How Companies Can Use Hedging to Create Shareholder Value - Assignment Example

Setting up a Portfolio

1. a) My chosen date is the month of June 1st June 2014 because it is adjacent to the month that contains the hedge expiration date.

b). Based on the above results in question one, it can be securitized that the date has been chosen as 1 June and portfolio created. Based on the portfolio construction my position for equity will be 1*1000=1000. In addition, the value of my position may be obtained by finding the product of my equity position, which is 1000 with the FTSE100 Index, which are 6082.5. The amount received is $6082500

Hedging

a). The advantages and disadvantages of option scenario compared to future have been discussed. Some of the benefits for hedging this scenario using option as compared future are more returns can be obtained. For instance, in the scenario below in figures 1.0, 2.0 and 3.0 higher returns were derived using options rather than future. Besides, options are less standardized as compared to futures, which make them the most appropriate choice for hedging this scenario. The impact figure 1.0 below help to explain the above scenarios.

Figure 1.0

Besides, they have the ability for high-risk tolerance, which makes them suitable for investors who are risk tolerant. For example, on a black Monday, the profit and loss was $ 31.8 and during the September 11, the profit was $29.27. This involved a high volatility as illustrated by the delta that was -$51.75% in the black Monday and -$52.48 after September 11. Hedging would have cushioned the investor against this risk. The effect is indicated below in figure 2.0

Figure 2.0

Unlike futures, options do not have an upfront payment that each party in the contract should pay prior trading. Lack of such upfront margin requirement makes the option more attractive because both parties are to fill committed to performing their obligation without much pressure. Besides, margin requirements act as collateral held by the clearinghouse. In addition, derivative traders can be in a position to know in advance the amount they should pay for a given option unlike when trading futures.

Figure 3.0

The above scenario in figure 3.0 is highly volatile which make it more attractive to hedge using options rather than futures. The other advantage of an option as compared to future is that they have higher advantage potential because options holder can choose an option that they will minimize risk and maximize returns, which is not the case with futures. Options are considered to have a strategic alternative as compare to futures due to their flexibility element (Hull, Treepongkaruna, Colwell, Heaney, & Pitt, 2013).

Despite options having more advantages than futures in this scenario, options tend to face some disadvantages. Firstly, options may end up putting the short position holder at the risk of being out of the money, especially in the short position. Secondly, options may not be in a position to eliminate unsystematic risk even after executing diversification strategy. Thirdly, some legal regulations and restrictions may negatively influence the option, thereby putting the option holder at a risk of losing the underlying asset. Timing difference may also affect option thus putting the option holder at a risk. However, the advantages of the option over futures in these scenarios outweigh its disadvantages and hence it should be exercised (Hull, Treepongkaruna, Colwell, Heaney, & Pitt, 2013).

b).The zero collars is a hedging strategy that combines that entails buying a put and selling a call option. It involves the ability to buy a put option at a given exercise price commonly known as capped price and selling the call option. It is vital to note that both call and put options are based on the same underlying asset whereby, the zero cost collar put a limit/ ceiling on the option selling whenever the price of the sale of such option tend to fall. The aim is to offset the risk and ensure that the option holder is secure. Let us assume that an option holder who is focused on purchasing a derivative based on the short-term volatility of a given commodity such as gold will provide money for exercising a call option. Based on the affirmation scenario an option holder has a spot market price of gold the premiums earned from the sale of the put option(Gold) at a lower exercise price will provide necessary funds for purchasing a call option at a higher capped/ striking price. Such transaction lead to the zero cost caller (Stulz, 2013).

In this scenario, once the spot market price is greater the zero value, callers tend to effectively and efficiently reward itself making the put option values less. At that point, such a put option may not be relevant any longer and may not be needed. On the other hand, the spot market price may fall below the floor of the put option making it difficult for the investor to participate in the downwards investment options. The zero cost callers may apply in this scenario as follows. Supposing that equity is trading currently at $6226.55.On 17th June 2016, the option holder of 100 equity stocks may protect himself against stock volatility. The equity option holder may also want to hedge the assets as they feel that such shares will appreciate in value in the next six or twelve months. The holder may step up in a zero caller by writing a one-year July 07 at 70 on the leaping call of $6226.55. If the equity price rise to $70 at the expiry date the investor’s maximum price might be capped, and he will be obligated to exercise a put option at the exercise price of $70 whereby at 100 equity stock his profits/premiums will be $1000. On the other hand, if the equity stock price declines to $5443.80 he would lose zero because his protective put option allows the investor to sell his equity shares at $6226.55. In case, the stock price remains fixed at $6226.55. The effect of this scenario may be observed in figure 1.1below

Figure 1.1

While his net loss remains zero, the investor would lose a one-year investment period worth $6226.55 have been obtained if there was no protective put option (Stulz, 2013).

c).Option Scenario Analysis entails the process of evaluating all the possible events that may arise in the future by taking into consideration all the possible results that may occur. In this case, my results using the Option Scenario Analysis may be confirmed as follows;

Figure 4.0

The analysis confirms the number of options that might be needed to hedge one (1) units of UK equity. The FTSE will be obtaining by first finding the number of futures that should be bought which can be derived by dividing my equity position with FSE index and comparing it with the values in the table above. The value is as follows $16417350/6082.5=$2699.11. The equivalent hedge ratio above is 75% of the total equity stocks, which indicates that 0.75 will be provided security cover by the hedge, and the remaining 0.25 will not be covered by the hedge (Ram, & Montibeller, 2013).

