How many of these contracts should Mort sell so that he hedges the stock market risk of this...

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APPLICATION Hedging with Stock Index Futures Financial institution managers can use stock index futures contracts to reduce stock market risk. Suppose that in March 2010, Mort, the portfolio manager of the Rock Solid Insurance Company, has a portfolio of stocks valued at $100 million that moves percentagewise one-for-one with the S&P Index. Suppose also that the March 2011 S&P 500 Index contracts are currently selling at a price of 1000. How many of these contracts should Mort sell so that he hedges the stock market risk of this portfolio over the next year? Because Mort is holding a long position, using the basic principle of hedging, he must offset it by taking a short position in which he sells S&P futures. To calculate the number of contracts he needs to sell, he uses Equation 1. VA + $100 million VC + $250 * 1000 + $250 000 Thus, NC + $100 million/$250 000 + 400 Mort s hedge therefore involves selling 400 S&P March 2011 futures contracts. If the S&P Index falls 10% to 900, the $100 million portfolio will suffer a $10 million loss. At the same time, however, Mort makes a profit of 100 × $250 + $25 000 per contract because he agreed to be paid $250 000 for each contract at a price of 1000, but at a price of 900 on the expiration date he has a delivery amount of only $225 000 (900 * $250). Multiplied by 400 contracts, the $25 000 profit per contract yields a total profit of $10 million. The $10 million profit on the futures contract exactly offsets the loss on Rock Solid s stock portfolio, so Mort has been successful in hedging the stock market risk. Why would Mort be willing to forgo profits when the stock market rises? One reason is that he might be worried that a bear market was imminent, so he wants to protect Rock Solid s portfolio from the coming decline (and so protect his job). Jul 18 2014 08:00 AM

 

Solution ID:609183 | This paper was updated on 26-Nov-2015

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