Risk Management Case It is July 17 and a portfolio manager at NPR is concerned o

Question

Risk Management Case

It is July 17 and a portfolio manager at NPR is concerned over the increased volatility of the market and plans to hedge his $430 million growth portfolio over the next three months. The beta of his portfolio is 1.65. The December futures contract for the S&P 500 index is currently quoted at 874.5. The value of each futures contract is 250 times the value of the index.

What actions you would take to protect the value of the portfolio over the next three months?

What is the hedge ratio?

Show what happens if the market drops by 8 % over the next three months.

Show what happens if the market advances by 5 % over the next three months.

Answer the above questions in word and upload it to dropbox.

Explanation / Answer

Ans 1 . Actions would depend on the expectation of the appreciation/depreciation of the portfolio.

1. Expect the market to drop

In such a case, to prevent any potential loss on portfolio, One should enter in to an agreement to sell futures (Go short on futures) so that any reduction in Portfolio value is protected by excess of agreed sales price over market price.

Hedge Ratio=Beta which is 1.65 in this case. Hedge ratio is used to measure the basis risk between the hedged item and hedging item. In this case Hedged item is portfolio which is hedged by Future contract for S&P index. Beta is interpreted as the expected volatality of the portfolio with reference to market, ie For every one unit of portfolio 1.65 Index is required to eliminate the basis risk.

Ans

Details Details Amount Value of the Portfolio        4300,00,000.00 Value of the Index required to hedge the volatality of Portfolio        7095,00,000.00 Value of one contract 874.5*250               2,18,625.00 No of Contracts to be bought                           3,245 Market Drops by 8% Reduction in Index as a % 8% Reduction in corresponding Portfolio Value as a % 13.20% Reduction in Portfolio Value 430000000*13.20%           567,60,000.00 This will be offset by gain on future contract 709500000*8%           567,60,000.00 Market Advances by 5% Increase in Index as a % 5% Increase in corresponding Portfolio Value as a % 8.25% Increase in Portfolio Value 430000000*8.25%           354,75,000.00 This will be offset by Loss on future contract 709500000*5%           354,75,000.00

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