Question (d)

The evaluation shows that in a hedged position the returns as given by profit and loss are less volatile. For example, on a black Monday, the profit and loss was $ 504.67 and during the September 11, the profit was $380.13. This involved a high volatility as illustrated by the delta that was -0.58 in the black Monday and -0.52 after September 11. Hedging would have cushioned the investor against this risk. On addition, figure 5.0 shows high predisposition risk for the investor who invests in the market without a hedge. For example, using 35 multi asset scenario using Greece financial crisis, the extent to which the option was exposed to the changes in the underlying price was 57% as shown by delta, where the rate of change of the delta of the option per $1 change in the price of the underlying asset was 0.01 (as shown by the gamma).

Figure 5.0

Question E

Black-Scholes Option Pricing Model assists in calculating theoretical call price using expiration time, strike price, stock price, and short-term interest rate. The model is based on underlying assets’ normal distribution, which similar to saying that the prices of the underlying assets are log-normally distributed. Log-normal distribution allowed for the distribution of the stock price between zero and infinity and had an upward bias. In practice, the distribution of price of the underlying assets often departs significantly from lognormal. For instance, historical distribution of the return of the underlying assets has right tails and fatter left compared to the normal distribution, which shows that the dramatic moves take place with a higher frequency than it would be predicted by the returns of the normal distribution. In derivatives, Black-Scholes Options Pricing Model is used to get the premium or the value of the European call, and it can as well be adopted in other options (Bailey and Lopez de Prado, 2012).

In the Black-Scholes Option Pricing Model, volatility is measured by annual standard deviation. One of the benefits of using the Black-Scholes Option Pricing Model is the speed at which on can calculate many numbers of options prices using a very short time. However, one of the limitations of this model is that it cannot be used to price American option accurately because it will calculate the price of the option at the end of the time (at the expiration date). The model fails to consider various steps along the way where there could be the possibility of having an early American exercise.

Other limitations of the model are derived from the assumptions that are made in coming up with the model as a representation of the reality. Some of this assumption includes no taxes and no transaction cost, no short sales penalty; the risk-free rate is constant and known. In addition, the market remains in operation continuously, there is only one risky assets type which is available to invest in, which is the stock, the option is always European, and there is no arbitrage in the market (Bailey and Lopez de Prado, 2012). Other assumptions include option payoff depends on only the price per the stock, and the stick follows time Geometric Brown Motion. Not all these assumptions are real in the market.

Question F

Further considerations should be given to avoid a situation where heading then the option will lead to a higher risk level. Hedging can raise the level of risk when the investor is forced to purchase the short-dated options and at the same time hedge them. For example, when the investors short the stock to hedge, and unfortunately the price of this stock goes up to strike, the option will expire worthless (Bielecki and Rutkowski, 2013). This means that the investor will loose on both the stock position and the option and ends up in a worse off situation than if he/she had not hedged. On addition to this, the investor in this situation needs to use complex spread to cushion the situation against such risks as price movement risk. For example, in heading the price movement risk, an investor may come up with an option position that has Delta that is inversely equivalent to the position at hand. Given that, equality bears a delta of one per unit, which means that the delta position is equivalent to the total number of shares.

Other factors that need consideration when using options to hedge against risks are cost, advantage, regulation, return on enhancement, diversification, and hedging. Regarding costs, the option contract can expire worthlessly, and its worthlessness is increasing the extent to which the option is out of the money with a shorter time to expiration. Selling the option short increases risk. This risks are theoretically unlimited but practically they are limited to the underlying because the price of the underlying assets cannot fall beyond zero. However, if the value of the underlying asset was to fall sharply, the losses on the short put will be horrendous (Bingham and Kiesel, 2013). An investor should also realize that options could have an impact on downside performance as well. On addition to this, an investor should consider regulatory interventions, which can prevent exercise that may be undesirable. Regulations can impose restrictions upon the exercise. When using the option to hedge the direction and timing of the stock price can lead to a less than a perfect hedge.

Reference List

Bailey, D.H. and Lopez de Prado, M., 2012. Balanced baskets: a new approach to trading and hedging risks. Journal of Investment Strategies (Risk Journals), 1(4).

Bielecki, T.R. and Rutkowski, M., 2013. Credit risk: modeling, valuation and hedging. Springer Science & Business Media.

Bingham, N.H. and Kiesel, R., 2013. Risk-neutral valuation: Pricing and hedging of financial derivatives. Springer Science & Business Media.

Hull, J., Treepongkaruna, S., Colwell, D., Heaney, R., & Pitt, D. (2013). Fundamentals of futures and options markets. Pearson Higher Education AU.

Ram, C., & Montibeller, G. (2013). Exploring the impact of evaluating strategic options in a scenario-based multi-criteria framework. Technological Forecasting and Social Change, 80(4), 657-672.

Stulz, R. M. (2013). How companies can use hedging to create shareholder value. Journal of Applied Corporate Finance, 25(4), 21-29.