Effect of the Hedge on Profit - Research Paper Example

Hedging Equity Portfolio

Introduction

Market drawdowns and volatility define the roles of hedging in the investment portfolios (Chen & Sebastian, 2012, P. 81) while hedging is the buying of securities with the primary aim of limiting risks connected to the portfolio (Litterman & Goldman Sachs Asset Management, 2003, p. 145). The purchased stocks or securities are envisioned to have negative correspondence to the remainder of the portfolio to counterbalance any likelihood of portfolio losses. For example, Holding unassociated assets, bonds, and stocks are among the most vital techniques for limiting portfolio risks because historically, bonds and stocks are relatively uncorrelated (Fabozzi & Markowitz, 2002, p. 415). Other methods for hedging Equity Portfolio Downside Risks are also available; however, it is essential to determine the principal hedging techniques for long equity positions. One of the most common methods for limiting downside risk is to exit long positions when equities fall below the long-term moving average. Technically, this process might not constitute hedging because the whole position is exited. Exiting the position is a useful technique for reducing risk and volatility in the portfolio.

Part 1: Market Portfolio Setup

The set up for the market portfolio mainly includes the size of the market portfolio and the date set for price index data. The first phase has been conducted using FTSE 100 index price data as well as the futures of a selected period, which is between May 11, 2014 and May 23, 2016. Therefore, this research would involve making decisions through quoting and using price data of May 13, 2016. The second phase involved determining the size of the portfolio, whereby the volume of FTSE 100 index in the market portfolio are generated by multiplying the authors' birthday by 1000. Therefore, the investment fund holds 23,000 units of the FTSE 100 index. It is presumed that the investor is intending to buy FTSE 100 index, which implies that they have an extended position in the portfolio performance. The underlying FTSE 100 Index is the ‘UKX’ in Bloomberg. Therefore, the investor has a long position for the UKX regarding the market portfolio as of May 5, 2016 with 23,000 issues held in the index.

Using Futures to Hedge Risks

Planned commodity futures trading enhances hedging and speculation. The existence of futures trading on a particular product makes the speculator locates its significance to futures contracts instead of either:

• Purchasing a quantity of the product on the spot based on the current price and holding it with the hopes of an increase in the price, or
• Selling the product shortly after discussing with a buyer to deliver the same at a detailed later date and at prices above the current price

The futures markets are equally significant for hedging activities. An essential characteristic of commodity hedging is that the investor can coordinate his or her practices in two markets. That is, the futures market and the “spot” or cash market that provides instant delivery (Litterman & Goldman Sachs Asset Management, 2003, p. 142).

A future agreement is a promise that the seller will deliver the product on a particular date. The good under delivery must be within the required qualities and quantities. However, the agreed price is readily adjustable because of changes in the homogeneous nature of the market; hence, the products are traded on special exchange rates depending on the underlying market factors. The product exchange offers a central point where potential sellers and buyers make offers and bids for deals covering delivery in different later dates (Fabozzi & Markowitz, 2002, p. 415). Each delivery date in which businesses take place refers to the “futures”. The sales' price in futures during the working day is a near-perfect reflection of demand and supply of the existing market conditions that are available at that instant of date. Nonetheless, the centralized character of the market, as well as the ease and speed with which purchases and sales are made, are the most likely factors to affect the futures sales' prices (Engel & Matsumoto, 2009, p. 6).

Short Futures Theory

The position of short futures acts as an insurance against the risks of downside price without making prior cash disbursement. Portfolio insurance is obtained by taking long positions both in the put option and in the underlying security. However, option-based strategy suffers initial cash payments in the design of put premium whenever put contract is signed. It is striking that during the stock market crunch of 1987, the dynamic portfolio program trading and insurance activities were blamed to have been the primary causes because there had been several short portfolio positions compared to long spot and futures markets. This situation put more pressure to sell stocks and result in prices that cascaded furthers downwards.

