Q1. Suppose you are managing a stock portfolio that is currently valued at $2,00
ID: 2654649 • Letter: Q
Question
Q1. Suppose you are managing a stock portfolio that is currently valued at $2,000,000. You expect the stock market will be bullish in the next 3 months. But you are also aware of a small chance of market crash and you want to insure that your portfolio value will be at least $1,700,000 in 3 months even in a market crash. In other words, you don’t want to suffer more than 15% loss in the next 3 months. Assume your stock portfolio has a beta of 1.4, the current S&P 500 level is 2,000 and the risk-free rate is 3% per annum.
How would you hedge against your portfolio value dropping below $1.7M in 3 months? Be specific with your strategy. If you are using options, specify what the underlying asset is, the strike price, time to expiration. whether it’s a call or a put and how many units to buy or short.
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Explanation / Answer
Ans:
Hedging is a tool used to avoid the risk of declining value of the portfolio as the value of the portfolio keeps changing due to change in the share values of the stocks. When it is predicted that, the value of the underlying stock is going down, then it is very important that, the portfolio has been hedged, so that, there is no impact on the portfolio in case the market crashes. In order to hedge the portfolio, there are different methods used like going for futures, forwards, Options etc. In the present trend viewing the market dynamics, it is better that, we should go for Options.
The present value of the portfolio is $2,000,000 and it is anticipated that the portfolio may have a depleted value to $1,700,000 in next three months as there is an anticipation that the market value will come down. As the Beta of the portfolio is 1.40 , which is more than 1 meaning that, the portfolio is very aggressive and it’s movement is along with the movement of market index S&P 500. When the Beta value is more than 1, it means that, when the goes up, the value of the portfolio will go up and when the market goes down, the value of the portfolio will go down. So the portfolio manager needs to be extremely careful while thinking up a strategy to invest in the stock market.
The strategy to be used here in order to protect the portfolio will be Option strategy. Options are basically two types namely Call Option and Put Option. Call Options are the ones, where there is a promise to buy, whereas Put option are the ones, where we got to sell the share at a particular price. Here in view of the volatility, we got to use put option assuming that, we shall be selling at a particular price in next three months. If the share prices are going up and in turn the value of the portfolio, we are not concerned, we shall be more worried, when the price of the each share will come down below the present stock price by leading to erosion in the existing value of the portfolio. While booking for option, we go to pay certain amount of premium.
Let us assume that, there is a stock A which has each stock value of $50 and hence while going for options contract with three months time to expiration, it will worth of $50*100 = $5,000. In order to get the put option, we got to give $3 as premium per each stock. Now if due to the volatility, share price goes up, then there is no concern at all, but due to the market volatility, each share has a current price of $43. Assuming that strike for the stock is $45 and when exercising the option, the portfolio manager will gain $50 - $43 - $3 = $4 per stock and like that it goes.
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