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Hedging and Speculative Strategies using Index Futures

Learn about short hedges and hedging with stock index futures to offset market losses and generate gains. Explore different hedging approaches and their impact on portfolio value.

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Hedging and Speculative Strategies using Index Futures

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  1. Hedging and speculative strategies using index futures Finance 30233 S. Mann, Fall 2001 Short hedge: Sell Index futures - offset market losses on portfolio by generating gains on futures Market Market Short Hedge (Sell Index Futures) Spot Position (Portfolio)

  2. Example: Portfolio manager has well-diversified $40 million stock portfolio, with a beta of 1.20 Hedging with Stock Index futures 1 % movement in S&P 500 Index expected to induce 1.20% change in value of portfolio. Scenario: Manager anticipates "bear" market (fall in value), and wishes to hedge against possibility. One Solution: Liquidate some or all of portfolio. (Sell securities andplace in short-term debt instruments until "prospects brighten") • Broker Fees • Market Transaction costs (Bid/Ask Spread) • Lose Tax Timing Options (Forced to realize gains and/or losses) • Market Impact Costs • If portfolio large, liquidation will impact prices

  3. Assume you hedge using the June 02 S&P 500 contract, currently priced at 920. The contract multiplier is $250 per point. Naive Short hedge: dollar for dollar Dollar for dollar hedge: find number of contracts: V $40,000,000 P = = 174 contracts V (920) ($250) F where: V = value of portfolio P V = value of one futures contract F

  4. hedge initiated November 15, 2001, with Index at 900. If S&P drops 5% by 2/2/02 to 855, predicted portfolio change is 1.20 (-5%) = -6.0%, a loss of $2.4 million But: portfolio has higher volatility than S&P 500 Index ( portfolio beta=1.20) Date Index Spot position (equity) futures position 11/15/01 900 $40,000,000 short 174 contracts 2/2/02 855 $37,600,000 futures drop 45 points -45 -$2,400,000 gain = (174)(45)(250) = $1,957,500 Net loss = $ 442,500 Assumes: 1) portfolio moves exactly as predicted by beta 2) futures moves exactly with spot

  5. Estimate Following regression: Estimating Minimum Variance Hedge ratio spot returnt = a + bSFFutures ‘return’t + et Portfolio Return x x xx x x x x x intercept = a{ x xxx x x Futures ‘return’ (% change) x x x xx x x x x xx x line of best fit (slope = bSF )

  6. Hedge using June 02 S&P 500 contract, currently priced at 920 [ 920 900 ( 1 + r - d)t ] Calculating number of contracts for minimum variance hedging Minimum variance hedge number of contracts: VP $40,000,000 = 208 contracts bPF = (1.20) VF (920) ($250) where: VP = value of portfolio V = value of one futures contract F bPF = beta of portfolio against futures

  7. hedge initiated November 15, 2001, with Index at 900. If S&P drops 5% by 2/2/02 to 855, predicted portfolio change is 1.20 (-5%) = -6.0%, a loss of $2.4 million Minimum variance hedging results Date Index Spot position (equity) futures position 11/15/01 900 $40,000,000 short 208 contracts 2/2/02 855 $37,600,000 futures drop 45 points -45 -$2,400,000 gain = (208)(45)(250) = $2,340,000 Net loss = $ 60,000 Assumes: 1) portfolio moves exactly as predicted by beta 2) futures moves exactly with spot ( note: futures actually moves more than spot : F = S (1+c) )

  8. DefinebPFas portfolio beta (against futures) Altering the beta of a portfolio Change market exposure of portfiolio tobnew by buying (selling): VP (bnew - bPF ) contracts VF VF = value of one futures contract VP = value of portfolio where:

  9. Return on Portfolio Original Expected exposure Impact of synthetic beta adjustment Expected exposure from reducing beta Return on Market Expected exposure from increasing beta

  10. Begin with $40,000,000 portfolio:bPF = 1.20 Prefer a portfolio with 50% of market risk (bNew=.50) Hedge using June 02 S&P 500 contract, currently priced at 920. Changing Market Exposure: Example V $40,000,000 P (bNew- bPF) = (.50 - 1.20) V (920) ($250) F = - 122 contracts

  11. hedge initiated November 15, 2001, with Index at 900. If S&P drops 5% by 2/2/02 to 855, predicted portfolio change is 1.20 (-5%) = -6.0%, a loss of $2.4 million. predicted loss for bP =0.5 is (-2.5% of $40 m) = $1 million Reducing market exposure: results Date Index Spot position (equity) futures position 11/15/01 900 $40,000,000 short 122 contracts 2/2/02 855 $37,600,000 futures drop 45 points -45 -$2,400,000 gain = (122)(45)(250) = $1,372,500 Net loss = $ 1,027,500 Assumes: 1) portfolio moves exactly as predicted by beta 2) futures moves exactly with spot ( note: futures actually moves more than spot : F = S (1+c)

  12. Portfolio manager expects sector to outperform rest of market ( a> 0) Sector "alpha capture" strategies Portfolio Return x x xx x x x x x intercept = a{ x xxx x x Futures ‘return’ (% change) x x x xx x x x x xx x line of best fit (slope = b )

  13. Expected exposure with "hot" market sector portfolio Return on Sector Portfolio "Alpha Capture" } a > 0 0 Return on Market Slope = bSF = beta of sector portfolio against futures

  14. Expected exposure with "hot" market sector Return on Asset "Alpha Capture" Expected return on short hedge } expected gain on alpha 0 Return on Market

  15. Assume $10 m sector fund portfolio withb = 1.30 You expect Auto sector to outperform market by 2% Eliminate market risk with minimum variance short hedge. (using the June 02 S&P 500 contract, currently priced at 920) Alpha Capture example The desired beta is zero, and the number of contracts to buy (sell) is: V $10,000,000 P (bNEW- bSF) = (0 - 1.30) V (920) ($250) F = - 56 contracts

  16. hedge initiated November 15, 2001, with Index at 900. If S&P drops 5% by 2/2/02 to 855, predicted portfolio change is 1.30(-5%) + 2% = -4.5%, a loss of $450,000. Alpha capture: market down 5% Date Index Spot position (equity) futures position 11/15/01 900 $10,000,000 short 56 contracts 2/2/02 855 $9,550,000 futures drop 45 points -45 - $450,000 gain = (56)(45)(250) = $630,000 Net GAIN = $ 180,000 Assumes: 1) portfolio moves exactly as predicted by beta 2) futures moves exactly with spot ( note: futures actually moves more than spot : F = S (1+c))

  17. hedge initiated November 15, 2001, with Index at 900. If S&P rises 5% by 2/2/02 to 945, predicted portfolio change is 1.30( 5%) + 2% = 8.5%, a gain of $850,000. Alpha capture: market up 5% Date Index Spot position (equity) futures position 11/15/01 900 $10,000,000 short 56 contracts 2/2/02 945 $10,850,000 futures rise 45 points 45 $850,000 loss = (56)(45)(250) = $630,000 Net GAIN = $ 220,000 Assumes: 1) portfolio moves exactly as predicted by beta 2) futures moves exactly with spot ( note: futures actually moves more than spot : F = S (1+c))

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