The most Appropriate Futures

June futures are the most suitable for hedging a portfolio. If a trader intends to take a delivery, he or she may wait until the expiry date of the contract, and then take or make delivery (Patel, 2004, p. 22). However, at the time of expiration, holders of short stock futures positions are physically settled, and they are also needed to deliver physical security shares. Similarly, holders of long positions proceed with the delivery of the original security (Patel, 2004, p. 22). These conditions indicate that purchasing stocks in the future and holding the date of expiration, guarantees the ownership of the initial security after the same date.

The Use and Limitations of Hedge Ratio

The use of Hedge Ratio

The hedge ratio is considered as the percentage or fractions of a hedging instrument needed to hedge an original position, compared with the size of the underlying position itself (Alexander, 2008, p. 312). Hedge ratio is used to determine and minimize risks in a contract.

Limitation

Despite the extensive popularity of the hedge ratio method, there are significant analytical limitations regarding its use. Further, there are unanswered questions about its legitimacy. For example, according to Poitras (2002, p. 115), its application is intensively reliance on an optimal answer that is based on a single variable, the quantity of the position of the futures. Moreover, the cash position is presumed as absolute and fixed. Additionally, it does not provide allowances for leveraging to buy the spot commodity or for some hedging cases where the scope of the cash position is undefined, for example, a farmer who suffers stochastic output (Poitras, 2002, p. 115).

The Number of Futures required for Hedging

In this case, it is worth noting that for May 5, 2016, the UKX portfolios and holds 23,000 issues have long positions. The unit of trading for FTSE 100 Index has a contract value of 10 per index point (for example, value at £50,000 at £5,000.0). The index point for FTSE 100 on May 5, 2016, was £6,069.5 (market price of the ticket). Therefore, for this market, the futures contract will use the Ice Brent Crude Futures. The use of the index point for the selected contract futures is instrumental in paying the Ice Brent Crude £6069.5*10 portfolio by June 2016. The number of futures contracts that the portfolio instrument requires for its futures safety from market risks is determined as follows:

Number of futures contracts = Amount to be paid to the supplier/the contract size

The amount to be given to the supplier = £6069.5*10 = £60,695

The contract size = 23,000

Therefore, the Number of futures contract = £60,695/£23000 = 2.64

The findings indicate that 2.64 futures contract will be required to hedge the payable euro.

Hedging Part d: Option Scenario Analysis

Figure 1: Option Scenario Analysis (The Bloomberg Professional 2016)

The manually calculated number of futures contract that are required to hedge the portfolio is not similar to the value obtained from Bloomberg’s Option Scenario Analysis (OSA). The OSA output gives -0.34 as the number of its futures contract. The primary objective of the portfolio is to protect the position against exposure to risks, that is, the portfolio has a long position on the UKX with a standard futures contract. The calculations have confirmed and proved the theory that if the portfolio has a long position on the underlying security; it is highly likely to attain a short position on the futures agreement when hedging is applied (Bhat, 2009, p. 518). The process also provides the explanation for reaching negative values when determining the number of futures contracts. The reason for negative futures value is practical. For instance, if it is assumed that the portfolio has a short position on the underlying security, then, the intention of the investor is to purchase the futures. More probably, there are possibilities of having longer positions on the futures contract (Fabozzi & Markowitz, 2002, P. 423). When hedging is applied to the market portfolio, the number of futures is close to the zero mark. The hedge ratio is equivalent to the number of contracts in OSA function. Primarily, the hedge ratio describes the number of futures of the hedging instrument needed to sell or buy to develop the hedge.

Hedging Part e: Effect of the Hedge on Profit/Loss of the Portfolio in Various Market Scenarios

Figure 2: Function 33 Scenario Matrix (Hedged) (The Bloomberg Professional 2016)

The hedged scenario matrix for this portfolio shows that the delta value for ZM6 is -£23.26K and £23K for the UKX. The scenario totals have a delta value of -260. The positive sign of the UKX Delta is an indication of a call option, that is, an opportunity to buy stocks at an arranged price before or on a particular date. The negative sign of ZM6 is a sign of a call option, that is, the opportunity to sell securities at an arranged price before or on a specific date.

