BAFI3192 - DERIVATIVES AND RISK

MANAGEMENT

ASSESSMENT 3
INDIVIDUAL RISK MANAGEMENT REPORT

LECTURER
KOK SENG KIONG

STUDENT’S NAME
LUONG QUANG THOAI

STUDENT ID
S3836577

TUTORIAL
THURSDAY 3PM

WORD COUNT
3030
 I. Trading philosophy

In trading strategies, fundamental stock analysis plays a critical role in approaching

appropriate investments. It includes examining current macroeconomic indicators conditions

since it is suitable in the context of numerous market changes, especially the economy during

the Covid-19 pandemic. Next, an in-depth investigation of industry business is necessary to

determine stocks expected to perform well. Professional technology platforms such as Eikon

provide practical target price recommendations for investors as many companies in

recommended industries will be identified. We can evaluate companies' strategies, qualitative

factors, market prospects, etc. Then, we can use the double moving average approach to

determine buying or selling signals. An examination of technical analysis comprehends

numerous loosely held paradigms based on the analysis of financial stock price and volume

data to understand past price movement and anticipate future prices (Trivedi et al). Hence,

technical analysis is one of the vital strategies.

Furthermore, hedging tools consideration is necessary to deal with future market volatilities.

Besides, strategies should be flexible to adapt to concurrent situations, such as adjusting stock

holdings and strategy depending on the market situation. The results of Charles Schwab's

Investor Profile Questionnaire assigned suitable investment strategies to me as "Moderate

Allocation". Investors only need some growth potential along with less volatility than the

overall market. However, I would prefer to buy both value and growth securities as long as I

see the profit opportunities when purchasing them.

II. Portfolio Construction

 1. Stock fundamentals

CVS Health (NYSE: CVS)

Table 1: The latest P/E and P/B ratios of CVS Health in comparison with the market

and industry median (reproducing from Simply Wall st).

Table 2: CVS's fundamentals (reproducing from MarketWatch and Macrotrends).

CVS is a healthcare solutions company that provides healthcare products, prescription

medications, beauty products, and cosmetics. According to Table 1, both the company's P/E

and P/B ratios are lower than the market and industry median, which means the company is

presently undervalued. However, the company performed strongly in the first quarter of

2022, increasing the quarterly dividend by 10%, leading to a return of $722 million to

shareholders (CVS 2022). An increase in EPS in Q1 2022 refers to CVS's business

profitability well marked.

 Figure 1: Advanced chart of CVS Health, Technical Analysis, MACD (12,26,9)

(MarketWatch 2022)

Overall, the CVS 1-month chart (from April 22 to May 9) shows a declining trend. However,

the pending merger with Aetna health insurer, another leading healthcare provider, will

promote bullish momentum. In May, the MACD line crossed the signal “from below to

above” which we consider a buying signal.

Intel (NYSE: INTC)

Table 3:The latest P/E and P/B ratios of Intel in comparison with the market and

industry median (reproducing from Simply Wall st).

 Table 4: INTC fundamentals (reproducing from MarketWatch and Macrotrends).

Intel is an American multinational corporation that provides motherboard chipsets, integrated

circuits, graphics, and microprocessors for computer system manufacturers and other

computing devices. Both P/E and P/B ratios are reported to be lower than the industry

median, proving the company is undervalued compared to its peers. However, EPS and ROE

fluctuated over the period which can be inconsistent profit.

Figure 2: Advanced chart of Intel, Technical Analysis, MACD (12,26,9) (MarketWatch

2022).

Over one year, INTC has experienced a long downward trend because of the global

semiconductor chip shortage during Covid-19 (LI 2022). However, the computer hardware

market is expected to recover in 2022 (ReportLinker 2022). The intersection of MACD and

signal line "from bottom to top" indicates buying signal.

Bank of America (NYSE: BAC)

 Table 5:The latest P/E and P/B ratios of Bank of America in comparison with the

market and industry median (reproducing from Simply Wall st).

Table 6: BAC's fundamentals (reproducing from MarketWatch and Macrotrends).

The company operates in the financial sector, which serves an extensive range of banking,

asset management, investing, and other financial products and services. BAC is one of the

largest financial institutions in the US. P/E ratios of BAC are still lower than the market and

industry average, which suggests the possibility of being undervalued; meanwhile, P/B ratios

are equal to the US banking industry median. All figures have a decreasing trend in Q1 2022.

Figure 3: Advanced chart of Bank of America, Technical Analysis, MACD (12,26,9)

(MarketWatch 2022).
Figure 3 illustrates an upward trend of BAC at the end of 2021 and a decline trend in the first

quarter of 2022. It can be seen that both MACD and signal lines crossed below during May,

which compelling a possible buying signal.

Table 7:The latest P/E and P/B ratios of JP Morgan Chase in comparison with the

market and industry median (reproducing from Simply Wall st).

