STOCK PORTFOLIO HEDGING WITH DERIVATIVES

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STOCK PORTFOLIO HEDGINGWITH DERIVATIVES

• Madalina Cojocaru Petrila
• Darius Cipariu
• Mentor Professor Thomas Krueger
• July 15th , 2005

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United States stock market

• New York Stock Exchange (NYSE) - founded in 1792
  and was named New York Stock Exchange Board
  until 1863
• National Association of Securities Dealers
  Automated Quotation System (NASDAQ) an
  electronic stock exchange founded by the
  National Association of Securities Dealers (NASD)

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United States Exchange Indexes

• The Dow Jones Industrial Average - is the oldest
  and most watched index
• The NASDAQ Stock Market composite (IXIC) - is
  composed of all the stocks on the NASDAQ exchange
  more than 5,000 firms
• The Standard Poors 500 Index (SP500) is a
  market weighted index - tracks 500 of the most
  representative companies based in the US selected
  upon size, liquidity and sector

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Romanian stock market

• Bucharest Stock Exchange was re-opened in 1995
  and launched the first official index in
  September 1997 BET Bucharest Exchange Trading
  index
• Rasdaq Electronic Exchange was designed for
  filling the trading needs as a result of
  mass-privatization program and launched the first
  official index in July 1998 RAQ-C Rasdaq
  Composite index

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Stock Portfolio

• Steps in order to build a portfolio
• Setting the objective
• Setting the time horizon
• Choosing the stocks

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Stock Portfolio

• Strategies for choosing the stocks
• Buy and hold
• Market timing
• Growth
• Value
• GARP
• Income

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Stock Selection

• Fundamental analysis
• Earnings per share
• Dividend Payout Ratio
• Return on Equity
• Technical analysis
• Chart patterns analysis

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Stock portfolio protection with derivatives

• Risk of stock portfolio price DECLINE in
  the stock market
• Hedging Taking a position in a futures or
  option market opposite to a position held in the
  cash market to minimize the risk of financial
  loss from an adverse price change.
• Position cash market LONG
• Position in futures market SHORT
• ¹ www.liffeweather.com/glossary.aspx

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Stock portfolio protection with derivatives

• By using derivatives instruments a portfolio
  manager can preserve or improve the value of a
  stock portfolio.
• Hedging Taking a position in a futures or
  option market opposite to a position held in the
  cash market to minimize the risk of financial
  loss from an adverse price change.
• Risk DOWNTREND in stock market
• Cash market position LONG on stocks
• Futures market position SHORT on stocks or index
• Option market position LONG PUT OPTIONS on
  stock or index
• ¹ www.liffeweather.com/glossary.aspx

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Stock portfolio protection with derivatives

• Derivatives instruments used to protect a stock
  portfolio
• Single stock futures - One Chicago, SMFCE
• Equity Index futures - CME, CBOT
• Single stock options - CBOE
• Equity options - CBOE
• Options on futures - CME, CBOT, SMFCE

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Stock portfolio hedging with single stock futures
Single stock futures contract an agreement to
deliver a certain amount of shares of a
specific stock at the expiration date. In the
USA, over 200 stocks are traded at One
Chicago. In Romania 19 stocks are traded at
SMFCE. Position cash market LONG Position in
futures market SHORT
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Stock portfolio hedging with single stock futures

• Example Best Buy Co (BBY)

NYSE LONG 1,000 BBY shares at 55
One Chicago SHORT 10 BBY contracts at
68 (1 futures 100 shares) Value of BBY
shares ensured 1,000 x 68 68,000
gain
LONG BBY (NYSE)
55
68
BBY cash price
SHORT BBY (One Chi)
loss
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Stock portfolio hedging with single stock futures
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Stock portfolio hedging withequity index futures

• The stock index futures contract has the
  same specifications as the single stock futures
  contract, the only difference arising from the
  underlying assets which is not a specific number
  of stocks, but a specific number of index units.
• At the expiration date, all settlements are
  in cash because of the nature of the indexes
  (they are just abstract numbers and not physical
  items like agricultural commodities for example).
  

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Stock portfolio hedging withequity index futures

• The principle of using stock index futures
  for hedging purpose is the same like in the
  single stock futures situation a long position
  in the stock market will be offset by a short
  position taken in the stock index futures market.
• Most traded indexes on the US futures markets
• SP 500, DJIA, NASDAQ

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Stock portfolio hedging withequity index futures

• The number of futures contracts that must be
  sold in order to hedge a stock portfolio is
  called hedge ratio and is computed by using the
  following formula
• Dollar value of portfolio
• HR beta of portfolio
• Dollar value of SP 500
• index futures contract

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Stock portfolio hedging withequity index futures

• Number of SPX Sep 05 futures contracts needed
  to be sold in order to protect the 10,000,000
  portfolio
• 10,000,000
• HR 1.1 36.72 (37 rounded).
• 250 x 1,198

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Stock portfolio hedging withequity index futures
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Stock portfolio hedging withoptions

• Options give the buyer the right, but not the
  obligation to buy or sell the underlying asset at
  the strike price until the expiration date of the
  contract. The buyer must pay a premium to the
  seller of the option.
• In this situation, the underlying asset
  means a stock, an equity index or a futures
  contract.
• The best hedging strategy with options means to
  buy PUT options on single stock or equity index.

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Stock portfolio hedging withPUT options

• Number of Puts needed to be sold in order to
  protect the
• stocks purchased on the cash market is given
  by the formula of hedge ratio
• Dollar value of portfolio
  1
• HR
• Contract value Delta
• Delta is a specific element of options and
  shows how an option price changes for a given
  change in the underlying asset.

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Thank you