alternative investment vehicles have been using by the investors to reduce the risk and maximize the profit. In this paper, we will discuss alternative investments opportunities and reducing the risk of portfolio by using the stock index future. Buying or selling the stocks is highly risky because of weak economic conditions. Investors should include various types of assets in the portfolio so that portfolio will not suffer the impact of a decline of any one security. For example; if an investor uses stocks and bonds in his/her portfolio, if stock price decline due to market fall then, the bonds would get higher return and it will eliminate the risk of decline. In the portfolio management it says that "not putting all eggs in one basket," it means investor should not invest in only one asset; they should construct the portfolio containing various types of assets. Thus, the portfolio must be diversified.
Alternative Investment Vehicles:
There are many alternative vehicles such as;-
Investing in bonds or debt
Investing in Stocks or equity
Investing in Mutual funds
Investing in options, future and forward contracts etc.
During the 1980's and 1990's the stock market enjoyed the greatest run-ups in History. The S & P. index annualized return was 16%. But stock prices don't only move upward as we have seen that the stocks declined 20% and more in just a few months in 1998's 3rd quarter. Currently investors are seeking various strategies to protect their portfolios from significant losses.
There are various strategies to protect the portfolio of stocks. Here I am explaining one strategy to protect the portfolio or to reduce the risk of portfolio.
Using Stock Index Future to Hedge Equity Portfolio:
We should consider the size and construction of portfolio and correlation of portfolio with the stock index future. For example; if S & P. 500 Index has a value nearest to $287,000, if an investor has a portfolio value less than $287,000 then, he/she would not be able to use the Index future contract effectively. Suppose investor has a portfolio value of $150,000 & he want to hedge the portfolio by using S&P 500 stock index fund that means, he is hedging a $150,000 portfolio with the future contract value of $287,000. He would be over hedged or this hedge would be out of balance.
Stock Index future only can hedge the equity portfolio that is highly correlated with Stock Index. It cannot hedge other securities such as debts or bonds. Future contract of the stock index may be good vehicle to hedge against the decline in market.
If your portfolio contains midcap stock then, hedging the S&P 500 future contract would not be adequate because midcap stock is not highly correlated with the S&P 500 index. It is better to hedge the midcap index future for the midcap stock.
Example: An investor owns a portfolio of stocks that is highly correlated with S&P 500 index. The current value of portfolio is $140,000. The market outlook is short-term bearish. An investor looking to decline at least 10 to 50% and current future Index of S&P is trading at 1415 pts.
How many S&P Index future should be sale = Value of portfolio/(Current Future Index x lot size)
= $140,000/(1415 x $50) = 2 (approximately).
Thus, an investor should sell 2 S&P 500 future contract in order to hedge against the portfolio of $140,000/-
Now, suppose the outcome is that'd&P 500 index future declined by 15% to 1195 pts.
Portfolio declined by 15.5%.
Profit loss from this strategy:
Value of portfolio declined = $140,000 x 15.5% = $21,700, thus loss from the portfolio declined is $21,700.
Value of S&P Index future declined by =
Gain from the sale of S&P 500 index future = 220 pts x 50 x 2 =$22,000/-
Overall profit or loss from this strategy = $22,000 - $21,700 = $300/-
In the above example, an investor's portfolio is fully protected against the decline in market. We have seen that the decline in portfolio was offset against the 2 future contracts of S&P500 index.
Hedging through Index Option Strategy:
An investor can use Index option to hedge the portfolio. If an investor's outlook for the market is bearish then, investor may choose buying an index put option or writing the call option of stock index that is highly correlated with the portfolio. An investor may choose both buying a put option and writing a call option of stock index.
For example; If the value of portfolio is $150,000, suppose that the portfolio is highly correlated with the S&P 500 Index which is trading at 1400 pts. The price of at the money put option is $5/- and the price of in the money call option is $10/- and the size of lot is 500/-
How many option contract required = $150,000/(500 x$15) =20 contacts
Outcome is that the S&P index declined by 140 pts. Then the profit or loss from this strategy is as follows:
Premium Received on Selling or Writing the Call option = $10 x 500 x 20 = $100,000
Premium paid on buying the put option = $5 x 500 x 20 = $50,000
Net premium Received = $100,000 - $50,000 = $50,000/-
The value of portfolio declined by 20% = $150,000 x 20% = $30,000
Value of portfolio before hedge = $150,000 - $30,000 = $120,000/-
Value of portfolio after hedge = $120,000 + $50,000(premium received) = $170,000/-
Suppose after the decline the value of put option is $10/- and the value of call option is zero.
Overall profit from the options:
Profit from the call option = $5 x 500 x 20 = $50,000
Profit from the put option = $10 (premium received) - $5 (premium paid) = $5/-
=$5 x 500 x 20 = $50,000/-
Total profit from the options = $50,000 + $50,000 = $100,000
Thus, now the value of portfolio = $120,000 + $100,000 =$220,000/-
Now, we can see that the going with the option strategy is more profitable than the future contract. But sometimes options are risky if there is no moment or low moment in the Index then; the options price would reduce to zero at the end of expiry.
Thus, trading with the option strategy is highly profitable and highly risky.
If we consider the following cases, we would get the answers as follows:
Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm he and his wife, Judy, founded several years ago have prospered. Because he is self-employed, Hector is building his own retirement fund. So far, he has accumulated a substantial sum in his investment account, mostly by following an aggressive investment posture. He does this because, as he puts it, "In this business, you never know when the bottom's gonna fall out." Hector has been following the stock of Rembrandt Paper Products (RPP), and after conducting extensive analysis, he feels the stock is about ready to move. Specifically, he believes that within the next 6 months, RPP could go to about $80 per share, from its current level of $57.50. The stock pays annual dividends of $2.40 per share. Hector figures he would receive two quarterly dividend payments over his 6-month investment horizon.
In studying RPP, Hector has learned that the company has 6-month call options (with $50 and $60 strike prices) listed on the CBOE. The CBOE calls are quoted at $8 for the options with $50 strike prices and at $5 for the $60 options.
a. How many alternative investment vehicles does Hector have if he wants to invest in RPP for no more than 6 months? What if he has a 2-year investment horizon?
There are three alternatives to invest in the RPP: one is that he can buy stocks for the period of less than 6 months, second alternative is that he can buy a 6 months call option with $50 strike price, 3rd alternative is that he can buy a call option with a strike price of $60/-
If he has a 2-year investment horizon then, he has only one alternative i.e. he can buy a stock and hold for the two years.
b. Using a 6-month holding period and assuming the stock does indeed rise to $80 over this time frame:
1. Find the value of both calls, given that at the end of the holding period neither contains any investment premium.
The call option with a $60 strike price that gives a right to buy 100 shares at $60 per share for a premium of $5 per share:
Price per share after 6 months = $80/-
Proceeds from option = ($80 - $60) x 100 shares = $2,000
Premium paid to purchase option ($5 x 100)
Net profit from the option
The call option with a strike price of $50 that gives right to buy 100 shares at $50 for a premium of $8 per share: