Lecture 18 Hedging the Risk of portfolio by Using index option contract

Suppose your portfolio has long positions in NYSE stocks valued at 50 million $ and NYSE index is now at 2500. What is risk to your portfolio? How can you hedge it using index option contracts? Risk is: That prices of shares in your portfolio would fall and you may have loss in market value of portfolio. Hedge: One month maturity put option on NYSE index at strike (exercise) price of 2400 is available. Note that underlying asset for index options is not is not stocks or gold, but index, therefore strike price is in terms of value of index. But to make it meaningful, the option exchanges use a dollar multiplier, in this case it is 100 dollars. Therefore one put option controls underlying value of: 100$ *strike price 100$*2400 = 240,000 to hedge 50 million $ value of your portfolio you need to buy how many put options? 240,000* X = 50,000,000 X=50,000,000/240,000 X=209 put option contracts Suppose you bought one month maturity 209 put options on NYSE- Index at option premium of 3 ( that is 3 points of index) at the strike price of 2400 (Index points): note it is out of money option because market price (2500) is higher than the strike price (2400), so exercising this put option now would mean selling some thing at 2400 which could have been sold at 2500 at its current market price. So no sane person would exercise this put option now, therefore it should be priced cheaply . Option Premium is the money you pay to buy an option contract. If option premium of this put option were 1, it would mean 1 index points *100$, and that would be 100$ Since Option Premium of this put option is 3, it means 3 index points *100$= 300$ Option premium for 209 put option contracts= 300$*209= 62,700$. And this is your investment in creating this hedge.

Suppose your fear of market decline within this month comes true; and after 25 days NYSE- index falls from 2500 to 2000. But you are hedged because you have bought( taken long position) in 209 put options on NYSE index. Dollar Value controlled by 1 put option contract is now: 2000 index points *100$= 200,000 If you can exercise it now you can make profit because now you can sell for 240,000 something which is at 200,000 at its current market price. So when market price is below strike price, put option is called inthe-money; and now due to fall in index from 2500 to 2000 this option is in the money, meaning, exercising this option would give profits to the option holder. Profits on one option contract = = = Exercise value Market value 240,000-200,000 40,000

On 209 options contracts your profit as hedger = 40,000$*209 = 8,360,000$ Now suppose during these 25 days your portfolio of shares initially valued at 50,000,000 has experienced a fall in prices as well , and is now worth 41,000,000. Your loss on portfolio is 50-41= 9 million dollars. But your gain on your long position in 209 put options has hedged some of that loss by giving you gain of 8.36 million. So most of your loss in your portfolio value has been neutralized ( hedged) by the profits on options Net loss to your portfolio is = 9 8.36=0.64 million or 640,000 dollars. You would notice that it was not a perfect hedge but did help you hedge most of the loss.

Index Arbitrage: S & P 500 index and futures contract on S & P 500 Index must have same value on the maturity date of the futures contract. You can make risk less profits by taking position in both the Index and Index futures contract: To take position in Index, you buy shares of an index mutual fund (long position in Index) or short sell them. Similarly you can take long or short position in futures contracts on S&P index. Example: Suppose by watching your screen you discovered ( and note it happens for brief periods) S&P index is greater in value than one month maturity futures contracts on S&P index

You know by maturity date index would fall or futures contract on index would go up, because both must have the same value that date. You can short sell the index (by shorting shares in S&P 500 index or by shorting mutual funds shares which mimics S&P 500 index), and you can take long position (buy) future contracts on index . By maturity date future contract would rise to give you profit or index would fall to give you profit; in any case you would have profits. Example: If today index is lower Index Futures contract You know both must be same on maturity date that means either index would go up or index future contract would fall You can take long position in index by buying shares of Index mutual fund or you can short index futures contract. On maturity date, again, you would have definite profits because by that time either mutual funds share would rise (index would increase) or future contract on index would fall and give you profit on your short position Computers are programmed to identify such mispricing and they automatically generate the relevant buy or sell orders in index and future on index. It is called programmed trading. This kind of investment strategy is called index arbitrage. It gives risk less profit to the investor who after taking the position holds it till the maturity date of the futures contract on index. Only momentarily such mispricing occurs, and only vigilant investor can take benefit of it; but due to computers now programmed to identify such mispricing, the frequency and length of mispricing periods are becoming more and more rare.