Table 8: JPM's fundamentals (reproducing from MarketWatch and Macrotrends).

JP Morgan & Chase is a global leader in financial services and is one of the long-standing

banks in the world which offers financial services for individuals and businesses, asset

management, and investment banking. The P/E ratio is smaller than the industry median

whilst the P/B ratio is higher than the industry median. However, both of them are still lower

than the market that indicating the company is still undervalued. Both EPS and ROE declined

gradually from Q2 2021 to Q1 2022.

 Figure 4: Advanced chart of JP Morgan Chase, Technical Analysis, MACD (12,26,9)

(MarketWatch 2022).

Like other stocks, JPM has also experienced a decreasing trend. The continuous intersection

below of two lines indicates a buying signal.

Apple (NYSE: AAPL)

Table 9:The latest P/E and P/B ratios of Apple in comparison with the market and industry

median (reproducing from Simply Wall st 2022).

Table 10: AAPL's fundamentals (reproducing from MarketWatch and Macrotrends).

Apple Inc is a multinational giant tech company in the world that mainly designs and

manufactures smartphones, tablets, and personal computers. Both P/E and P/B are much

higher than the market and the US technology median which means the company is

overvalued. EPS varied significantly while ROE kept rising over the period.

Figure 5: Advanced chart of Apple, Technical Analysis, MACD (12,26,9) (MarketWatch

2022).

The price grew significantly at the end of 2021 but it fell slightly in the early 2022.

The intersection of MACD and signal line is observed as the same as the JPM's trend, hence

it's expected to increase in the next month.

2. News and macroeconomic conditions

JPM is expected to reach 17% returns sooner than forecasted because rising-rate rates provide

a boost. While guiding about 2022 expenses remained constant at approximately $77 billion,

Federal Reserve combats inflation rate by raising interest rate expectations and may issue a

boost (Son 2022) .

The US's inflation rate increased dramatically from 2.6% to 8.5% over one year (Figure 6). A

high level of inflation rate wears down the purchasing power of future cash flow over time,

fueling volatilities in the market then adversely influences investment level and depresses
economic growth (Mamo 2012). When monetary policy is tightened to manage high inflation

rates, financial institutions would take advantage related to interest rates (Gaggar 2022).

Figure 6: Monthly inflation rate in the United States from April 2021 to April 2022

(Statista 2022).
 Figure 7: Annualized growth of real GDP in the United States from 2012 to 2022, by

quarter

GDP growth rate in the US fell steeply in Q3 2020 and recovered remarkably in the next

quarter of 2020. However, until early 2022, GDP growth fell at a 1.4% pace in the nation due

to a widening trade deficit (Cox 2022). In spite of the disappointing records, stock and bond

yields continue to rise with technology stock in the lead (Cambon 2022).

3. Securities weighting and CAPM calculation.

 Figure 8: Weighting of the initial portfolio.

Before buying decisions, I had taken a look at historical data and fundamental data to choose

companies that are currently undervalued. I am just a beginner in the stock market, despite

being a moderate investor, I have spent 26% of my portfolio's weight on INTC stock which is

the most volatile one (beta > 1), and the rest of 74% weight on F, BAC, JPM and CVS that is

less fluctuated (beta <1). I assigned 18% of the weight for each bank which is higher than

14% of F, since banking securities will benefit from the high inflation rate in the US.

Creating a value-weight portfolio will be safer since large capital stock displays less

volatility.
 Table 11: Weighting of initial portfolio and Capital Asset Pricing Model (CAPM)

calculation.

The US government 10 years treasury bond yield (risk-free rate) is at 1.51% in 2021 (Statista

2022). The 10-year expected return on the US market is 16.58% (Thune 2022). The trading

duration is from 25/4 to 8/5 hence there are overall 10 effective trading days excluding

weekends.

4. Unsystematic risk

Unsystematic risk is specific to each enterprise or sector and can be alleviated through

portfolio diversification.

Technology industry: competitive risk is a common risk that we frequently see in the

technology industry. Samsung and Huawei race to launch new affordable smartphones but

Apple has no announcement of new foldable smartphones. Apple has always created a unique

difference in its products and prioritized the core value of the product over new features and

utilities. This has contributed to the reduction of competitive risks. On the other hand, the

vulnerability of Intel security recently permitted unauthorized individuals with physical

access to exploit and install malware chips (Lifars 2022). Its users' data can be stolen since

the system was hacked.

Healthcare industry: Amongst the Covid-19 pandemic, the industry obtains more attention

due to its importance. Moderna is a prime example of this. Specifically, at the time when the

Covid-19 pandemic became more serious again, Moderna had several protests about the

effectiveness of the vaccine ( Trefis Team 2021). If MRK’s antiviral studies are effective, this

impact might be seen, and vice versa. Moving to CVS, its new policies and restrictions on

activities have become barriers to CVS. For example, employees' salaries and CVS business

expenses negatively impacted its price moving on 4th August 2021 (Baccardax 2021).

