Hedging risk with

Derivatives
Review of equity options
Review of financial futures
Using options and futures to hedge
portfolio risk
Introduction to Hedge Funds

Options -- Contract

Calls and Puts

Underlying Security (Number of Units)
Exercise or Strike Price
Expiration date
Option Premium

American, European, Asian, etc.

Options -- Markets

1 Buyer + 1 Seller (writer) = 1 Contract

Examples of Price Quotations
Premium = Intrinsic Value + Time Prem
Options available on

Equities
Indicies
Foreign Currencies
Futures

Options -- Basic
Strategies

Buy Call
Sell (write) Call
Buy Put
Sell (write) Put

Options -- Advanced
Strategies

Straddle
Strips and Straps
Vertical Spreads
Bullish
Bearish

Options - Determinants of
Value

Value of Underlying Asset

Exercise Price
Time to Expiration
VOLATILITY
Interest Rates
Dividends

Options -- Black Scholes

Option Pricing Model

C = SN(d1) - Xe-rTN(d2)
ln(S/X) +(r+ 2/2)T
d1 = -------------------------- 1/2
d2 = d1 - 1/2

Put-Call Parity: P = C + Xe-rT - S

Futures Contract
Agreement to make (sell) or take (buy) delivery of
a prespecified quantity of an asset at an agreed
upon price at a specific future date.
ex. S&P 500 Index Futures:

Price: 1126.10; Delilvery month: June

Buyer agrees to purchase a portfolio representing the S&P 500 (or its
cash equivalent) for $1126.10 x 250 = $281,525 on Thursday prior to
3rd Friday in June. (Buyer is locking in the purchase price for the
portfolio.)
Seller agrees to deliver the portfolio described above.
Note: since this is a cash settled contract, if the price was 1116.10 on
the delivery date, the buyer would pay the seller $2,500 (= 10 x 250).
If the price was 1136.10, the seller would pay the buyer $2,500

Futures Contract: Marking

to Market
Marking to market:
Price of Futures contract is reset every day
Gains/Losses versus previous day are
posted to buyer and seller margin accounts
Futures = a bundle of consecutive 1-day
forward contracts
If futures held to expiration, effective
delivery price is same as when contract
initiated

Futures Contract: Marking

to Market example (C$
contract)

Index Futures Market

Speculators often sell index futures
when they expect the underlying
index to depreciate, and vice versa.
April 4

June 17

1. Contract to sell
S&P @ 1126.1
($281,525) on
June 17.

2. Buy S&P @ 1106.1

($276,525) on spot
market and deliver
@ 1126.1
3. Profit = $5,000.

Index Futures Market

Index futures may be sold by
investors to hedge risk associated
with securities held.
April 4

June 17

1.Contract to sell
S&P @ 1126.1
($281,525) on June
17.

2. Market falls to
1106.1.Gain =$5000
3. Gain offsets
(approx.) loss of
$5000 on securities
held

Index Futures Market

Most index futures contracts are
closed out before their settlement
dates (99%).
Brokers who fulfill orders to buy or
sell futures contracts earn a
transaction or brokerage fee in the
form of the bid/ask spread.

Hedging with Derivatives

Basic option strategies
Covered call
Protective put
Synthetic short

Basic futures strategies

Using interest rate futures to reduce
risk

Covered Call
Sell call on stock you own. (Long stock, short
call)
Good:
As value of stock falls, loss is partially offset by
premium received on calls sold.
Essentially costless since hedge generates a cash inflow

Bad:
Maximum inflow from call = premium; Hedge is less
effective for large drop in stock price
If stock price rises, call will be exercised; Investor
transfers gains on stock to holder of call.

Protective Put
Buy put on stock you own. (Long stock, long
put)
Good:

As value of stock falls, loss is partially offset by gain

in value of put. Gain from put continues to grow as
stock price falls.
If stock price rises, maximum loss on put = premium;
Investor keeps all stock gains less fixed put premium.

Bad:

More expensive to hedge with put

Synthetic Short
Sell call and buy put on stock you own. (Long stock,
short call, long put)
Good:

As value of stock falls, loss is offset by gain in value of put.

