Question

Assume it is March 1 2020. A fund manager owns 1,000,000 shares of Airworks Growth Ltd. The manager is concerned that the market as a whole will be bearish over the coming 3 months (March 1 to June 1 2020). Airworks Growth’s stock is currently selling at $2.50 a share and its beta is 1.05. The stock is expected to pay no dividends over the next 3 months.

Required:

1. Construct a hedge using a stock index futures contracts that will protect, as best as possible, the value of shares owned by the fund manager in Airworks Growth against movements in the stock market as a whole. The current price (as at March 1) of the June 2020 stock index futures contract (with mandatory close out date of June 1) is 980. Each stock index futures contract has a ‘multiplier’ of $25 an index point.

Note: Clearly indicate whether tobuy or sellthe index futures contracts and the number of contracts (rounded to a whole number) you would enter into.

QUESTION 7 continued:

2. Evaluate the outcome of the hedge in part a. above if on June 1 the stock index futures price at the time of mandatory close out is 1,020.00 and Airworks Growth’s stock price is $2.60.

Answer 1

Given:

Current Airwork Growth's Stock Price = $2.50

Stock Beta = 1.05

Stocks owned= 1,000,000

Current Price of June Index Futures = 980

Index multiplier = $25

Initial Position is long on 1,000,000 Stocks

Investment = Number of shares*Share price = 1,000,000*2.5 = $ 2,500,000

Futures investment = Current Futures Price * Futures multiplier = 980*25 = 24500

Hedge Ratio = * Current Stock investment / Current Futures investment = 1.05*2,500,000 / 24,500 = 107.14 approx =108 Contracts

Since Fund Manager Owns Stocks, he needs to short 108 Futures Contract

If Stock prices goes up, he will earn on stock while lose on futures and vice versa if stock falls

b) On Jun 1 if Futures = 1020 and Stock = $2.60

Profit from Stock = (Current Price-Original Price)*Number of shares = (2.6 - 2.5)*1,000,000 = $100,000

Since Manager have Short Position in Futures, manager will incurr loss

Loss from Futures = (1020-980)*25 *107.14= $107,142.86

Net Profit/Loss = 100,000 - 107,142.86 = - $ 7,142.86

Loss of $7,142.86