Banking: Entering the banking sector, emerging financial technologies are often disrupted

and this has become the challenge that JPM and BAC need to face. In particular, the

consumer banking segment contributes notably to the main revenue source of those two

companies. Decentralized finance (commonly known as Defi) is a form of block-chain-based

finance that does not depend on central financial intermediaries like brokers, exchanges, or

banks to provide financial services, or traditional financial instruments, which instead use

smart contracts on the blockchain. This offers a danger to incumbents in traditional banking,

since Defi raised $80b in 18 months, owing to unhappiness with the current system,

including:

- Low deposit returns (Brooks 2021).

- Hidden trade costs (Brooks 2021).

- Hurdles across centralized systems (Brooks 2021).

As a result, the traditional banks will not soon be replaced by Defi in the problem associated

with the lack of credit generation.

5. Systematic risk
Systematic risk refers to an undiversifiable risk that the whole market has to deal with like

unexpected nationwide phenomena and the change in macroeconomic conditions (Bhavana

2022). Beta is an index that represents systematic risks in the CAPM theory (Kirill, Carlota,

and Neus 2016). In my initial portfolio, technology stocks are the most volatile (beta > 1)

while healthcare and banking sectors have less volatility. The weighted beta (1.033) indicates

the portfolio shift closely with the market.

The Covid-19 outbreak: many countries imposed strict lockdowns which resulted in an

interrupted supply chain. The highest volatility was recorded during Covid-19, despite stocks

in high-income countries being vulnerable, they still bound back stronger than in low-income

countries (Baker et al 2020).

Russia's invasion of Ukraine: because the US imposed unprecedented sanctions against

Russia, many businesses announced a partial or full halt to operating in Russia (Francis

2022). Apple has halted its exports, McDonald, Starbucks, PepsiCo and Coca-cola shuttered

all their locations in Russia which put downward pressure on stock market prices.

6. One day 99% value at Risk

Table 12: One day 99% Value at Risk.

Value at Risk measures the possibilities of loss in financial portfolios over a specified period

of time with a specified probability (Liu and Wu 2008). According to Table 12, I am 99%

confident that my portfolio will lose more than $41,751.8, making up 4.6% of my initial

portfolio. 1% opportunity of losing more than $41,751.8 can occur if a systematic risk

happens such as war or a pandemic outbreak that adversely affects the stock market.
 Figure 9: Histogram of portfolio's daily return frequency in three years from 9/5/2019

to 9/5/2022.

The chart shows a right-skewed distribution, the total positive return day is approximately 3

times compared to the total negative return day throughout 3 years, which means my initial

portfolio is likely well-performed.

7. Hedging

a. Future contract:

Regarding the information analyzed above, the US stock market tendency was going down during the

serious breakout Covid-19’s period. Hence, I would expect that the market price volatility could also

decrease and I also took advantage of buying future contracts to limit financial risks. Since the

securities in my initial portfolio all belong to the S&P 500 index, I decided to buy the E-Mini S&P500

Future Continuous Contract on the first day of the trading session (25th April 2022).
 Table 12: Future trading data

With the contract size of 50, the contract’s number might be calculated throughout the formula of

option hedge ratio, showing the risk’ magnitude posed by a hedging instrument movement.

After finishing the calculation of the option hedge ratio, there were 4 contracts that I would sell on

25th April 2022 to limit the financial risk due to my expectation of decreasing market trend on 9th

May 2022.

Figure 10: E-mini S&P 500 Future Contract Continuous Contract on 9th May 2022

Reproduced from: Market Watch 2022.

 Table 13: Net return in future trading.

Based on Figure 10, the market price went down to $4,015.50 as I expected. Consequently, I,

fortunately, got a profit from the futures contract of $55,450 (Table 13).

b. Option contract:

From Appendix 1, in my hedging transaction, the final decision was to sell 4 put option

contracts, equivalent to 400 AAPL shares. More notably, each contract would have a price of

$5.8 and the strike price would be $160 as my AAPL holding was 792 shares. Additionally,

our final trading day is on 9th May 2022, so the expiration date of buying 4 put option

contracts was 6th May 2022.

Table 14: Option contract criteria

According to the calculation shown in Table 15, the net return on 9th May 2022 in those two

cases was at a loss. However, it might be seen that I should choose the case of using the put

option and selling 400 AAPL shares at $160 because the net return of that case is greater than

the other case on 9th May 2022. If I still exercise the put option, the advantage that I might

receive:
 Option profit = (160-152.06) x 400 = $2382

To sum up, on 9th May 2022, I decided to choose the first case to create the option profit of

$2382.