Gain from put continues to grow as stock price falls.
If stock price rises, gain is offset by loss on call. Loss from
call continues to grow as stock price rises.
Very effective hedging device
Can be self-financing (premium received on put sold offsets
premium paid on call purchased)

Bad:

Often more expensive than simply shorting the stock itself.

Delta Hedging with

Options
Call Delta = C= C/S
From Black-Scholes model,
C = N(d1)
Ex.:

If S=74.49, X=75, r=1.67%, =38.4%,

t=0.1589 yrs.
Then, C = 4.40 and N(d1) = 0.5197

If S increases by $1, C increases by $0.5197

Hedge Ratio = H = 1/C
Sell 1.924 calls per share of stock held to hedge!

Example of Call Hedge Held to

Expiration, 1000 share stock
position
IBM

Profit S

Profit C

Combined

90

15,510

-20,140

-4,630

85

10,510

-10,640

-130

80

5,510

-1,140

4,370

75

510

8,360

8,870

74.49

8,360

8,360

70

-4,490

8,360

3,870

65

-9,490

8,360

-1,130

60

-14,490

8,360

-6,130

55

-19,490

8,360

-11,130

Delta Hedging - Puts

Put Delta = P= P/S
From Black-Scholes model and Put-Call Parity,
P= C 1 =N(d1) - 1

Ex.:

If S=74.49, X=75, r=1.67%, =38.4%,

t=0.1589 yrs.
Then, C = 4.40, P = 4.71, N(d1) = 0.5197,
and N(d1) -1 = -0.4803

If S increases by $1, P decreases by $0.4803

Hedge Ratio = H = 1/
Buy 2.082 puts per share of stock held to hedge!

Example of Put Hedge Held to

Expiration, 1000 share stock
position
IBM

Profit S

Profit P

Combined

90

15,510

-9,891

5,619

85

10,510

-9,891

619

80

5,510

-9,891

-4,381

75

510

-9,891

-9,381

74.49

-8,820

-8,820

70

-4,490

609

-3,881

65

-9,490

11,109

1,619

60

-14,490

21,609

7,119

55

-19,490

32,109

12,619

Delta Hedging with

Options
Delta changes over time!
S changes
Time declines
Other factors (r, ) may change

True Delta Hedging Adjust hedge when S

changes

Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000
Call options also drop by $0.5197 ==> Gain of
$1037.97 ==>Net change $37.97
IBM stock rises by $1 to $75.49
==> Gain of $1000
Call options also rise by $0.5193 ==> Loss of
$1037.97
==> Net change ($37.97)

True Delta Hedging Adjust hedge when t

changes
Scenario 3:
One week passes, IBM stock at $71.49 ==> Loss of $3000
Call options now worth $2.73
==> Gain of $3173
==>Net change $173
New call delta = 0.4029
New hedge ratio = 1/0.4029 = 2.482 ==> Sell 5 more
contracts!

Scenario 4:
One week passes, IBM stock at $77.49 ==> Gain of $3000
Call options now worth $5.82
==> Loss of $2698
==> Net change ($302)
New call delta = 0.6238
New hedge ratio = 1/0.6238 = 1.603 ==> Buy 3 contracts!

True Delta Hedging Adjust hedge when S

changes

Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000
Put options also rise by $0.4803 ==> Gain of $1008.63
==>Net change $8.63

IBM stock rises by $1 to $75.49

==> Gain of $1000
Put options also fall by $0.4803 ==> Loss of $1008.63
==> Net change ($8.63)

True Delta Hedging Adjust hedge when t

changes
Scenario 3:
One week passes, IBM stock at $71.49 ==> Loss of $3000
Put options now worth $6.06
==> Gain of $2835
==>Net change ($165)
New put delta = 0.4028 1 = -0.5972
New hedge ratio = 1/0.5972 = 1.674 ==> Sell 4 contracts!

Scenario 4:
One week passes, IBM stock at $77.49 ==> Gain of $3000
Put options now worth $3.15
==> Loss of $3276
==> Net change ($276)
New put delta = 0.6238 1 = -0.3762
New hedge ratio = 1/0.3762 = 2.658 ==> Buy 5 more
contracts!

