Overview: describe your hypotheses and trades in detail?; Futures and exchange-t
ID: 2616525 • Letter: O
Question
Overview:
describe your hypotheses and trades in detail?;
Futures and exchange-traded options are widely available for the following asset classes:
Equities
Energy
For each of these asset classes, please develop a well-reasoned hypothesis regarding the relative performance of two assets within the asset class. A relative performance trade (otherwise known as a pairs trade) does not require you to identify whether a given security will increase or decrease or value. Instead, it requires the following:
1. Identify two assets within the asset class.
2. Identify which of the two assets you believe will outperform the other asset.
3. Long the asset that you believe will outperform and short the asset that you believe will underperform.
Relative performance trade example
Here is an example of a relative performance trade.
Imagine you are forming a relative performance hypothesis related to the following two stocks in the apparel stores industry:
Gap, Inc.
TJX Companies
You do not know whether the overall stock market will increase in value or decrease in value in the future. But you do believe that whether markets increase or decrease in value, GAP, Inc. will outperform TJX Companies. Therefore, you should long Gap, Inc. and short TJX Companies. If you do so:
- If markets increase in value, your long position in Gap, Inc. will increase in value more than your short position in TJX Companies will decrease in value.
- If markets decrease in value, your long position in Gap, Inc. will lose less money than your short position in TJX Companies will earn in value.
For each hypothesis, please develop an exchange-traded derivatives trade that can monetize the view. Hence, derivatives that do not trade on exchanges, such as forwards, credit default swaps, or interest rate swaps, should not be used. Only use derivatives – do not use any cash products such as stocks or bonds.
Please assume that you have up to $1,000,000 to allocate to each strategy
Please assume that you will acquire the position sometime during this week June 9, 2018, and will hold it until July 2018
Explanation / Answer
We are developing a relative performance hypothesis related to the following two stocks in the Energy industry:
1. Exxon Mobil Corp. (XOM)
2. US based Williams' companies
Irrespective of how the overall stock market will perform in future but that whether markets increase or decrease in value, Exxon Mobil Corp. will outperform Williams' Companies referring to the historical data of performance. Therefore, it is advisable to take a long position on Exxon Mobil and take a short position on Williams' Companies.
The results could be:
- If markets increase in value, long position in Exon Mobil will increase in value more than short position in Williams' Companies which will decrease in value.
- If markets decrease in value, long position in Exon Mobil will lose less money than your short position in Williams' Companies will earn profit.
Assuming an investment of $1,000,000 in each long and short position strategy, we will enter derivatives market as below:
When market increases Short - William's co Sell call = expecting the price to decrease Total investment 10,00,000 Call price 20 No of put units 1000000/ 20 = 50,000 Premium paid = 20% of total investment = 1000000*20% = 2,00,000 Date 30 July 2018 Strike Price 20 Date 30 July 2018 Spot price 25 Loss 20-25 = 5 In case of loss option is not excercised and loss is equal to the premium paid Total loss 2,00,000 Long - EXON Mobil Buy call = expecting the price to increase Total investment 10,00,000 Call price 85 No of call units 1000000/ 85 = 11,765 Premium paid = 20% of total investment = 1000000*20% = 2,00,000 Date 30 July 2018 Strike Price 85 Date 30 July 2018 Spot price 100 Profit 100-85 = 15 Total loss = No of put units *Profit 1,76,471Related Questions
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