Index futures contracts are used to manage risk arising from stock market volatility.. 3.1 Measuring and Managing the Risk of Equities = × Index futures are used to manage the ris
Trang 1“ RISK MANAGEMENT APPLICATIONS OF
1 INTRODUCTION
Companies should take risk in those areas in which business has expertise &
avoid risks in areas not related to their primary lines of business
Risk management is about managing risk not necessarily only hedging risk
2 OPTIONAL SEGMENT
3 STRATEGIES AND APPLICATIONS FOR MANAGING EQUITY MARKET RISK
Stock markets are more volatile & liquid than bond markets
Index futures contracts are used to manage risk arising from stock market volatility
3.1 Measuring and Managing the Risk of Equities
= ×
Index futures are used to manage the risk of diversified equity portfolios
Broad market movements’ exposure is called systematic risk while risk associated with a specific company is known as non-systematic risk
β plays a critical role in stock risk management but it is subject to systematic risk only
$β of stock portfolio = × MV of the stock portfolio
Futures $ β = × future price
β of futures contract can be different from 1
Following relationship holds to achieve target level of β:
் = ௌ + where
் = Target β ௌ = Current portfolio β
S = Stock portfolio value
F = Actual futures price = quoted FP × multiplier
To () β, futures contracts must be bought (sold)
Index futures should be representative of portfolio investment style
FP = Futures Price
FC = Futures Contracts
3.2 Managing the Risk of an Equity Portfolio
Scaling β up or down with futures contract can magnify both, gain or loss
ௌ are difficult to measure
Diff b/w effective β & target β can be due to:
Rounding off of FC
Expected value of β may not be equal to observed actual value of β
Trang 23.3 Creating Equity out of Cash
Synthetic cash (long Rf bonds) = long stock + short futures
Synthetic stock (long stock) = long Rf bond + long futures
Advantages of synthetic equity position:
Lower transaction costs
Higher liquidity
3.3.1 Creating a Synthetic Index Fund
∗= × 1 + ் ×
∗= ∗× ×
1 + ்
∗×
1 + #்
$ℎ " ! − ∗ = ∗× × (்−)
Steps to create synthetic index fund:
Calculate no of futures contracts to represent the ending cash value:
where
V = Portfolio value
q = Multiplier
f = Futures price
Round the no of FC to the nearest whole number & estimate the amount of cash needs to be equatized
The amount of treasuries equatized will grow at Rf
The amount of stocks that will be purchased at the start of contract:
where
# = dividend yield
At the end of investment horizon:
where
் = Index value at time T
Issues:
Index used to create synthetic equity position is price only so ignores dividend portion
Futures expiration date may be different than horizon date
3.3.2 Equitizing Cash
Cash is converted into equity position using FC while maintaining the liquidity provided by cash
Issue ⇒ investors have no control over the pricing of futures
3.4 Creating Cash out of Equity
Synthetic cash (long Rf bond) = long stock + short futures
Steps:
Calculate the no of FC needed to short (Nf)
Determine the actual amount synthetic cash created (V)
Settle the short position by selling the equity position (management will be left with synthetic cash)
Trang 3Advantages & Limitation of Using Derivatives
Liquidity & transaction costs
Provide better timing & allocation strategies
Derivatives have less disruption &
provides a quicker way to execute transactions
Derivatives require less capital to trade &
provide ease to alter risk exposure
Liquidity problem exist in longer maturity derivatives
4 ASSET ALLOCATION WITH FUTURES
Asset allocation can effectively altered through FC
Portfolio performance significantly depends on asset classes allocation
Duration of portfolio through FC does not liquidity of position
Reasons of imperfect hedge:
Exact hedging is not possible
Rounded of FC
β & duration is difficult to measures (expected value may not be equal to the observed actual values)
Basis risk
FC are based on price only indexes
4.2 Pre-Investing in an Asset Class
Pre-investing ⇒ strategy in which futures contracts convert a yet-to-received cash into desired synthetic equity or bond exposure
Useful when attractive investment opportunities are available & investors might not have cash at that time
Investor will take long position in futures & close out the position in futures when cash is received & invest that cash in the underlying
Risk ⇒ leveraged futures position can magnify losses in case of adverse market movements
5 STRATEGIES AND APPLICATIONS FOR MANAGING FOREIGN CURRENCY RISK
Companies dealing in foreign currency are exposed to:
Exchange rate risk
Future business related risks
Types of Foreign Exchange Rate Risk
Translation Exposure Economic Exposure Transaction Exposure
Foreign currency receipts become less valuable
in terms of domestic currency if foreign currency
depreciates
In case of purchases, currency loss incurred
when foreign currency appreciates
Risk faced by multinational companies if foreign currency depreciates (assets will have domestic value)
Risk faced by importer or exporter
When foreign currency appreciates (depreciates) exporter (importer) is at currency risk
Trang 45.1 Managing the Risk of a Foreign Currency Receipt
If foreign currency receipts ⇒ sell forward contract to hedge currency risk
If foreign currency payments ⇒ buy forward contract to hedge currency risk
Equity risk of foreign investment can be hedged by selling futures contracts on foreign market index
Foreign exchange risk can be hedged through forward contracts on the foreign currency
5.3 Managing the Risk of a Foreign-Market Asset Portfolio
Investors can:
Hedge foreign equity market return & leave the currency risk unhedged
Hedge (remain unhedged) both equity market return & currency risk
It is not possible to remain unhedged in local equity market & hedge currency risk
Hedging market risk ⇒ generates foreign Rf rate
Hedging both risks (market & exchange rate) ⇒ generates domestic Rf rate
These strategies are useful only in short-run
6 FUTURES OR FORWARDS?
Preferred instruments in different situations:
Specific dates risks ⇒ forward contracts
When transaction costs are a concern & not a perfect hedge is required ⇒ futures contracts
Flexibility with respect to horizon date ⇒ futures contacts
Usually equity risk is managed through equity index futures
Usually forward contracts are used to hedge exchange rate risk
Future & Forwards v/s Options
Many organizations are not permitted to use fully leveraged position (e.g forwards or futures) so they use options
Option loss is limited to option premium (non linear payoffs)