Delta Hedging with

options
Delta represents response of call (or put) price with
change in the stock price
Delta changes as stock price, time to expiration,
interest rates, volatility change
It is too expensive to hedge individual stock
positions with matching options. It is more
common to hedge a portfolio with index options
(cross hedging)
Most managers monitor delta itself to decide when
to rebalance.

A True Protective Put

Puts can be used to build a floor
under the value of a long position
Buy 1 put per long share
Ex.: Long 1000 shares of IBM at
$74.49

Buy 1000 puts at $4.71

Puts guarantee a value of $75 per share
This is insurance, not a hedge!

A True Protective Put

IBM

Profit S

Profit P

Combined

90

15,510

-4,710

10,800

85

10,510

-4,710

5,800

80

5,510

-4,710

800

75

510

-4,710

-4,200

74.49

-4,200

-4,200

70

-4,490

290

-4,200

65

-9,490

5,290

-4,200

60

-14,490

10,290

-4,200

55

-19,490

15,290

-4,200

Hedging with Futures (example from May

2001)
There are futures on the S&P500. Suppose
I have a portfolio that is currently worth
$1,117,672. The portfolio has a beta of 1.3.
June S&P500 futures are at 1430.70

==> contract is worth 500 x 1430.70 =

$715,350
Hedge ratio =
(Value of portfolio / Value of Futures contract)(Portfolio Beta)

= (1,117,672/715,350)(1.3) = 2.031 ==> Sell 2

Contracts !

Hedging with Futures (example from May

2001)

S&P Spot in June

% change

Port. in June

% change

Profit Portfolio

Profit Futures

1573.75

Combined

10%

1,262,969

13.0%

145,297

-143,050

$2,247

1502.25

5%

1,190,321

6.5%

72,649

-71,550

1,099

1430.7

0%

1,117,672

0.0%

1359.15

-5%

1,045,023

-6.5%

-72,649

71,550

-1,099

1287.65

-10%

972,375

-13.0%

-145,297

143,050

-2,247

Adjusting Systematic Risk with

Futures
PM may choose to adjust systematic exposure
up or down to reflect
investor desires
expectations of market movements

About index futures:

Represents contract to make/take delivery of a

portfolio represented by the index
Since index itself may be non-investable, most index
futures contracts are cash-settled
example:
S&P500 futures CME contract value = 250 x index
Initial margin: $6K for spec, $2.5K for hedgers.

Adjusting Systematic Risk with

Futures
I have an $11 million stock portfolio with =1.05. I want
to increase to 1.2.
Value of Futures = 1314.50 x 250 = $328,625
f = 1.0.
Target = contribution from portfolio + contribution
from futures
1.2 = (1.0)(1.05) + [(F x 328,625)/$11,000,000](1.0)
F = (T - Wss)(Vs/VF)
F = 5.02 => buy 5 contracts
What have we done?

Used futures contracts to leverage holdings and increase

exposure to market risk

Adjusting Systematic Risk with

Futures
Suppose target = .90
0.90 = (1.0)(1.05) + [(F x 328,625)/
$11,000,000](1.0)
F = (.90 - 1.05)(33.4728)(1.0) = -5.02
contracts (sell)
We have shorted futures to reduce systematic
exposure.

Hedging with Interest Rate

Futures
How do you reduce duration for a bond portfolio?
Sell high D, buy low D
Sell bonds, buy Tbills
Sell interest rate futures

Interest rate futures: agreement to make/take delivery of

a fixed income asset on a particular date for an agreed
upon price
ex: Sept Tbond futures contract
$100K FV US Treas bonds with 15-years to maturity and
8% coupon (what if they don't exist?)
Price: 99-27 = 99 27/32 % of $100,000 = $998,437.50
(Tick = $31.25) D = 8.64 years

Hedging with Interest Rate

Futures
I own an $11,000,000 face value portfolio of high grade
US corporate bonds with an aggregate value of 101-08
(or $11,137,500) and a duration of 7.7 years.
I expect rates to rise. How can I immunize my portfolio?
Target D = contribution of bond port + contribution of
fut.
0 = (1.0)(7.7) + [(F x 998,437.50)/11,137,500](8.64)
F = (0.0 - (1.0)(7.7))(11,137,500/998,437.50)/8.64
F = -9.94 contracts => short 10 Tbond futures contracts
This is the weighted average duration approach