For example, if we buy shares at 100 and write the 150 calls
for 10, the maximum profit possible (unless the option is closed out)
is 60.
The shares rise to 190. In our portfolio we are showing a profit of
90 on the stock. However, the option price has risen to 50 so we are
also showing a loss of 40 on the option position. The net result is
that we are showing a profit of 50 so that is OK. However, if we failed
to reflect the loss on the option revaluation we would be overstating
the portfolio’s performance by 90.
Then the option position is assigned and we deliver the shares at
150 realising a profit of 50 and though yesterday we showed a profit
of 90 the share price has not moved! If the option premium of 10 has
been ‘lost’ elsewhere in the records as income then not only is the
performance measurement unrealistic but the valuation of the funds
assets is wrong, the published price of the fund is wrong and reports
to the investors may be wrong. It will take some explaining to the
investors.
More importantly it will take some explaining to the auditors, the
trustee and the regulator and will hardly fill them with confidence
that the fund is using derivatives safely and properly.
Hedging
The fund manager is reviewing the portfolio and is concerned that
the UK stock market may fall in the short term. However, they does
not wish to change the weighting in the portfolio. They, therefore, are
not looking at an asset allocation or to sell stock. They look at two
possibilities. First, they can sell FTSE Futures Contracts which will
provide them with a profit as the market falls thereby offsetting the
fall in value of the stocks. Secondly, they could buy a three-month
FTSE Put option.
With the futures contracts the fund manager risks incurring a loss
if the market should rise until they decide to close the position. With
the put option they can determine how much the ‘insurance’ against
a fall in the market will cost and has the comfort that if the market
should rise they will never pay more than the original cost of the
option.
Index stands at 6960 on January 3rd
The March Futures contract is trading at 6975.
The FTSE Feb 6950 Put is quoted at 50p.
118 Clearing and settlement of derivatives
Scenario one
Fund manager sells 2 FTSE futures contracts @ 6975.
Market RISES to 7010 by mid-Feb and fund manager decides the
market will not fall and buys 2 contracts at 7050 to close the position.
Outcome The hedge has cost the fund manager 2 75 points or
150 ticks, (7050 6975) £5 £1500.
Scenario two
Fund manager buys 2 Feb. 6950 Puts @ 50p.
Market rises to 7010 by mid-Feb.
The 6950 Puts are priced at 10p.
Outcome – The hedge has cost the fund manager £1000 in option
premium paid to open the position. If they close the position by sell-
ing the put option they receive £200.
Therefore, there is a net cost of £800 excluding dealing fees.
Both strategies gave protection against a fall in the market. The put
option restricted the cost of the hedge against a rise in the market.
However, bear in mind that whilst there is a loss occurring on the
futures position as the index rises, the value of the stock has increased
to compensate.
With the option, the rise in the stock prices accrues to the portfolio
once the £1000 outlay has been compensated for.
The settlement issues are that once again the use of the derivative,
whether it is futures or options must be properly recorded in the port-
folio so that both the hedged item and the hedging item are valued
and included in the overall value of the portfolio.
Additionally the sale of the futures would create margin calls, which
need funding and reflecting in the accounts. It is important that the
operations teams and fund managers are aware that an imbalance in
funding can occur.
For example in the above scenario if the market was to rise, from
a profit-and-loss perspective the portfolio is flat, i.e. the rise in the
shares is offset by the loss on the future’s. However, that is not the
case in terms of the cash flow.
The loss on the futures will generate daily VM that must be settled.
The profit on the shares does not create a cash flow, it is merely a
revalued position.
There also needs to be a careful reconciliation of positions to make
sure that one leg of a derivative strategy like hedging has not been
Using derivatives in investment management 119
..................Content has been hidden....................
You can't read the all page of ebook, please click here login for view all page.