Chris Sierra VY Take Home exam 143008827 Number 1 A Johnson Minimum Variance Hedge ratio: Johnson derives this particular hedge ratio by minimizing portfolio risk. An issue with this ratio can be that itis not consistent with the mean variance framework because it ignores the expected return on the portfolio being hedged. This creates a problem now and in order to make the ratio consistent, those using it need to be completely risk averse for longas they invest. If they are not, the expected return on the futures contract mt be zero. This ratio however, is the most widely used static hedge ratio. Sharp Hedge Ratio: When looking at hedging strategies, Sharpe’s measure, which is the risk-return tradeoff criteria, can be used to incorporate the portfolio return. Chen et al. can be held accountable for a few assumptions on this ratio. Chen noted that this ratio is a highly non-linear function of the hedge ratio. Considering equating the first derivative to zero derives this equation, the equation may give hedge ratio that would actually minimize the Sharpe Ratio. This assumption would most definitely be true if the second derivative of the Sharpe ratio was positive rather than negative. Chen et al. also discovered that the optimal hedge ratio might be undefined when the Sharpe ratio increases with the hedge ratio. He discovered this in a case in 2007. Optimal Minimum - Variance Hedge Ratio From what we've studied, we can conclude that the hedge ratio based on this utili function would be basically consistent with the mean variance framework since j includes both risk and return. The optimum hedge ratio can be relatively difficulE to derive here, because we need to know the persons risk aversion parameter ‘people will choose different optimal hedge ratios based on their level of risk B. ‘The Johnson Minimum Variance Hedge Ratio Can be defined as: ope + Given the Information we see = (.015/.02)".6=.45 When looking at the Optimum Minimum Variance Hedge Ratio, we see:= [(.025/250".0242) - 6(.015/.02)] =.2 From Sharpe’s Hedge Ratio, we see: [(.015/.02)((.015/.02).025/(.015-.02)-.6)} / ((1 -75(4.35)/(3.25) ~ (015/.02)(,025)(.6)/(.015-. 004 C. From our tests, we can see that if E(RA) comes to to be zero then Sharpe's hedge ratio will equal .45. We can also wee that when A approaches infinity the optimal minimum variance hedge ratio will also be .45, We can see that the Optimal MV hedge ratio and Sharpe’s hedge ratio are generalized cases of the Johnson MV hedge, ratio. When looking at the Johnson Minimum Variance Hedge Strategy se can see that the ratio is simply a measure of the relative dollar amount to be invested in futures per dollar of spot holding. We get the value .45, which is smaller than 1, And that is important to keep in mind. As for the optimal mean variance hedge see the value of 2, which is greater than 0. This shows that lambda is greater which indicates a long futures position. For Sharpe's hedge ratio holding a value of 1,004 which is greater than 1, we can conclude that there is a positive benefit of hedging with that future. Misses, Number 2 3 Gr A. Long Straddle Long a Call at strike price E $75.00 Premium $05 Long a Pat at strike price E $75.00 Premium $12 Upper Breakeven Point $76.79 Net Premium paid sar Strike price of long call + Net Premium paid Lower Breakeven Point $73.21 Strike price of long put - Net Premium Paid Stock(P) Long Call at strike price E ‘Long Put at strike price E Long Straddle Price Payoff Profit Payoff Profit Payoff Profit $50.00 $0.00 $0.52 $25.00 $23.73 $25.00 $23.2 $55.00 $0.00 $0.52 $20.00 $18.73 $20.00 $18.2 $60.00 $0.00 -$0.52 $15.00 $13.73 $15.00 $132 $65.00 $0.00 -$0.52 $10.00 $8.73 $10.00 $82 $70.00 $0.00 $0.52 $5.00 $3.73 $5.00 $3.2 $75.00 $0.00 -$0.52 $0.00 $1.27 $0.00 $1.7 $80.00 $5.00 $4.48 $0.00 $1.27 $5.00 $3.2 $85.00 $10.00 $9.48 $0.00 $127 $10.00 $8.2 $90.00 $15.00 $14.48 $0.00 $1.27 $15.00 $132 $95.00 $20.00 $19.48 $0.00 $1.27 $20.00 $18.2 $100.00 $25.00 $24.48 $0.00 $1.27 $25.00 $23.2Lower BE points : Strike Price of Short