Options and Derivatives

Usually used to speculate on risky returns

Used by hedge funds as hedging tool to limit overall risk
of investment
Example:

S&P 500 is at 100

S&P Volatility = 25%
Portfolio beta = 1.5
Risk Free Rate = 5%
S&P Options are two month, at the money puts

Un-Hedged
Today
Portfolio

Assets
$ 100.00 stock

Equity
$ 100.00
Tomorrow (S&P 500
+5%)
Assets
$ 107.50
stock
Equity
$ 107.50
ROE = 7.50%

Tomorrow (S&P 500 -5%)

Assets
$ 92.50
stock
Equity
$ 92.50
ROE = -7.50%

Hedged Portfolio
Today
Assets
$ 89.09 stock
$ 10.91 S&P
puts

Tomorrow (S&P 500 +5%)

Assets
$ 95.77 stock
$ 5.60 S&P
Puts
Equity
$ 101.37
ROE = 1.37%

Equity
$ 100.00
Tomorrow (S&P 500 -5%)
Assets
$ 82.41 stock
$ 19.07 S&P
Puts
Equity
$ 101.48
ROE = 1.48%

 Value of put options is negatively correlated with the

value of stock
Put options are held to insure against fluctuations
The ratio for perfectly hedge a portfolio = f(options) x
portfolio deltas
Hedge position protects portfolio from downside risk
and limits potential gains

Hedge Fund Strategy

Investment strategy = one way to categorizing hedge
funds
Based on skills and competitive advantage in assessing
risks
Example:
A manager is confident in valuing individual companies but
not the performance of the entire market
Used market-neutral strategy hedge market risk, keep
firm-specific risk