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Review of equity options Review of financial futures Using options and futures to hedge portfolio risk Introduction to Hedge Funds
Options -- Contract
Calls and Puts Underlying Security (Number of Units) Exercise or Strike Price Expiration date Option Premium
Options -- Markets
1 Buyer + 1 Seller (writer) = 1 Contract Examples of Price Quotations Premium = Intrinsic Value + Time Prem Options available on
Equities Indicies Foreign Currencies Futures
Futures Contract
Agreement to make (sell) or take (buy) delivery of a prespecified quantity of an asset at an agreed upon price at a specific future date.
ex. S&P 500 Index Futures:
Price: 1126.10; Delilvery month: June Buyer agrees to purchase a portfolio representing the S&P 500 (or its cash equivalent) for $1126.10 x 250 = $281,525 on Thursday prior to 3rd Friday in June. (Buyer is locking in the purchase price for the portfolio.) Seller agrees to deliver the portfolio described above. Note: since this is a cash settled contract, if the price was 1116.10 on the delivery date, the buyer would pay the seller $2,500 (= 10 x 250). If the price was 1136.10, the seller would pay the buyer $2,500
June 17
2. Buy S&P @ 1106.1 ($276,525) on spot market and deliver @ 1126.1 3. Profit = $5,000.
June 17
2. Market falls to 1106.1.Gain =$5000
Covered Call
Sell call on stock you own. (Long stock, short call) Good:
As value of stock falls, loss is partially offset by premium received on calls sold. Essentially costless since hedge generates a cash inflow
Bad:
Maximum inflow from call = premium; Hedge is less effective for large drop in stock price If stock price rises, call will be exercised; Investor transfers gains on stock to holder of call.
Protective Put
Buy put on stock you own. (Long stock, long put) Good:
As value of stock falls, loss is partially offset by gain in value of put. Gain from put continues to grow as stock price falls. If stock price rises, maximum loss on put = premium; Investor keeps all stock gains less fixed put premium.
Bad:
Synthetic Short
Sell call and buy put on stock you own. (Long stock, short call, long put) Good:
As value of stock falls, loss is offset by gain in value of put. Gain from put continues to grow as stock price falls. If stock price rises, gain is offset by loss on call. Loss from call continues to grow as stock price rises. Very effective hedging device Can be self-financing (premium received on put sold offsets premium paid on call purchased)
Bad:
60
55
-14,490
-19,490
8,360
8,360
-6,130
-11,130
60
55
-14,490
-19,490
21,609
32,109
7,119
12,619
Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000 Call options also drop by $0.5197 ==> Gain of $1037.97 ==>Net change $37.97 IBM stock rises by $1 to $75.49 ==> Gain of $1000 Call options also rise by $0.5193 ==> Loss of $1037.97 ==> Net change ($37.97)
Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000 Put options also rise by $0.4803 ==> Gain of $1008.63 ==>Net change $8.63 IBM stock rises by $1 to $75.49 ==> Gain of $1000 Put options also fall by $0.4803 ==> Loss of $1008.63 ==> Net change ($8.63)
60
55
-14,490
-19,490
10,290
15,290
-4,200
-4,200
Hedging with Futures (example from May 2001) There are futures on the S&P500. Suppose I have a portfolio that is currently worth $1,117,672. The portfolio has a beta of 1.3. June S&P500 futures are at 1430.70 ==> contract is worth 500 x 1430.70 = $715,350 Hedge ratio =
(Value of portfolio / Value of Futures contract)(Portfolio Beta)
% change
Port. in June
% change
Profit Portfolio
Profit Futures
Combined
Represents contract to make/take delivery of a portfolio represented by the index Since index itself may be non-investable, most index futures contracts are cash-settled example:
S&P500 futures CME contract value = 250 x index Initial margin: $6K for spec, $2.5K for hedgers.
Used futures contracts to leverage holdings and increase exposure to market risk
Interest rate futures: agreement to make/take delivery of a fixed income asset on a particular date for an agreed upon price ex: Sept Tbond futures contract $100K FV US Treas bonds with 15-years to maturity and 8% coupon (what if they don't exist?)