Hedging, Portfolio Insurance & Cascade Theory

Financial Derivatives
Hedging, Portfolio Insurance and Cascade Theory
Dr Eirini Konstantinidi & Dr Ser-Huang Poon
December 1, 2020
(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 1 / 44

Outline
Up to now we have introduced futures, forward and options.
k Definition, pricing, hedging etc.
In this lecture we will further discuss how these insights relate to

k Optimal hedge ratio and cross hedging
k Hedging using index contract (futures & options)
k Arbitrage using index futures
k Cascade theory
Reading list:
k Supplementary reading on Cascade Theory on Blackboard.
k Hull (6th Edition): Sections 3.4-3.5, 5.9, 14.3, 15.12.
k Hull (9th Edition): Sections 3.4-3.5, 5-9, 17.1, 19.13.
Optimal Hedge Ratio
& Cross Hedging

Optimal hedge ratio in futures hedge
Hedging: Managing and reducing your risk.
How many units of a futures contract do we need to cancel out every

move in the spot price?
k Loss suffered by adverse price movements in one market is offset by
favourable movements in the other market.
Hedge portfolio, Π:
A portfolio of the spot asset and the futures contracts.
Hedge ratio, h:
Number of futures contracts bought/sold relative to the number of units of
the spot asset sold/bought.
Optimal Hedge ratio, h∗ :

The hedge ratio that minimises the variance of the returns of the hedge
portfolio.
Finding the optimal hedge ratio
Let St denote the spot price of an asset and Ft the futures price written on
the same asset at time t. (Omitting the maturity date of the futures
contract for now.)
Enter the hedge at time t. The value of the portfolio is: Πt = St − hFt
Hold the hedge from t to t + 1, then t + 1 to t + 2, ..., till T − 1 to T .
The change in the value from t to t + 1 is: ∆Πt +1 = ∆St +1 − h ∆Ft +1
The variance of ∆Π is:

σ2 (∆Πt +1 ) = σ2 (∆St +1 − h∆Ft +1 )
= σ2 (∆St +1 ) + σ2 (h∆Ft +1 ) − 2cov (∆St +1 , h∆Ft +1 )
= σ2 (∆St +1 ) + h2 σ2 (∆Ft +1 ) − 2hcov (∆St +1 , ∆Ft +1 )

Finding the optimal hedge ratio (cont’d)
We want to find the optimal hedge ratio, h∗ : min σ2 (∆Πt +1 )
h
The first order condition yields:

∂ 2
σ (∆Πt +1 ) = 2hσ2 (∆Ft +1 ) − 2cov (∆St +1 , ∆Ft +1 ) = 0
∂h
cov (∆St +1 , ∆Ft +1 )

⇔ h∗ =
σ2 (∆Ft )
Reminder
The OLS estimators for the regression Yi = β0 + β1 Xi + εi are:
cov (X ,Y ) ρ σ X σY ρ σY
β̂1 = var (X )
= σ2X
= σX , var (εi ) = (1 − ρ2 )var (Y )
β̂1 is an estimate of the optimal hedge ratio h∗ !

Estimating the optimal hedge ratio
To estimate the optimal hedge ratio h∗ run the following regression:
∆ S t = α + h ∗ ∆ F t ,T + e t
where S is the spot price, F is the futures price and ε is the hedging error.
The optimal hedge ratio is the estimated slope coefficient:
σF ,S ρ σF σS ρ σS
ĥ∗ = = =
σ2F σ2F σF
where σF ,S is the covariance, σS is the standard deviation of ∆S, σF is

the standard deviation of ∆F , and ρ is the coefficient of correlation
between ∆S and ∆F .
Example:
When h∗ = 2 then we need two units of F to cancel out every move of S.
Cross hedging
Cross hedging occurs when the asset underlying the futures contract is
different from the asset whose price is being hedge.
k Example: Jet fuel being hedged using heating oil futures (ρ ≤ 1).
k Correlation is the linear relationship between two variables.
The determination of the hedge ratio is crucial!
The regression approach above is valid only if the relationship between

∆S and ∆F is linear.
The cross hedge is effective only if σ2 (ε) → 0.

k If σ2 (ε) is large, the hedging error is large.
When σ2 (ε) = 0, then R 2 =1 (explanatory power), the correlation ρ = 1.
When ρ = 1 and σF = σS then h∗ = 1.

k The futures mirrors the spot perfectly, and the hedge is perfect. The
implication here is that there is no basis risk otherwise ρ will not be 1.
Optimal hedge ratio & cross hedging: Example
Example (Optimal hedge ratio)

