Question

2-X is a portfolio manager investing in US stocks with am average Beta of 1.05. The assets under her control is $50,000,000. She is afraid of a market downturn nd wants to hedge her risk against this occurrence. Formulate an exact plan/strategy as to how to meet her goal? Be specific and clear.

Answer 1

For hedging against the market downturn, 2-X (Portfolio manager) can use put options for reducing the risk of market.

Strategy for hedging the risk will be as below:-

If the portfolio manager is afraid that market will go down in near future then

the best strategy would be to buy put option (At the money) on market index which is the same market index portfolio manager is using as his benchmark index.

Suppose the market index is at 2000 and portfolio manager is afraid that market will go down in near future by some percentage (say 5-7%). So according to manager market may move to (2000*0.95 = 1900 level) 1900.or in worst case to 1860 level.

So for saving himself from the market downturn risk manager will buy put option at the money i.e. at 2000 and for financing this option he will sell put option out of the money at the low level i.e. (May vary from 7-10% i.e. 1860 to 1800 level).

If the market does not go down manager will not loose a single diem on the portfolio as he the put option he has is of no value also the put options he sold do not have any value.

If the market goes down by suppose 5-7% (1900 to 1860)

The amount that manager will loose from his stocks will be compensated by the amount he will get from exercising of put options.

Now if in the worst case market goes down more than at where manager has sold put options, in that case manager will have a loss upto the amount multiply with no. of options.

So by using above strategy manager would be able to manager the downturn risk upto a certain level where he believe market could plunger.

Thank You!!