The unhedged scenario matrix for the Black Monday has a delta value of 23K, £123.28M market value, -12.68 P&L%, and -17.9M P&L for the UKX Index ticker. The Vega, Theta, Rho, and gamma have zero values.

Figure 3: The unhedged scenario matrix for the Black Monday (The Bloomberg Professional 2016)

Figure 4: Function 35 Multi-asset Scenario (The Bloomberg Professional 2016)

The hedging had different effects on the profits and losses of the portfolio. However, gains were reported in all the scenarios simulated in Bloomberg’s market scenario management. Significant gains of over £10, 000 were reported in scenarios such as Tequila Crisis (£11.31k), Asian Crisis (£13K), Original TARP (£10.88K), Equity Markets (£16.48K), and Japan Earthquake (£11.1K). Market scenarios that reported profits below £10,000 include Black Monday (£9.02K), Russian Crisis (£7.15K), 9/11 (£9.18K), Lehman Default (£8.43K), Greece Financial Crisis (£9.04K), and Debt Ceiling Crisis (£8.63K). The main market scenarios on which the hedging had significant effects include the Greece Financial Crisis 2010, 9/11, and Asian Crisis 1977-98.

Figure 5: The scenarios simulated in Bloomberg’s market scenarios (The Bloomberg Professional 2016)

The portfolio summary conducted indicates that the position of UKX Index was £23K, with a cost or market price of £6,138.50. The ZM6 Index’s position was -2.33K and a market price/cost of £6,069.50. The adjusted delta notional value for the portfolio was £20,560. The UK index had a delta notional value of £141,185,500, and the ZM6’s delta notional value was -£141,164,940. As explained earlier, negative delta values are evidences of put/sell options and call/buy options are positive.

The scenario in Function 34 shows a steady increase (price*percentage shift of 2.0) in P&L, market value, and delta notional. However, this shift is not evident in P&L%, delta, gamma, gamma notional, and Vega. The output for Functional 34 is provided below:

Figure 6: The output for Function (The Bloomberg Professional 2016)

The output of Function 33 shows the percentage shift in benchmarking in regards to hedging the portfolio. The benchmarking shift (percentage) indicated a negative trend in P&L after hedging the equity portfolio. However, there are no changes in the value of P&L%, delta, gamma, Theta, and Vega. P&L and these values were similar for both ZM6 Index and UKX Index, with each reporting £11,630.

Figure 7: The output for Function (The Bloomberg Professional 2016)

The scenario matrix in price shift in the table below shows a steady increase in P&L with an increase in price shift. Metrics such as Vega, Theta, Gamma, Delta, and P&L% do not indicate any change after hedging the equity portfolio.

Figure 8: The scenario matrix (The Bloomberg Professional 2016)

Other Risks Associated with Hedging

In planning for futures portfolio management strategies, it is important to determine the hazards connected with futures trading. The following are additional risks that are connected to futures trading:

Leveraged Losses

Leveraged exposures generated by futures contracts may lead to significant losses for a portfolio (Investment Management Consultants Association, 2015, p. 687). It is noteworthy that at the period of opening transaction, an outlay is constricted to the underlying margin. This indicates that the percentage return (either negative or positive) made on the initial investment may be larger than the movement in the original index. Therefore, the market is destined to move against the investment, and the possible losses suffered from trading the futures can be substantial.

Conclusions

Index funds are applied to hedging against uncertainties or risks of either a fall or rise in the original index. Selling index futures ensures that the value of the equity portfolio is protected. Correspondingly, buying index futures provides that purchase price of future date’s index is locked. The concept behind using futures in hedging activities is that profits in one market may offset losses in the share market. Therefore, the success of a hedging strategy relies partly on how closely motions in the value of shares being hedged. Thus, it is vital to track the changes in the index defining the futures contract.