Alternative investment options and hedging with stock-index futures

¶ … 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:

Case -1

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.

Questions

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)

= $500

Net profit from the option

= $1,500/-

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:

Price per share after 6 months = $80/-

Proceeds from option = ($80 - $50) x 100 shares = $3,000

Premium paid to purchase option ($8 x 100)

=$800

Net profit from the option

=$2,200/-

2. Determine the holding period return for each of the 3 investment alternatives open to Hector Francisco.

Return from buying shares:

Purchase price per share

= $57.5/-

Expected dividend per share

=$1.2 per share

% Return

($80 - $57.50 + $1.2)/$57.50 = 41.2%

Return from the call option of $50 strike = $2,200/$800 = 275%

Return from the call option of $60 strike = $1,500/$500 = 300%

c. Which course of action would you recommend if Hector simply wants to maximize profit? Would your answer change if other factors (e.g., comparative risk exposure) were considered along with return? Explain.

I would recommend buying $60 strike call option to maximize the profit because it gives the highest return than other two alternatives.

If we consider other factors such as comparative risk exposure, percentage of portfolio being put at risk, I would make an argument for choosing a different investment vehicle. Such as if he is considering investing in a large percentage of his portfolio then, I would recommend buying the stock because if stock price fall or doesn't move the value of stock option would fall to zero so, he would lost all amount of his investment.

Case -2

Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a 2-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis' portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading.

Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that's the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditions -- though some will drop more in price than others.

Jim has been following stock-index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock-index futures -- in particular, the S&P MidCap 400 futures contract -- as a way to protect (hedge) their portfolio of common stocks.

Questions

a. Explain why the Pernellis would want to use stock-index futures to hedge their stock portfolio, and how they would go about setting up such a hedge. Be specific.

Pernellis thinks that the market will fall in the future and his portfolio would fall accordingly. Thus, he wants to eliminate the portfolio risks by using the stock index future contract.

Pernellis may set this strategy by short selling of the stock index future contract. For short selling Pernellis would required the number of future contract for short selling equal to his value of portfolio divide by current price of future contract x the lot size.

1. What alternatives do Jim and Polly have to protect the capital value of their portfolio?

They have other alternatives rather than stock index future contract such as:

They can buy a stock put option and they can write call option of the stock, they can buy index put and write the call option of stock index.

2. What are the benefits and risks of using stock-index futures as hedging vehicles?

The benefit is that they can reduce or eliminate the risk of portfolio and the risks is that they may requires more amount after buying or selling the stock Index future contract due to shortfall.

b. Assume that'd&P MidCap 400 futures contracts are currently being quoted at 769.40. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?

No. Of contracts required to hedge the portfolio = $375,000/(769.40 x 100) = 4.87

Or 5 contracts are required to buy or sell to set up the hedge.

1. Say the value of the Pernelli portfolio dropped 12% over the course of the market retreat. To what price must the stock-index futures contract move in order to cover that loss?

The portfolio value dropped = 12% of $375,000 = $45,000

No. Of stock Index future contract should be shorted = 5

The stock index future must move to 90 pts [45,000 / (5 x 100)] in order to cover that loss.

3. Given that a $16,875 margin deposit is required to buy or sell a single S&P 400 futures contract, what would be the Pernellis' return on invested capital if the price of the futures contract changed by the amount computed in part b1, above?

Margin deposit required = $16,875/-

Future contract changed by = 90

Gain from future contract = $90 x 100 = $9,000

Return of capital invested in future contract = $9,000/$16,875 x 100 = 53.33%

c. Assume that the value of the Pernelli portfolio declined by $52,000, while the price of an S&P 400 futures contract moved from 769.40 to 691.40. (Assume that Jim and Polly short sold one futures contract to set up the hedge.)

Value of portfolio declined by = $52,000

Future contract moved by = $78 [769.40 -- 691.40]

Gain from short selling of future contract = 78 x 100 = $7,800/-

1. Add the profit from the hedge transaction to the new (depreciated) value of the stock portfolio. How does this amount compare to the $375,000 portfolio that existed just before the market started its retreat?

Depreciated value of portfolio = $375,000 - $52,000 = $323,000/-

Profit from the short selling of future contract = $7,800

Value of hedged portfolio = $323,000 + $7,800 = $330,800/-

Loss from portfolio or declined value of portfolio = $375,000 - $330,800 =$44,200/-

2. Why did the stock-index futures hedge fail to give complete protection to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.

The stock index hedge future fails to give complete protection to the Pernelli portfolio because Pernelli didn't use right hedge ratio. There are 5 number of stock index future required to hedge the portfolio:

No. Of stock index future contract required = Value of portfolio (375,000) / (100*500) = 5 contract (approximately)

But Pernelli used only one stock index future.

It may not possible to obtain perfect (dollar to dollar) protection from these types of hedges. Pernilli could get maximum protection by using the right hedging ratio that is by short selling of 5 stock index future contracts then:

Gain from the short selling of stock index future = $70 x 100 x 5 = $35,000/-

Declined value of portfolio = $52,000, she could get protection of $35,000 against her portfolio loss.

d. What if, instead of hedging with futures contracts, the Pernellis decide to set up the hedge by using futures options? Fortunately, such options are available on the S&P MidCap 400 Index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying S&P 400 Index. Now, suppose a put on the S&P MidCap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and a comparable call is quoted at 2.35. Use the same portfolio and futures price conditions as set out in part c to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. (Hint: Add the net profit from the hedge to the new depreciated value of the stock portfolio.) What are the advantages and disadvantages of using futures options, rather than the stock-index futures contract itself, to hedge a stock portfolio?