A company knows that it will buy 1m gallons of jet fuel (S ) in three months.
The company chooses to hedge its exposure to jet fuel price fluctuations by
entering into long heating oil (F ) futures contracts. Each heating oil future
contract is on 42,000 gallons. Given also that σS = 0.032 and σF = 0.040
(both per three months), ρ = 0.8
The optimal hedge ratio is: ĥ∗ = ρ σσS = 0.8 × 00..040

032
= 0.64
F
The number of futures contracts is:
amount you want to hedge 1, 000, 000

hedge ratio × = 0.64 × = 15.2
contract size 42, 000
or 15 rounding to the nearest whole number.
The ’leftover’ (0.2 × 42, 000 in this case) is the amount underhedged.
Hedging Using Index Futures
ep − Rf = α + β(R
R em − Rf ) + eε
em + (1 − β)Rf + eε
ep = α + βR
R

Hedging using index futures
Hedging risk in a portfolio.
Number of contracts that should be shorted is (based on the spot price):
P amount you want to hedge

h = hedge ratio ×
A contract size
where h is the hedge ratio, P is the value of the portfolio, and A is the
value of the assets underlying one futures contract.
A could be:
1 The value of the assets underlying one futures contract.
or
2 The value of one futures contract (i.e. price × size of futures contract).
This incorporates an adjustment for the daily settlement of futures.
h is the hedge ratio: CAPM beta.

k Number of contracts to be shorted = β PA for a long position in stock portfolio.
Hedging with index futures: An example
Example (Hedging with index futures)

A company wishes to hedge a portfolio worth $2,100,000 over the next three
months using an S&P 500 index futures contract with four months to maturity.
Each futures contract traded on the CME is $250 times the index. The current
level of the S&P 500 is 900 and the β of the portfolio is 1.5.
Value of the asset underlying one futures contract:

900 × $250 = $225, 000
Number of contract to short: β PA = 1.5 × $$2225

,100,000
,000 = 14 contracts

Why hedge equity returns?
Theoretically, a fully hedged portfolio should earn return equal to the risk
free interest rate.
k Why not sell the portfolio and invest the proceeds in a risk-free instrument?
1 Hedger is confident that the portfolio is chosen well, but is uncertain about
the performance of the market as a whole.
k Hedger is exposed only to the portfolio performance relative to the market.
k Investor can take alpha profit without beta risk: Rp − Rf = α + β(Rm − Rf )
provided that the idiosyncratic risk is negligible & the regression R 2 is high.
2 Investor’s horizon is long term, but requires short term protection in an

uncertain market situation.
k Hedging avoids the cost of selling and repurchasing the portfolio.

Changing the beta of a portfolio
Up to now we reduced the beta of the hedger’s portfolio to zero.
What position in index futures is appropriate to change the beta of a

portfolio from β to β∗ ?
When β > β∗ the hedger needs to take a short position in

P
(β − β∗ ) contracts
A
When β < β∗ the hedger needs to take a long position in

P
(β∗ − β) contracts
A

Changing beta exposure: An example
Example (Changing beta exposure)

Consider the previous example:
A company wishes to hedge a portfolio worth $2,100,000 over the next three
months using an S&P 500 index futures contract with four months to maturity.
Each futures contract traded on the CME is $250 times the index. The current
level of the S&P 500 is 900 and the β of the portfolio is 1.5.
h i
,100,000
Change beta from 1.5 to 0: Short 14 contracts 1.5 2225,000
h i
,100,000
Change beta from 1.5 to 0.75: Short 7 contracts (1.5 − 0.75) 2225 ,000
h i
,100,000
Change beta from 1.5 to 3: Long 14 contracts (3 − 1.5) 2225 ,000

Using Index Option
in Portfolio Insurance

Portfolio insurance
Protective Put: Entering into put option position to ensure that the value of
a portfolio will not fall below a certain level.
Por$olio'
value'
Index'
value'
K"
The strike price K is chosen to give the appropriate insurance level.

Portfolio insurance (cont’d)
To limit the downside potential, portfolio managers can use:

1 Index put options, or
2 Synthetic put options.
Synthetic put option: p = Ke−rT N (−d2 ) − Se−qT N (−d1 )

k Sell ∆ = e−qT N (−d1 )× stocks, and deposit Ke−rT N (−d2 )
k Index futures: F = Se (r −q )T ∗ where T* is the futures maturity

k S = Fe−(r −q )T ∗ or ∂∂FS = e−(r −q )T ∗
k If we sell index futures instead the stocks in the portfolio, then the amount of
stocks to sell is ∆ = e−qT N (−d1 ) × e−(r −q )T ∗ × futures contracts.
k As stock value decreases, ∆ becomes more negative, more futures contract
have to be sold (or shorted).

Using index options for portfolio insurance
‘Protective Put’ using index put option is a static hedge.

1 We decide what the level of protection should be.
2 We buy the right number of put options with the appropriate strike.
3 We hold the option until maturity.
The treatment of β = 1 and β 6= 1 are slightly different.

Portfolio insurance using put options: β = 1
Assume that the portfolio is well diversified, i.e. portfolio beta is β = 1.

k The portfolio returns mirror the returns on the stock index.
k Rep − Rf = α + β(Rem − Rf ) + eε
k Rep = α + Rem + eε, for β = 1
k Assume that the portfolio dividend yield is the same as the index dividend
yield.
k erp + qp = α + erm + qm + eε, and qp = qm
k erp = α + erm + eε
If the manager buys one index put with a strike price K & maturity T , then:
k The value of the portfolio is protected against the possibility of the index
falling below K .

Portfolio insurance: An example when β = 1
Example (Portfolio insurance when β = 1)

Suppose that the portfolio has a β = 1.0 and is currently worth $500,000. The
value of the index is 1,000 and each index point is worth $100 in index options.
Value underlying one option contract = $100 × 1,000 =$100,000
Number of puts to be bought = $$500 ,000

100,000
= 5 contracts
For a strike K = 960, the level of protection is 5 × $100 × 960 = $480,000.
Check:
k Assume that the the index falls by 10% (from 1,000 to 900).
k The equity portfolio value also drops from $500,000 to $450,000.
k Payoff from put options = 5 × $100 × (960 − 900) = $30, 000.
k Total value = $450, 000 + $30, 000 = $480, 000.
Portfolio insurance using put options: β 6= 1
When the portfolio’s β 6= 1, we need to take out the dividend effect in the
CAPM beta.
The total return is the sum of capital gain and dividend income.
Total return on the market: RM = rM + qM

Total return on the portfolio: RP = rP + qP
where r represents capital gain and q represents dividend income.
According to the CAPM: RP = RF + β (RM − RF )

k All returns are expected returns and there is no error term.
CAPM is a total returns relationship that includes dividend.

k But hedging using option protects only against capital losses exclude
dividend.
Portfolio insurance: An example when β 6= 1
A trader owns a portfolio worth $500,000, and wants to buy S&P 500 puts
with T = 3 months to ensure that value does not drops below $450,000.
What should be the strike price of the S&P 500 puts if:
k The S&P 500 index stands at 1,000.
k The portfolio beta on the S&P 500 is 2.0.
k Dividend yield for both assets is 4% per annum.
k The risk-free rate is 12% per annum.

Expected portfolio value in terms of the index value
Assume the index rise to 1,040 after 3 months
k Capital gain: rM = 1,040−1,000
1,000
= 4%.
k Dividend yield per 3 months: qM = 4%
4
=1%
k Total return per 3 months: RM = rM + qM = 4% + 1% = 5%.
k Interest rate per 3 months: Rf = 12%
4
= 3%
k Excess return per 3 months = 5% - 3% = 2%.
From the CAPM model, the expected portfolio return is:

RP = Rf + β(RM − Rf ) = 3% + 2(5% − 3%) = 7%
The portfolio’s expected capital gain is:

rp = RP − qP = 7% − 1% = 6%
The expected portfolio value is: 1.06 × Initial value = $530, 000.
Expected portfolio value in terms of the index value (cont’d)
Index at T 1,040 1,000 960
1040−1000
rM 1000 = 4% 0% −4%
3
qM (given) 4% × 12 = 1% 1% 1%
RM = r + M + qM 4% + 1% = 5% 1% −3%
3
RF (given) 12% × 12 = 3% 3% 3%
E (RP ) 7% −1% −9%

= 3 + 2(5 − 3) = 3 + 2(1 − 3) = 3 − 2(−3 − 3)
3
qP 4%× 12 =1% 1% 1%
E (rP ) = E (RP ) − qP 7% − 1% = 6% −1% − 1% = −2% −9% − 1% = −10%
Portfolio value at T .5m × 1.06 = .53m .5m × .98 = .49m .5m × .90 = .45m

Choosing the right strike
What will the value of the S&P 500 when portfolio value drops to
$450,000?
A put option with a strike price equal to $960 ensures that the expected
portfolio value does not drop below $450,000.
k Protection against a 10% decline in the portfolio value.
k Portfolio value is maintained at $0.45 million.

