Hedging an Equity Portfolio Harvard Case Solution & Analysis

Introduction

            This paper attempts to perform hedging over the equity portfolio by making the use of the exchange traded derivative instruments. The futures contracts have been used in order to hedge the position. The portfolio that has been formed by the fund manager basically comprises of the major UK stocks. The benchmark index that is being used by the fund manager to monitor the performance of his portfolio is the FTSE 100 index. Therefore, as the portfolio mainly comprises of all the equity stocks then the portfolio would be exposed to a number of risks so in order to mitigate those risks, hedging is necessary to be performed. This paper shows the complete identification of the risks and the calculations of futures in order to hedge the portfolio risk.

Portfolio Setup

            First of all, the setup for the equity portfolio has been laid. The price data for the FTSE 100 index has been extracted from the yahoo finance website. The monthly data for a period of 8 months has been extracted and the current value of the FTSE 100 index is taken to be 6521 as of 6/1/2015. The size of the portfolio has also been constructed based upon the 1000 times of the date of the birthday. The date of my birthday is 30 July therefore; the size of the portfolio is calculated to be of 30,000 units as shown below.

Setup

30

Birthday Times

1000

Size of Portfolio

30000

 Risks faced by Fund Manager

            As the fund manager has constructed a portfolio, which comprises of the major UK stocks, therefore, the risk is going to be quite high. This is because the fund manager has not incorporated any other types of asset classes such as the bonds, t-bills or any other real assets. The investment in the equity stocks, although, generates huge investment returns however, the risks faced by the investors are also huge and most of the investors are not willing to take such a high risk for a high return. Therefore, it is always recommended to form a diversified portfolio of stocks. There are many significant risks due to which the fund manager is exposed to and the major risks are:

  • The first significant risk due to which the fund manager is exposed to is that the stocks might have performed well in the past over the long term however; there is still no guarantee that the stocks are going to follow the same pattern in the future as well. Therefore, there is a considerable risk that the stocks might not perform well and the portfolio does not generate adequate returns for its investors.
  • There are many reasons due to which the prices of the stocks might change over the time and as a result of that, the investors might result some or all of their money that they have invested.
  • The companies in which the fund manager has invested are also exposed to a number of other risks such as the interest rate risk and the inflationary risk. As the interest rates and the inflation rates climb up, then the costs of financing for these businesses also go up which impact negatively upon the stock prices of these companies.
  • Furthermore, each company is given a credit rating. When these credit ratings are changed, then the prices are impacted due to significant rating risk.
  • Apart from these risks, the fund manager is also exposed to a number of other risks which might impact upon the share prices of the major UK stocks in which the fund manager has invested. These include the detection risk, legislative risk and model risk.

Hedging an Equity Portfolio Case Solution

Use of Futures Contracts

            The futures contracts are a type of the exchange traded instruments that have been used here in order to hedge the portfolio risk faced by the fun manager. The June futures would be most appropriate because this date is the nearest to the transaction. Furthermore, the expiration date would be the 3rd day of this particular month. The futures contracts have been used in order to hedge the risk faced by the portfolio manager and the total number of the futures contracts that would be sold should be enough to cover the size of the portfolio which is around 30,000......................

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