Risk Management

using

Index Options and Futures

Outline
Introduction
Using

options
Using futures contracts
Dynamic hedging

Introduction
Portfolio

protection involves adding

components to a portfolio in order to
establish a floor value for the portfolio
using:
Equity or stock index put options
Futures contracts
Dynamic hedging
3

Hedging

Hedging removes risk. Hedging involves

establishing a second position whose price
behavior will likely offset the price behavior of
the original portfolio.

The objective of portfolio protection is the

temporary removal of some or all the market
risk associated with a portfolio. Portfolio
protection techniques are generally more
economic in terms of commissions and
managerial time than the sale and eventual
replacement of portfolio components.
4

Using Options
Introduction
Equity

options with a single security

Index options

Introduction
Options

enable the portfolio manager to

adjust the characteristics of a portfolio
without disrupting it

Knowledge

of options improves the

portfolio managers professional
competence
6

Equity Options with

A Single Security
Importance

of delta
Protective puts
Protective put profit and loss diagram
Writing covered calls

Black-Scholes Formula
(European Options)
C S0 e
P Ke

qT

rT

N (d1 ) Ke

rT

N (d 2 ) S0e

N (d 2 )

qT

N (d1 )

where
ln( S0 / K ) (r q 2 / 2)T
d1
T
d 2 d1 T
8

Importance of Delta
Delta

is a measure of the sensitivity of the

price of an option to changes in the price of
the underlying asset:
P
Delta
S
where P option premium
S stock price
9

Importance of Delta (contd)

Delta

enables the portfolio manager to

figure out the number of option contracts
necessary to mimic the returns of the
underlying security. This statistic is
important in the calculation of many hedge
ratios.
10

Importance of Delta (contd)

Delta:

Equals N(d1) in the Black-Scholes Call price.

Equals -N(-d1) in the Black-Scholes Put price.
Allows us to determine how many options are
needed to mimic the returns of the underlying
security
Is positive for calls and negative for puts
Has an absolute value between 0 and 1
11

Protective Puts
A

protective put is a long stock position

combined with a long put position

Protective

puts are useful if someone:

Owns stock and does not want to sell it

Expects a decline in the value of the stock

12

Protective Put
Profit and Loss Diagram
Assume

the following information for ZZX:

13

Protective Put
Profit & Loss Diagram (contd)
Long

position for ZZX stock:

Profit or Loss

0
Stock Price at
Option Expiration

-50

$50

14

Protective Put
Profit & Loss Diagram (contd)
Long
Profit or Loss

44
0

position for SEP 45 put ($1 premium):

Maximum
Gain = $44
$45

-1
Maximum
Loss = $1

Stock Price at
Option Expiration
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Protective Put
Profit & Loss Diagram (contd)
Protective

put diagram:

Profit or Loss

-6

Maximum
Gain is unlimited
$45

Maximum
Loss = $6

Stock Price at
Option Expiration
16

Protective Put
Profit & Loss Diagram (contd)
Observations:

The maximum possible loss is $6

The potential gain is unlimited

17

Protective Put
Profit & Loss Diagram (contd)
Selecting

the striking price for the

protective put is like selecting the
deductible for your stock insurance
The more protection you want, the higher the
premium

18

Writing Covered Calls

Writing

covered calls is an alternative to

protective puts
Appropriate when an investor owns the stock,
does not want to sell it, and expects a decline in
the stock price

An imperfect form of portfolio protection

19

Writing Covered Calls (contd)

The

premium received means no cash loss

occurs until the stock price falls below the
current price minus the premium received

The

stock price could advance and the

option could be called

20

Differences

Protective puts provide protection against

large price declines, whereas covered calls
provide only limited downside protection.
Covered calls bring in the option
premium, while the protective put requires
a cash outlay.
21

Index Options
Investors

buying index put options:

Want to protect themselves against an overall

decline in the market or
Want to protect a long position in the stock

22

Index Options (contd)

If

an investor has a long position in stock:

The number of puts needed to hedge is

determined via delta (as part of the hedge ratio)
He needs to know all the inputs to the BlackScholes OPM and solve for N(d1)
23

Index Options (contd)

The

hedge ratio is a calculated value

indicating the number of puts necessary:
Portfolio value
1
HR
Portfolio beta
Contract "value"
Delta
where contract value = index level 100

24

Portfolio Insurance Example #1:

S&P 100 index Options (OEX)
The

OEX contract is the tool of choice for

many professional portfolio risk managers.

While

the S&P 100 futures contract is

similar to traditional agricultural futures,
delivery does not occur, nor does it need to
occur for this to be an effective hedging
tool.
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Index Options (contd)

Example
OEX 315 OCT puts are available for premium of $3.25.
The delta for these puts is 0.235, and the current index
level is 327.19.
How many puts are needed to hedge a portfolio with a
market value of $150,000 and a beta of 1.20?