Put-Net Premium Received J5-1.73=73.27 ¢. Long Vertical (Bull) Spread ‘This Strategy will combine a long call (put) with a low strike price and a short call (put) with a high strike price. Short a Call at strike price E1 $77.20 Premium $2.85 Long a Call at strike price E2 $73.25 Premium $0.08 EI>E2 Net Premium Paid $2.77 Breakeven Point $70.48 Strick price of long call + Net Premium Paid Stock (P) Write Call atstrike price Long Call at strike price F2 Bull Spread (Call) Value Price Payoff Profit Payoff Profit Payoff Profit $52.20 $0.00 $2.85 $0.00 $0.08 $0.00 S277 $57.20 $0.00 $2.85 $0.00 $0.08 $0.00 92.77 362.20 $0.00 52.85 $0.00 $0.08 $0.00 $2.77 367.20 $0.00 $2.85 $0.00 $0.08 $0.00 $2.77 $72.20 $0.00 $2.85 $0.00 $0.08 30.00 $2.77 $77.20 $0.00 $2.85 $3.95 $3.87 $3.95 $6.72 $82.20 $5.00 $2.15 $8.95 $8.87 $3.95 36.72 $87.20 -$10.00 S715 $13.95 $13.87 $3.95 36.72 $92.20 $15.00 -$12.15 $18.95 $18.87 $3.95 $6.72 $9720 $20.00 -$17.15 $23.95 $23.87 $3.95 $6.72 $102.20 $25.00 -$22.15 $28.95 $28.87 $3.95 $6.72 BE Point = Strike Price of Long Call + Net Premium Paid B2SH(-2.77)=10.48 Short Vertical (Bear) Spread This Strategy combines the long call (put) with a high strike price and a short call (put) with a low strike price.In The Long Straddle strategy, the stock price is used to determine the payoff and profit figures for a long call and put option when they are at the same strike price. We see that the long call will not yield any profit ifthe price is equal or below the strike price. On the other hand, we can see that the long put will only yield a profit if the stock price falls below the strike price, We notice our Upper BE oint = Strike price of Long Call + Net Premium Paid 75+1.70=$76.79 Our Lower BE point = Strike price of Long Put- Net Premium Paid 75-4.79= $73.21 B, Short Straddle Here, a short call and short put with identical exercise price is purchased when little or no movement on stock prices is expected. Short a Call at strike price E $75.00 Premium $0.50 Short a Put at strike price F $75.00 Premium $1.23 : Net Premium Upper Breakeven Point $16.73 ere $1.73 Strike price of short call + Net Premium Received Lower Breakeven Point $73.27 Strike price of short put - Net Premium Received Stock (P) Short Callat strike price short Put at strike price E Short Straddle Price Payoff Profit Payoff Profit Payoff Profit 350 30.00 $0.50 “$25.00 SBT “$25.00 “$23.27 $55 $0.00 $0.50 -$20.00 $18.77 $20.00 $18.27 360 $0.00 $0.50 $15.00 $13.7 -$15.00 $13.27 $65 $0.00 $0.50 $10.00 $8.77 -$10.00 $8.27 370 30.00 $0.50 $5.00 “$3.77 $5.00 $3.27 315 30.00 $0.50 30.00 $1.23 $0.00 31.73 380 $5.00 $4.50 $0.00 $1.23 $5.00 $3.27 sss $1000 -$9.50 $0.00 $1.23 ~ -$10.00 “$8.27 39 $15.00 -$14.50 $0.00 $1.23 $15.00 $13.27 $95 $20.00 -$19.50 $0.00 31.23 $20.00 $18.27 $100 -$25.00___—-$24.50 $0.00 $1.23 $25.00 $23.21 Our upper BE points : Strike price of Short Call + Net Premium Received 1.73475 = 76.73Short a Call at strike price E1 $72.50 Premium $0.5 Long a Call at strike price E2 $75.00 Premium $13 Net Premium E1 Cu=[P(Cuu+(1-p)Cud] Cu=(P{PCuuu+(1-p)Cuud/R] + (1-p)[PCuud+(1-p)Cudd]}/ ={{p"2Cuuu+(p-p*2)Cuud]/R] + [(p-p*2) Cuud+(1-p)2Cydd]/R}/R =P42Cuuu+Pcuud-P*2Cuud+PCuud-P*2Cuud+Cudd-2PChidd+P*2Cud Cu=[P*2Cuuu+2{Cuud-2P*2Cuud+P*2Cudd-2PCudd Cupid] /R°2 Cud=[PCuud+(1-p)Cudd]/R | Cdd=[PCudd+(1-p)(dda)]/R |-> result Cd=[PCud+(1-p)Cdd]/RCd=(P[PCuud+(1-p)Cudd]/R + (1-p)[Pcudd+(1-p)Cddd}/R}/R =[P*2Cuud+Pcudd-p*2Cudd+PCudd-p*2Cudd+(1-p*2)Cddd]/R*2 =[p*2Cuud+2pCudd-2p"2Cudd+Cddd-2PCddd+P*2Cddd]/R*2 Co=[PCu+(1-p)Cd]/R Co=([P*3Cuuu+2P*2Cuud-2P*3Cuud+P*3Cuud-2P92Cudd+PCudd) +(1- P)[P*2Cuud+2PCudd-2P*2Cudd+Cddd-2PCddd+P*2Cdd}}/R*3 [P*3Cuuu+2P*2Cund-2P*3Cuud+P*3Cudd-2P*2Cudd+PCudd+P*2Cuud- PA3Cuud+2PCudd-2P*2Cudd-2P*2Cudd+2P*3Cudd+Cddd-Peddd- 2PCddd+2P*2Cddd+P*2Cddd-P*3Cddd]/R*'3 Co = [P3Cuuu + (3P*2 ~ 3P43)Cuud + (3P*3 ~ 6P*2 + 3P)Cudd + (—P*3 + 3PA2 = BP-+ 1)/R°3 Co = [P*3Cuuu + 3PA2(1 — P)Cuud + 3P(P*2 — 2P + 1)Cudd + (1 = P)*3Cddd]/R*3 Co =[P*3Cuuu + 3P*2(1 — P)Cuud + 3P(1 — P)*2Cudd + (1 — P)\3Cddgf/R*3 Wwe Ton back