to sell them against the current options that the company possesses (Charnes, Gneezy, & Imas 2013, p. 45). Known as a covered call strategy, the phenomenon may allow the company to acquire additional monies from the shares it may already have sold.

However, the options strategy is also characterized by certain disadvantages. According to research, options can also be high risk, which forms a looming danger for any organization. In a manner that is akin to other financial products, options have been demonstrated to conform to the risk/reward rationale. In this ration, the rewards and risks in the options will be directly proportional for the company. The leverage that has been mentioned above with regard to options is a double-edged sword. When losing money, the usage of options is going to be horrible compared to the usage of futures.

2(b) Zero Cost Collar

“Zero Cost Collar” or a “Costless Collar” is an Options trading strategy that is used in the short term to seek protection from short-term market volatility forecasts (Lee & Kim 2015, p. 10649). In the above illustration, the company is going to exercise its call option, and the difference between the market price and the strike price is going to be received by its Zero Cost Collar buyer. However, in the event that the spot market price was below zero, the interested buyer in the zero cost cannot take part in the lower spot market price. Indeed, as long as the movement of the market prices is the strike price of the call option and the Put Option of the same strike price, the company will not receive any paybacks, which is the case herein.

Example: Assume that the stock of RST Company is presently trading at $50 in the month of June ’14. A trader who deals with options is looking to protect his 10 shares at the market in the event that the share prices plummet. He also desires to keep the shares as he has a feeling that their value is going to increase within the next 6 to 7 months. Similarly, he establishes a costless collar through writing a single year JUL ’15 LEAPS call for $5 whilst at the same time utilizing the earnings from the call sale so as to buy a single year JUL ’15 LEAPS that are put for $5.

In the event that stock price will reach $7 at the expiration date, the buyer’s maximum profit will be capped since one is required to dispose his shares at $60 as the strike price. If the shares are 100, his profit will be $1000.

However, if the stock prices will plummet to $40, he is going to incur zero losses as the protective put that he has still allows him to dispose the shares at $50.

On the other hand, if the stock prices do not change, and the net loss remains zero, the buyer would have forsaken a year’s worth of premiums of $500, which he would have got if he had not placed the protective put purchase.

2(c) Option Scenario Analysis

The Option Scenario Analysis is a method that is used to confirm the expected return of an investment in a given portfolio after a certain period of time. The starting capital of the business was £1,046,954 as per the portfolio that was presented from Bloomberg. Given the fact that the confidence level that the same portfolio has given that the confidence level of the portfolio is 25%, then the OSC will be given by multiplying the capital by the confidence level.

Therefore, OSA= Capital x %confidence

= (£1 046 954×25%) + Capital

= £1 308 692.50

From the calculation, the expected return on the investment capital is expected to be £1,308,692.50.

2(d) Effect of Hedge on Profits and Loss

Hedging is important to a firm since it cushions it against certain risks that in turn affect the financial performance of a firm. When the firm looked to hedge its funds, its financial history was used since they affect its profitability. Hedging the firm’s funds means that the risk exposure of the firm has been minimized. The minimization of the risk exposure is integral since it positively impacts the financial performance of a firm. The hedging of the various risks such as currency fluctuations undertaken by the firm is mitigation strategies in nature and is intended to ensure that the companies continue to make profits.

However, hedging does not always produce the desired results. A company may experience a sharp fall in the item against which it has hedged. In this situation, a company suffers heavy losses on their hedge fund, which is transferred to its profit and loss account. In a case such as this, a company will either be required to scale down its hedging amount or abandon hedging altogether. Therefore, hedging is a double-edged sword when it comes to the profitability of a company.

2(e) The use and limitations of the Black-Scholes Option Pricing Model

The Black-Scholes pricing model is not a phenomenon that just appeared overnight. Pioneered by Fischer and Scholes, the method uses derivatives to offer a model that is startlingly precise with regard to option pricing. The method is particularly used to calculate the fair marketing value of a product using two parts. In the first part, known as SN(d1), the anticipated benefit is derived by obtaining a stock outright. In the second part of the tool, Ke(-rt)N(d2), the present value that will be necessary for paying the excise price on the day of expiry is determined (Varian 2013, p. 29). The difference between the two parts is then the representative of the fair market value regarding the call option.

Apart from its use, the Black-Scholes pricing model has certain limitations. According to authors, limitations are the suppositions that go into a pricing model as well as the degree of their representativeness. One of the model’s assumptions’ entails its postulation that there are no dividends payable on the stock throughout the option’s life (Katz & Donna 2016, p. 45). This is fallacious as companies such as Apple, Google, and McDonald’s among others have been demonstrated to pay dividends to their shareholders. The model is limited to the utilization of European exercise terms. The terms mentioned above command that exercising the option can only be done on the date of expiry. However, the American exercise term permits the option to be applied at any period before its expiry, turning it into an invaluable alternative owing to its characteristic flexibility.

Further, the assumption states that the market works incessantly minus and that the share prices follow an uninterrupted Itô process (Singh & Dixit 214, p. 78). The assumption is fallacious since drawing an Itô process can be done using minimum effort, which is entirely untrue. The model also assumes that there is no charging of commissions. Nevertheless, everybody who participates in a market is required to pay commissions in order to either buy or sell options (Abernethy et al. 2013, p. 2350). In this regard, it has been established that individual investors generally pay more substantial fees, which can mostly disfigure the results of this model (Choo, Malhotra, & Munjal 2013, p. 195).

2(f) Risks and Considerations

There are certain risks and considerations that investors need to take into account before they hedge funds using options. The usage of this strategy is risky as there is the potential for one to suffer losses that are greater than the premium amount (Carr & Wu 2014, p. 20). For instance, in the event that the market realigns, the position that a company holds may also escalate very fast. There is the danger of a very risky situation if a company has a writing call options minus the very fundamental underlying securities since a company or an investor will be required to offer the securities in the event that they are exercised against.

In addition, the company should consider the fact that the option might fall in value. Since options have a date of expiry, it is highly likely that their values decrease over a certain period of time. The rate of the decrease in value may influence how close the option gets closer to the date of expiry (Martin, Gomez-Mejia, & Wiseman 2013, p. 453). Also, other market factors such as the prevailing interest rates and market volatility have the capacity to influence the value of an option.

The investor may also face what we called margin calls. In the event that the investor is writing options, the ASX may need one to offer additional security so as to make certain that they can meet obligations in the event that the options are exercised (Capinski 2015, p. 689). If this is the case, then the investor may be needed to pay extra funds so as to preserve their position (Shalit & Greenberg 213, p. 119). If the investor cannot achieve this, then he may be liable to position closure as well as any losses that arise thereafter.