Portfolio insurance: An example when β 6= 1
Value underlying one option = $100 × 1,000 = $100,000
Number of contracts = β × $$500 ,000

100,000
= 2 × $$100
500,000
,000 = 10 contracts
Check:
k Chose the strike at 960 as before.
k If the index falls to 920, the portfolio value is expected to drop to $410,000.
k Payoff from put options = 10 × $100 × (960 − 920) = $40, 000.
k Total value = $410, 000 + $40, 000 = $450, 000.

Arbitrage Using Stock Index Futures

Stock index futures
Can be viewed as an investment asset paying a dividend yield.
k The investment asset is the portfolio of stocks underlying the index.
The cost-of-carry relationship is:
Ft ,T = St e (r −q )(T −t )
where q is the average dividend yield on the portfolio represented by the

index during life of contract.
For the formula to be true, the index has to represent an investment asset.
k The index value correspond to the value of a tradable portfolio.
Example: CME traded Nikkei index futures.

k Nikkei index futures settle in $ and do not represent an investment asset.
Index arbitrage
When market quote Ft∗,T 6= St e (r −q )(T −t ) there is an arbitrage opportunity.

k Simultaneous trading in futures and many different stocks.
k Always buy low and sell high!
When: Ft∗,T > St e (r −q )(T −t )
an arbitrageur buys the stocks underlying the index and sells futures.
When: Ft∗,T < St e (r −q )(T −t )
an arbitrageur buys futures and sells the stocks underlying the index.

Index arbitrage (cont’d)
Index arbitrage involves simultaneous trades in futures & various stocks.
Often a computer is used to generate the trades.
Occasionally simultaneous trades are not possible and the no-arbitrage

relationship between Ft∗,T and St may not hold.
k Example: On Black Monday, Ft∗,T was 15% below St !
Futures price usually reacts faster to news than spot (cash) price.

October 1987 Crash
& The Cascade Theory

October 1987 crash
The record one-day decline on October 19, 1987 was 22%!
Brady Commission’s Cascade Theory:

It attributes the downward cascade in stock prices to "mechanical,
price-insensitive selling" by institution using:
k Dynamic portfolio insurance strategy using synthetic put with futures.
k Index futures arbitrage strategies.

Portfolio insurance: A reminder
Enter trades to ensure that the portfolio will not fall below a certain level.
k Index put options.
k Synthetic put options (sell ∆ index futures & invest in a riskless bond).
When the market goes up, we move away from the minimum threshold.
k ∆ becomes less negative.
k Buy more index futures and sell bonds.
When the market goes down, we move closer to the minimum threshold.
k ∆ becomes more negative.
k Sell more index futures and buy bonds.
Buy stocks in an up market and selling stocks in a down market!

k During stock market crashes, it triggers massive selling of index futures.

Index arbitrage: A reminder
Ft = St e (r −q )(T −t )
If Ft∗ 6= St e (r −q )(T −t ) , there is an arbitrage opportunity.
When Ft∗ < St e (r −q )(T −t ) , buy Ft∗ and sell St .
If index futures prices are falling, index arbitrage will lead to massive
selling of stock in the spot (or cash) market.

Cascade theory
When cash price starts to fall, portfolio insurance scheme triggers

massive shorting of index futures.
The sell side pressure on index futures creates an opportunity for index
futures arbitrage which leads to a massive selling of stocks in the cash
market.
The secondary downward pressure on the stock cash market feeds back
to dynamic portfolio insurance which triggers more index futures sales.
This goes on and on till both markets collapsed.

Cascade theory and the basis
The Brady Commission suggests that support for the cascade theory can
be found in the behaviour of the basis between spot (or cash) and futures
prices.

Santoni’s arguments against the cascade theory
The flip in the basis sign does not necessarily support the cascade theory.
k A large drop in the dividend growth may cause a massive price revaluation.
k A drop in cash price should immediately trigger a drop in futures price.
k Futures simply respond to it faster than cash.
Irrational price insensitive traders.

k Around 1:30pm EST on October 19, 1987, the futures price is 15 points
below the cash price.
k With such a wide gap, selling futures in the dynamic portfolio insurance
scheme is “suicidal” - not something “financial experts” would do.

Santoni’s arguments against the cascade theory (cont’d)
The missing arbs.

k Index futures arbitrage was halted at 1:30pm & restricted subsequently.
k This did not stop the sharp decline in stock prices.
Foreign markets and previous panics.

k Prices collapsed also in overseas markets where programme trading was
virtually non-existence in 1987.
k Panics where observed before programme trading started and continued
after trading halt was imposed.

Santoni’s explanations for the crash
Limit order book and "walking down the demand curve".
k A large sale order creates a sequence of recorded prices that run in the
same direction.
k Cascade is a phenomenon of large block sales.

