Hedging An Equity Portfolio Essay Example | Topics and Well Written Essays - 2000 words

Hedging An Equity Portfolio - Essay Example 7 Reference: 9 1.0 Introduction A US equity fund manager holds â‚ ¬100m in a portfolio comprising the largest US stocks which perfectly replicates and benchmarks the S&P 500 index. The US Federal Reserve indicated that the programmed quantitative easing of purchasing $85 billion is not going to be carried out. The quantitative easing is used to stimulate the price when the corresponding interest rate decreases to 0%. The non execution of the quantitative easing is set to correct the equity market. The fund manager predicts that the reluctance of the US Federal Reserve to perform a quantitative easing is going have a profound effect on the performance of the portfolio. For this reason the fund manager as such wants to hedge the portfolio using option instead of futures. 2.0 Advantages and disadvantages of using options to hedge this scenario compared to using futures only Fund managers use both futures and options to order to hedge their portfolio. Though there are some marked diff erences in the two types of hedging tools. The choices of the hedging tools depend on the fund manager as well as the objective to hedge. In the present scenario, the fund manager has decided to use the options instead of futures (Reilly and Brown, 2000). This is because of the reason that the options provide certain leverage in comparison to futures. The most basic advantage is that an option gives the option holder the right and not an obligation. In case of the futures both the parties have equal obligations. The second advantage is that the amount of loss is limited to the buyer of option while in futures the losses can be unlimited. Option and future both provides same opportunity to the holder to minimize loss and at same time make profit. The US Federal Reserve has decided to stop quantitative easing. The quantitative easing techniques are supposed to create a stimulant which helps to ease the pressure on prices of funds. The price decreases when the interest falls or drops s harply. The sharp drop of interest is associated with a corresponding decrease in the price level. This means if the fund manager wants to invest in various funds, then the increase in the price of the various funds will limit the ability of the fund manager to invest effectively (Hearth and Zaima, 1998). The fund manager is not sure what will happen in the future but the non execution of the quantitative easing program indicates that the fund manager can only invest in limited fund with the present value of the equity portfolio, since the price of the funds have increased. If the fund manager anticipates that the share price will increase then he can buy a future. The sudden growth in the share price of equity may not find enough buyers. The problem with buying a future contract is that if the price of the funds drop then the fund manager is obliged to sell the future at the decreased price. So the future holder is in a risk, if the anticipated increase in price does not take place and instead of that the price actually decreases. So on one hand there is chance to make profit while on the other hand there is chance to incur loss. There are no restrictions to the limit of profit or loss. This is one of the greatest disadvantages of using the future contract. The advantage of the options with respect to future can be explained with the help of an example. As already explained the find manager is anticipating in increase in the p