26

Index Options (contd)

Example (contd)
Solution: You should buy 23 puts to hedge the portfolio:

Portfolio value
1
HR
Portfolio beta
Contract "value"
Delta
$150, 000
1

1.20
$32,719
0.235
23.41
27

Portfolio Insurance Example #2

Suppose

the manager must protect a

$500,000 portfolio with a beta of 2.
Current riskless rate is 12%.
Dividend yield (on both the portfolio and
the market index) is 4%.
S&P 500 index is currently 1,000.
The manager must hedge the value that the
portfolio will take three months from now.
28

Example #2 (Contd)
Suppose

that we want to insure $450,000 of

the portfolio, i.e. the manager is willing to
let the portfolio go down in value by
$50,000 but no further.

What

strike price for the protective put

option should we choose?
29

Example #2 (Contd)
Suppose

that we want to insure $450,000 of

the portfolio, i.e. the manager is willing to
let the portfolio go down in value by
$50,000 but no further.

What

strike price for the protective put

option should we choose?
30

Example #2 (Contd)
Terminal

Portfolio Value that we can live

with: $450,000.
Change in value = (450-500)/500 = -10%
Dividends Earned = (3/12)(4) = 1%
Total Portfolio Return = -10+1 = -9%
Note that 3-month Rf = (3/12)(12) = 3%
CAPM: Rportfolio = Rf+beta(Rindex-Rf)
31

Example #2 (Contd)
Thus:

Rindex = (Rportfolio-Rf)/beta + Rf
So Rindex = (-9-3)/2+3 = -3%
Dividends from index = (3/12)(4) = 1%
Change in index value = -3-1 = -4%
Terminal index value = 1000(1-.04) = 960
Therefore we need an index put option with
a strike price of 960.
32

Example #2 (Contd)
And

the number of put option contracts that

need to be purchased is:
N = (2)500,000/[(1,000)(100)]=10
Note

that we do not care about delta this

time because we hold the option until
maturity.
33

Example #2 (end)
Also

note that if the value of the index falls to

880 for example, we can compute the
corresponding terminal portfolio value (using
CAPM) as about $370,000.
The options pay (960-880)(10)(100) = $80,000
Adding $80,000 to $370,000 brings the net
terminal value to $450,000: our required level.
34

Using Futures Contracts

Importance

of financial futures
Stock index futures contracts
S&P 500 stock index futures contract
Hedging with stock index futures

35

Importance of
Financial Futures
Financial

futures are the fastest-growing

segment of the futures market

The

number of underlying assets on which

futures contracts are available grows every
year

36

Stock Index Futures Contracts

A

stock index futures contract is a promise to buy

or sell the standardized units of a specific index at
a fixed price by a predetermined future date

Stock

index futures contracts are similar to the

traditional agricultural contracts except for the
matter of delivery
All settlements are in cash
37

Hedging with
Stock Index Futures
With

the S&P 500 futures contract, a

portfolio manager can attenuate the impact
of a decline in the value of the portfolio
components

S&P

500 futures can be used to hedge most

broad-based portfolios (ex: mutual funds).
38

Hedging with
Stock Index Futures (contd)
To

hedge using S&P stock index futures:

Take a position opposite to the stock position

E.g., if you are long in stock, short futures

Determine the number of contracts necessary to

counteract likely changes in the portfolio value
using:
The value of the appropriate futures contract
The dollar value of the portfolio to be hedged
The beta of your portfolio
39

Hedging with
Stock Index Futures (contd)
Determine

the value of the futures contract

The CME sets the size of an S&P 500 futures

contract at 250 times the value of the S&P 500
index
The difference between a particular futures
price and the current index is the basis

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Calculating A Hedge Ratio

Computation
The

market falls
The market rises
The market is unchanged

41

Computation
A

futures hedge ratio indicates the number

of contracts needed to mimic the behavior
of a portfolio
The hedge ratio has two components:
The scale factor
Deals with the dollar value of the portfolio relative
to the dollar value of the futures contract

The level of systematic risk

I.e., the beta of the portfolio
42

Computation (contd)
The

futures hedge ratio is:

Dollar value of portfolio

HR
Beta
Dollar value of S&P contract

43

Computation (contd)
Example
You are managing a $90 million portfolio with a beta of
1.50. The portfolio is well-diversified and you want to
short S&P 500 futures to hedge the portfolio. S&P 500
futures are currently trading for 353.00.

How many S&P 500 stock index futures should you short
to hedge the portfolio?
44

Computation (contd)
Example (contd)
Solution: Calculate the hedge ratio:

Dollar value of portfolio

HR
Beta
Dollar value of S&P contract
$90, 000, 000

1.50
250 $353
1,529.75
45

Computation (contd)
Example (contd)
Solution: The hedge ratio indicates that you need 1,530
S&P 500 stock index futures contracts to hedge the
portfolio.