Santoni’s explanations for the crash (cont’d)
The difference in the trading mechanisms in the cash and the futures
market caused the prices in the futures market to react faster to news.
k Specialist Rule 104 and Trading halt for the cash market
k Open outcry system for the futures market.
The index is not a cash product (you have to trade all 500 stocks to move
the index), but the index futures has a real price.

Santoni’s explanation for the crash (cont’d)
Cascade theory suggests positive auto- and cross-correlation for cash

and futures prices.
Evidence from intra day data suggest:

k Changes in cash prices is positive autocorrelated (Table 3).
k Changes in futures prices does not have autocorrelation pattern (Table 4).
k The autocorrelations in cash prices suggest a lag length up to 5 min -
During the crash, cash transaction took 10 to 75 min to execute (Table 5).
k Granger causality suggest futures price leads cash price (Table 6).

Summary
We have discussed the optimal hedge ratio and cross hedging.
We have seen how index futures and index options are used for hedging
purposes.
We have discussed Portfolio Insurance and Index Arbitrage.
We have discussed October 1987 crash and the cascade theory.
We have discussed Santoni’s rebuttal against the cascade theory.
Next time we will have our first revision lecture!

~ End ~

Hedging, Portfolio Insurance &amp; Cascade Theory

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Financial Derivatives

Hedging, Portfolio Insurance and Cascade Theory

Dr Eirini Konstantinidi & Dr Ser-Huang Poon

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 1 / 44

In this lecture we will further discuss how these insights relate to

& Cross Hedging

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 3 / 44

How many units of a futures contract do we need to cancel out every

Optimal Hedge ratio, h∗ :

Hold the hedge from t to t + 1, then t + 1 to t + 2, ..., till T − 1 to T .

The change in the value from t to t + 1 is: ∆Πt +1 = ∆St +1 − h ∆Ft +1

The variance of ∆Π is:

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 5 / 44

The first order condition yields:

cov (∆St +1 , ∆Ft +1 )

β̂1 is an estimate of the optimal hedge ratio h∗ !

The optimal hedge ratio is the estimated slope coefficient:

where σF ,S is the covariance, σS is the standard deviation of ∆S, σF is

The determination of the hedge ratio is crucial!

The regression approach above is valid only if the relationship between

The cross hedge is effective only if σ2 (ε) → 0.

When σ2 (ε) = 0, then R 2 =1 (explanatory power), the correlation ρ = 1.

When ρ = 1 and σF = σS then h∗ = 1.

Example (Optimal hedge ratio)

The optimal hedge ratio is: ĥ∗ = ρ σσS = 0.8 × 00..040

The number of futures contracts is:

amount you want to hedge 1, 000, 000

or 15 rounding to the nearest whole number.

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 10 / 44

P amount you want to hedge

h is the hedge ratio: CAPM beta.

Example (Hedging with index futures)

Value of the asset underlying one futures contract:

Number of contract to short: β PA = 1.5 × $$2225

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 12 / 44

2 Investor’s horizon is long term, but requires short term protection in an

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 13 / 44

Up to now we reduced the beta of the hedger’s portfolio to zero.

What position in index futures is appropriate to change the beta of a

When β > β∗ the hedger needs to take a short position in

When β < β∗ the hedger needs to take a long position in

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 14 / 44

Example (Changing beta exposure)

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 15 / 44

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 16 / 44

The strike price K is chosen to give the appropriate insurance level.

To limit the downside potential, portfolio managers can use:

Synthetic put option: p = Ke−rT N (−d2 ) − Se−qT N (−d1 )

k Index futures: F = Se (r −q )T ∗ where T* is the futures maturity

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 18 / 44

‘Protective Put’ using index put option is a static hedge.

The treatment of β = 1 and β 6= 1 are slightly different.

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 19 / 44

Assume that the portfolio is well diversified, i.e. portfolio beta is β = 1.

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 20 / 44

Example (Portfolio insurance when β = 1)

Value underlying one option contract = $100 × 1,000 =$100,000

Number of puts to be bought = $$500 ,000

For a strike K = 960, the level of protection is 5 × $100 × 960 = $480,000.

Total return on the market: RM = rM + qM

According to the CAPM: RP = RF + β (RM − RF )

CAPM is a total returns relationship that includes dividend.

(Konstantinidi & Poon, AMBS) Financial Derivatives December 1, 2020 23 / 44

From the CAPM model, the expected portfolio return is:

Hedging, Portfolio Insurance & Cascade Theory

Hedging, Portfolio Insurance & Cascade Theory