1. STOCK PORTFOLIO HEDGING WITH DERIVATIVES Madalina Cojocaru Petrila Darius Cipariu Mentor: Professor Thomas Krueger July 15 th, 2005

2. United States stock market New York Stock Exchange (NYSE) - f ounded in 1792 and was named New York Stock & Exchange Board until 1863 National Association of Securities Dealers Automated Quotation System (NASDAQ) – an electronic stock exchange founded by the National Association of Securities Dealers (NASD)

3. United States Exchange Indexes The Dow Jones Industrial Average - is the oldest and most watched index The NASDAQ Stock Market composite (IXIC) - is composed of all the stocks on the NASDAQ exchange – more than 5,000 firms The Standard & Poor’s 500 Index (S&P500) – is a market weighted index - tracks 500 of the most representative companies based in the US selected upon size, liquidity and sector

4. Romanian stock market Bucharest Stock Exchange was re-opened in 1995 and launched the first official index in September 1997: BET – Bucharest Exchange Trading index Rasdaq Electronic Exchange was designed for filling the trading needs as a result of mass- privatization program and launched the first official index in July 1998: RAQ-C – Rasdaq Composite index

5. Stock Portfolio Steps in order to build a portfolio:  Setting the objective  Setting the time horizon  Choosing the stocks

6. Stock Portfolio  Strategies for choosing the stocks:  Buy and hold  Market timing  Growth  Value  GARP  Income

7. Stock Selection Fundamental analysis:  Earnings per share  Dividend Payout Ratio  Return on Equity Technical analysis:  Chart patterns analysis

8. Stock portfolio protection with derivatives Risk of stock portfolio: price DECLINE in the stock market Hedging: “Taking a position in a futures or option market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change.” Position cash market: LONG Position in futures market: SHORT ¹ www.liffeweather.com/glossary.aspxwww.liffeweather.com/glossary.aspx

9. Stock portfolio protection with derivatives By using derivatives instruments a portfolio manager can preserve or improve the value of a stock portfolio. Hedging: “Taking a position in a futures or option market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change.” Risk: DOWNTREND in stock market Cash market position: LONG on stocks Futures market position: SHORT on stocks or index Option market position: LONG PUT OPTIONS on stock or index ¹ www.liffeweather.com/glossary.aspxwww.liffeweather.com/glossary.aspx

10. Stock portfolio protection with derivatives Derivatives instruments used to protect a stock portfolio Single stock futures - One Chicago, SMFCE Equity Index futures - CME, CBOT Single stock options - CBOE Equity options - CBOE Options on futures - CME, CBOT, SMFCE

11. Stock portfolio hedging with single stock futures Single stock futures contract : an agreement to deliver a certain amount of shares of a specific stock at the expiration date. In the USA, over 200 stocks are traded at One Chicago. In Romania 19 stocks are traded at SMFCE. Position cash market: LONG Position in futures market: SHORT

12. Stock portfolio hedging with single stock futures Example – Best Buy Co (BBY) gain loss LONG BBY (NYSE) SHORT BBY (One Chi) BBY cash price 5568 NYSE LONG 1,000 BBY shares at $55 One Chicago SHORT 10 BBY contracts at $68 (1 futures = 100 shares) Value of BBY shares ensured: 1,000 x $68 = $68,000

13. Stock portfolio hedging with single stock futures 1234 BBY price at futures expiration date Stock market (NYSE) Futures (One Chicago) Net result (2+3) BBY (NYSE)<$68 Assume BBY = $60 1,000*60 = $60,000 (68-60)*10*100 = $8,000 $60,000 + $8,000 = $68,000 BBY (NYSE) = $68 1,000*68 = $68,000 (68-68)*10*100 = 0 $68,000 + 0= $68,000 BBY(NYSE)>$68 Assume BBY = $75 1,000*75 = $75,000 (68-75)*10*100 = - $7,000 $75,000 – $7,000= $68,000

14. Stock portfolio hedging with equity index futures The stock index futures contract has the same specifications as the single stock futures contract, the only difference arising from the underlying assets which is not a specific number of stocks, but a specific number of index units. At the expiration date, all settlements are in cash because of the nature of the indexes (they are just abstract numbers and not physical items like agricultural commodities for example).

15. Stock portfolio hedging with equity index futures The principle of using stock index futures for hedging purpose is the same like in the single stock futures situation: a long position in the stock market will be offset by a short position taken in the stock index futures market. Most traded indexes on the US futures markets: S&P 500, DJIA, NASDAQ

16. Stock portfolio hedging with equity index futures The number of futures contracts that must be sold in order to hedge a stock portfolio is called hedge ratio and is computed by using the following formula: Dollar value of portfolio HR = * beta of portfolio Dollar value of S&P 500 index futures contract

18. Stock portfolio hedging with equity index futures Number of SPX Sep 05 futures contracts needed to be sold in order to protect the $10,000,000 portfolio: 10,000,000 HR = * 1.1 = 36.72 (37 rounded). 250 x 1,198

19. Stock portfolio hedging with equity index futures 1234 S&P 500 value price at futures expiration date Stock marketFutures MarketNet result (2+3) S&P 500 < $ 1194 Assume S&P 500 = 1,100 (decrease of 7,87%) 10m – (10m * 7,87%) * 1.1 = $9,134,300 37 * 250 * (1,198 – 1,100) = $906,500 9,134,300 + 906,500 = $10,040,800 S&P 500 = 1,194 $10,000,000 37 * 250 * (1,198 – 1,194) = $37,000 10,000,000 + 37,000 = $10,037,000 S&P 500 > $ 1194 Assume S&P 500 = 1,230 (increase of 3.015%) 10m* + (10m * 3.015% * 1.1) = $10,331,650 37 * 250 * (1,198 – 1,230) = - $296,000 10,331,650 - 296,000 = $10,035,650

20. Stock portfolio hedging with options Options give the buyer the right, but not the obligation to buy or sell the underlying asset at the strike price until the expiration date of the contract. The buyer must pay a premium to the seller of the option. In this situation, the underlying asset means a stock, an equity index or a futures contract. The best hedging strategy with options means to buy PUT options on single stock or equity index.

21. Stock portfolio hedging with PUT options Number of Puts needed to be sold in order to protect the stocks purchased on the cash market is given by the formula of hedge ratio: Dollar value of portfolio 1 HR = * Contract value Delta Delta is a specific element of options and shows how an option price changes for a given change in the underlying asset.

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