46

The Market Falls

If

the market falls:

There is a loss in the stock portfolio

There is a gain in the futures market

47

The Market Falls (contd)

Example
Consider the previous example. Assume that the S&P 500
index is currently at a level of 348.76. Over the next few
months, the S&P 500 index falls to 325.00.
Show the gains and losses for the stock portfolio and the
S&P 500 futures, assuming you close out your futures
position when the S&P 500 index is at 325.00.
48

The Market Falls (contd)

Example (contd)
Solution: For the $90 million stock portfolio:
-6.81% x 1.50 x $90,000,000 = $9,193,500 loss
For the futures:
(353 325) x 1,530 x 250 = $10,710,000 gain
49

The Market Rises

If

the market rises:

There is a gain in the stock portfolio

There is a loss in the futures market

50

The Market Rises (contd)

Example
Consider the previous example. Assume that the S&P 500
index is currently at a level of 348.76. Over the next few
months, the S&P 500 index rises to to 365.00.
Show the gains and losses for the stock portfolio and the
S&P 500 futures, assuming you close out your futures
position when the S&P 500 index is at 365.00.
51

The Market Rises (contd)

Example (contd)
Solution: For the $90 million stock portfolio:
4.66% x 1.50 x $90,000,000 = $6,291,000 gain
For the futures:
(365 353) x 1,530 x 250 = $4,590,000 loss
52

The Market Is Unchanged

If

the market remains unchanged:

There is no gain or loss on the stock portfolio

There is a gain in the futures market

The basis will deteriorate to 0 at expiration (basis
convergence)

53

Hedging in Retrospect
Futures

hedging is never perfect in practice:

It is usually not possible to hedge exactly

Index futures are available in integer quantities only

Stock portfolio seldom behave exactly as their

betas say they should
Short

hedging reduces profits in a rising

market
54

Dynamic Hedging
Definition
Dynamic

hedging example
The dynamic part of the hedge
Dynamic hedging with futures contracts

55

Definition
Dynamic hedging involves monitoring a portfolio's
position delta and readjusting this value as it
deviates from a target number.
Example:
Attempt to replicate a put option
By combining a short position with a long position
To achieve a position delta equal to that which would
be obtained via protective puts
56

Dynamic Hedging Example

Assume

the following information for ZZX:

57

Dynamic Hedging
Example (contd)
You

own 1,000 shares of ZZX stock

You are interested in buying a JUL 50 put for
downside protection
The JUL 50 put expires in 60 days
The JUL 50 put delta is 0.435
T-bills yield 8 percent
ZZX pays no dividends
ZZX stocks volatility is 30 percent
58

Dynamic Hedging
Example (contd)
The

position delta is the sum of all the

deltas in a portfolio:
(1,000 x 1.0) + (1,000 x 0.435) = 565
Stock has a delta of 1.0 because it behaves like itself
A position delta of 565 behaves like a stock-only
portfolio composed of 565 shares of the underlying
stock
59

Dynamic Hedging
Example (contd)
With

the puts, the portfolio is 56.5 percent

as bullish as without the puts

You

can sell short 435 shares to achieve the

position delta of 565:
(1,000 x 1.0) + (435 x 1.0) = 565

60

The Dynamic Part of the Hedge

Suppose

that one week passes and:

ZZX stock decline to $49

The delta of the JUL 50 put is now 0.509

The position delta has changed to:
(1,000 x 1.0) + (1,000 x 0.509) = 491
61

The Dynamic Part

of the Hedge (contd)
To

continue dynamic hedging and to

replicate the put, it is necessary to sell short
74 shares (435 + 74 = 509 shares)

62

The Dynamic Part

of the Hedge (contd)
Suppose

that one week passes and:

ZZX stock rises to $51

The delta of the JUL 50 put is now 0.371

The position delta has changed to:
(1,000 x 1.0) + (1,000 x 0.371) = 629
63

The Dynamic Part

of the Hedge (contd)
To

continue dynamic hedging and to

replicate the put, it is necessary to cover 64
of the 435 shares you initially sold short

64

Dynamic Hedging with

Futures Contract
Appropriate

Stock

for large portfolios

index futures have a delta of +1.0

65

Dynamic Hedging with

Futures Contract (contd)
Assume

that:

We wish to replicate a particular put option

with a delta of 0.400
We manage an equity portfolio with a beta of
1.0 and $52.5 million market value
A futures contract sells for 700
The dollar value is 250 x $700 = $175,000

66

Dynamic Hedging with

Futures Contract (contd)
We

must sell enough futures contracts to

pull the position delta to 0.600
The hedge ratio is:
Dollar value of portfolio
HR
Beta
Dollar value of S&P contract
$52,500, 000

1.0
250 $700
300 contracts
67

Dynamic Hedging with

Futures Contract (contd)
If

the hedge ratio is 300 contracts, we must

sell 40% x 300 = 120 contracts to achieve a
position delta of 0.600

68