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You are on page 1of 68

using

Outline

Introduction

Using

options

Using futures contracts

Dynamic hedging

Introduction

Portfolio

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

establishing a second position whose price

behavior will likely offset the price behavior of

the original portfolio.

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

Index options

Introduction

Options

adjust the characteristics of a portfolio

without disrupting it

Knowledge

portfolio managers professional

competence

6

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

price of an option to changes in the price of

the underlying asset:

P

Delta

S

where P option premium

S stock price

9

Delta

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

Delta:

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

combined with a long put position

Protective

Expects a decline in the value of the stock

12

Protective Put

Profit and Loss Diagram

Assume

13

Protective Put

Profit & Loss Diagram (contd)

Long

Profit or Loss

0

Stock Price at

Option Expiration

-50

$50

14

Protective Put

Profit & Loss Diagram (contd)

Long

Profit or Loss

44

0

Maximum

Gain = $44

$45

-1

Maximum

Loss = $1

Stock Price at

Option Expiration

15

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 potential gain is unlimited

17

Protective Put

Profit & Loss Diagram (contd)

Selecting

protective put is like selecting the

deductible for your stock insurance

The more protection you want, the higher the

premium

18

Writing

protective puts

Appropriate when an investor owns the stock,

does not want to sell it, and expects a decline in

the stock price

19

The

occurs until the stock price falls below the

current price minus the premium received

The

option could be called

20

Differences

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

decline in the market or

Want to protect a long position in the stock

22

If

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

The

indicating the number of puts necessary:

Portfolio value

1

HR

Portfolio beta

Contract "value"

Delta

where contract value = index level 100

24

S&P 100 index Options (OEX)

The

many professional portfolio risk managers.

While

similar to traditional agricultural futures,

delivery does not occur, nor does it need to

occur for this to be an effective hedging

tool.

25

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

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

Suppose

$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

the portfolio, i.e. the manager is willing to

let the portfolio go down in value by

$50,000 but no further.

What

option should we choose?

29

Example #2 (Contd)

Suppose

the portfolio, i.e. the manager is willing to

let the portfolio go down in value by

$50,000 but no further.

What

option should we choose?

30

Example #2 (Contd)

Terminal

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

need to be purchased is:

N = (2)500,000/[(1,000)(100)]=10

Note

time because we hold the option until

maturity.

33

Example #2 (end)

Also

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

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

segment of the futures market

The

futures contracts are available grows every

year

36

A

or sell the standardized units of a specific index at

a fixed price by a predetermined future date

Stock

traditional agricultural contracts except for the

matter of delivery

All settlements are in cash

37

Hedging with

Stock Index Futures

With

portfolio manager can attenuate the impact

of a decline in the value of the portfolio

components

S&P

broad-based portfolios (ex: mutual funds).

38

Hedging with

Stock Index Futures (contd)

To

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

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

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

40

Computation

The

market falls

The market rises

The market is unchanged

41

Computation

A

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

I.e., the beta of the portfolio

42

Computation (contd)

The

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:

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

If

47

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

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

If

50

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

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

If

The basis will deteriorate to 0 at expiration (basis

convergence)

53

Hedging in Retrospect

Futures

Index futures are available in integer quantities only

betas say they should

Short

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

Assume

57

Dynamic Hedging

Example (contd)

You

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

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

as bullish as without the puts

You

position delta of 565:

(1,000 x 1.0) + (435 x 1.0) = 565

60

Suppose

The position delta has changed to:

(1,000 x 1.0) + (1,000 x 0.509) = 491

61

of the Hedge (contd)

To

replicate the put, it is necessary to sell short

74 shares (435 + 74 = 509 shares)

62

of the Hedge (contd)

Suppose

The position delta has changed to:

(1,000 x 1.0) + (1,000 x 0.371) = 629

63

of the Hedge (contd)

To

replicate the put, it is necessary to cover 64

of the 435 shares you initially sold short

64

Futures Contract

Appropriate

Stock

65

Futures Contract (contd)

Assume

that:

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

Futures Contract (contd)

We

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

Futures Contract (contd)

If

sell 40% x 300 = 120 contracts to achieve a

position delta of 0.600

68

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