Question

A (HF) hedge fund, “BigBets” currently holds a well diversified (passive) portfolio of stocks worth V_p = $10m with β_p =1.2 (with respect to the market index the S&P500, which currently is at S=1000).

In addition, the HF holds V_B =$1m in Boeing stock, with a current price of S_B = $100 and a beta β_B = 2. The risk-free interest rate = 1% pa (continuously compounded). The volatility of Boeing stock is currently 30% pa.

Derivatives contracts available include a 1-year futures contract on Boeing stock, a 1-year stock index futures contract and calls and puts on Boeing stock, with 1 month to maturity. (Assume Boeing stock pays no dividends).

The HF believes that over the next month, the market index (S&P500) will decrease by 2% (due to a slowdown in the world economy). The HF also believes that there will be a clear announcement about the grounded Boeing 737-800 jet in 1 months time, which will result either in the plane not coming into service (for the foreseeable future) or, it is announced that all the technical problems have been solved. The HF therefore forecasts either a 20% rise or a 20% fall (with equal probability) in Boeing’s stock price, depending on the outcome.

The boss of the HF states that you cannot change the composition of your stocks’ portfolio but you can use futures and options contracts to achieve the best outcome possible, for the HF over the next month, given the above scenario.  

Explain ONE strategy you might use (with futures and/or options) and the potential outcomes from your strategy. Explain any costs and risks in your strategy.

Answer 1

Since the beta of boeing stocks is 2; it means that any change in the stock market value would result in twice the change in the value of boeing stocks. Therefore if the stock market is expected to go down by 2%, the stock price of Boeing is likely to go down by 4% due to this factor.

Now., there is 50-50 probability that there might be an increase or decrease of 20% in stock price of Boeing after the announcement of Boeing 737-800 jet. Now if the stock prices go up, considering both the factors, the effective increasse in the value of boeing prices will be 16% and if the stock prices go down by 20% due to announcement of Technical glitch in Boeing jets then the effective decrease in stock price would be 24%.

Therefore wee can use Short Hedging technique. A short hedge is one where a short position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will decrease.. Also in order to cater for the other scenario where the stock price of Boeing goes up after the announcement we can go for long hedging stratergy. Now allocation of funds in these two stratergies could be in a simple weighted average ratio.