III. Reflection

a. Risk appetite: is the level of risk that investors are willing to accept in

pursuing objectives (Shackleford n.d). Due to preferring moderate allocation

of investment strategies, I can be either a risk-seeking or risk-averse investor.

4 out of my 5 chosen stocks (JPM, BAC, INTC and CVS) are from companies

with outperforming financial performance in the past few years and are

presently undervalued in comparison with the market. Although AAPL is on

the downward, it is still overvalued compared to the market median. There is a

60% of stock weight in my portfolio that has lower volatility than the market

(JPM, BAC, and CVS) since the banking and healthcare industry can endure

and survive throughout the Covid-19 pandemic. My portfolio beta is 1.033

which is mostly the same as the market beta. After 2 week-trading, my

portfolio return decreased significantly due to the stock market's downward

trend. Hence, hedging is a good one to minimize my loss. Finally, changing

my risk appetite to risk-averse might be an appropriate one in the present

short-term investment.

b. The CAPM is frequently utilized to interpret the tradeoffs between portfolio

returns and their risks which were convinced by covariance with market

volatility (CFA Journal 2018). Moreover, CAPM assumes that all investors
 have the same expectations & plan in a specified period and there is no

transaction fee involved when investing. The model always gives a positive

average return on the market (CFA Journal 2018). Besides, the market return

is represented by the S&P 500 which recommends a "large-cap bias" because

of the over-inclusion of large corporations, resulting in a false representation

of systematic risks (Wobst et al 2020). The actual return is quite different from

the expected return calculated by using the CAPM method (table 13)

(expected return of $6770 and the actual loss of $44,828 on 9 May). Some

stocks might perform worse than the model's expectation, unsystematic risks

and business fundamental shocks were not included in the CAPM calculation.

c.

Table 15: AAPL net return with hedging transactions

Following table 15, I give a decision of exercising the option to sell 400 AAPL shares at a

market price of $160. The net portfolio return of AAPL stocks with using option is -

$1,175.2.

d. Net portfolio return with hedging transaction:

 Figure 11: Net initial portfolio return by using hedging

Regarding the above-calculated result in Table 13, the net return of five initial securities by

using hedging was $10,598.11 (Figure 11).

e. Comparison and contracting in using hedging:

- How hedging transactions affect the portfolio:

Under the above data calculations, my portfolio increased to $10,598.11 after using hedging

transactions. This increase in profit was mainly due to the fact that the portfolio received a

profit of $55,450 in the future trading and the price movement tendency for the options also

decreased as expected. Also, if I face a loss in using hedging for my portfolio, I personally

feel that spending on those trades is worth it. To explain more specifically, if I get back the

calculated VaR result above, the loss I might get is up to $41,751.80. To continue to receive a

significant amount of profit in the next period, it is very essential to carefully analyze the

market situation through information in newspapers or financial statements. From there, I

might accurately predict the general market tendency.

- The preferable derivative contracts:

After calculating and evaluating the above two hedging transactions' methods and examining

the effect that my portfolio is affected, my final decision is to choose the option contract for

the following reasons.

According to Trigeorgis & Reur (2016), the option contract has partially eliminated the

symmetric reward between those two upsides and downsides while purchasing an option, and

the inherent risk also does not exist. The reason for this has to do with the freedom of

investors to buy and sell shares. Specifically, they might trade their asset at any agreed-upon

price instead of being forced. Consequently, based on options having conditions, it is easier

for investors to make decisions to reduce risk as much as possible or they might receive a

periodic amount of profit for them. Whereas the financial risks in portfolios are covered by
future contracts, investors often use options to hedge price movements in securities. This

corresponds to investors’ concerns about risks during the trading session. Options might be

more effective to use since changes can not directly affect future hedges that depend on the

portfolio’s hedge ratios.

To conclude, options still have their strength and effectiveness on transferred risks. Because

of this, it is reasonable to choose the option of hedging.

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Appendix:
Appendix 1: AAPL options on 25th April 2022

Source: Market Watch 2022.

Appendix 2: AAPL options on 26th April 2022

Source: Market Watch 2022.

Appendix 3: AAPL options on 27th April 2022

Source: Market Watch 2022.

Appendix 4 : AAPL options on 28th April 2022

Source: Market Watch 2022.

Appendix 5 : AAPL options on 29th April 2022

Source: Market Watch 2022.

Appendix 6 : AAPL options on 2nd May 2022

Source: Market Watch 2022.

Appendix 7 : AAPL options on 3rd May 2022

Source: Market Watch 2022.

Appendix 8: AAPL options on 4th May 2022

Source: Market Watch 2022.

Appendix 9: AAPL options on 6th May 2022

Source: Market Watch 2022.

Appendix 10: AAPL options on 9th May 2022

Source: Market Watch 2022.