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IAPM

PGP17

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Portf Manag Tools (Nov 15)

Index linked Deposits A simple example of a product engineered with A simple example of a product engineered with options is the index‐ linked certificate of deposit (CD). 

Unlike conventional CDs, which pay a fixed rate of interest, these CDs pay depositors a specified fraction of the rate of return on a market index such as the NIFTY, while guaranteeing a minimum rate of return should the market fall.

For example the index linked CD may offer 70% of any For example, the index- linked CD may offer 70% of any market increase, instead of a fixed interest, but protect its holder from any market decrease by guaranteeing at least no loss (70% here is known as the ‘participation rate’ or the ‘multiplier’).

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How do banks arrive at this 70% multiplier?How do banks arrive at this 70% multiplier?

Or, given a risk-free rate, what is the appropriate mutiplier?

Sometime in Oct, NIFTY touched 8000 and the 5 month call (26MAR2015) was trading at 455 Rs.  

How does a 5 month index-linked deposit with 50% multiplercompare with a 5 month fixed deposit giving 3.75% return?

Basic idea: The bank uses the forgone risk free interest on your deposit to buy at-the-money index call options on your behalf.

What is the beta of this index-linked instrument?

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Extensions If the index‐linked CD guarantees a minimum return If the index linked CD guarantees a minimum return of 1%, then what should be the participation rate?

Giving rise to newer type of hybrid risk-free securities (“Un-fixed deposits”)

Participation in a particular fund/stock

What we have seen is a bullish CD. We can also d b h h f f f llconsider a bear CD, which pays a fraction of any fall in 

the market index.

Will the participation rate be same as that of a bull CD ?

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Creating Synthetic Positions with Futures Index futures let investors participate in broad market Index futures let investors participate in broad market movements without actually buying or selling large amounts of stock.

You can construct a T‐bill plus index futures position that duplicates the payoff to holding the stock index itself. 

1. Purchase as many market –index futures contracts as you need to establish your desired index position.

2. Invest enough money in T- bills to cover the payment of the future prices at the contract’s maturity date.

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Suppose an institutional investor wants to invest $110 million pp $for 1 month in the market and, to minimize trading costs, chooses to buy the S&P futures contracts as a substitute for actual stock holding. If the index is now at 1100, the month delivery future price is 1111, and the T-bill rate is 1% per month,

how many futures contracts should it buy? (assume a y y (multiplier of 250)

how much to invest in the risk-free asset?

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Adopting this portfolio strategy is same as holding the Adopting this portfolio strategy is same as holding the stock index

Results:

Easier to execute

Enables shorting the market easily: Short futures positions

Going between risk-free and risky investments

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Another use of this toolkit Hedging Systematic RiskHedging Systematic Risk

Suppose, for example, that you manage a $30 million portfolio with a beta of 0.8. You are bullish on the market over the long term, but you are afraid that over the next 2 months, the market is vulnerable to a sharp downturn.

If trading were costless, you could sell your portfolio, place the proceeds in T-bills for 2 months and then reestablish yourthe proceeds in T-bills for 2 months, and then reestablish your position after you perceive that the risk of the downturn has passed.

There is a better way . . .

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Keep your portfolio intact and sell 2 month stock index Keep your portfolio intact and sell 2 month stock index futures

Basically when your portfolio falls in value along with declines in the broad market, the futures contract will provide an offsetting profit.

How many futures contacts, given that the index is tl   t   ?currently at 1000 ?

A decrease in the index to 975 would represent a drop of 2.5%. with a portfolio beta of 0.8, you would expect a loss of 0.8 X 2.5% = 2%, or in dollar terms, 0.02 X $30 million = $600,000.

Therefore the sensitivity of your portfolio value to market movements is $600000 per 25 point movement in the S & P 500.

Hedging Systematic Risk The same idea can be used in another situationThe same idea can be used in another situation

Active managers sometimes believe that a particular asset is underpriced, but that the market as a whole is about to fall.

Even if the asset is a good buy relative to other stocks in the market, it still might perform poorly in a broad market downturn.

Th k k t t l b t th t k i The manager seeks a market neutral bet on the stock i.e. a position on the stock is taken to capture its alpha ( its abnormal risk – adjusted expected return), but the market exposure is fully hedged, resulting in a zero beta position

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Suppose the beta of the stock is 2/3, and the manager Suppose the beta of the stock is 2/3, and the manager purchases $375,000 worth of the stock. 

For every 3% drop in the broad market, the stock would be expected to respond with a drop of 2/3 x 3% = 2%, or $7,500.

The S&P 500 contract will fall by 30 points from a t  l   f   if th   k t d   %  current value of 1,000 if the market drops 3%. 

With the contract multiplier of $250, this would entail a profit to a short futures position of 30 X $250 = $7,500 per contract.

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Therefore, the market risk of the stock can be offset by Therefore, the market risk of the stock can be offset by shorting one S&P contract. 

Now that market risk is hedged, the only source of variability in the performance of the stock‐plus‐futures portfolio will be the firm‐specific performance of the stock.

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Protective Puts Buying Puts ‐ results in downside protection with Buying Puts  results in downside protection with unlimited upside potential

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Limiting the losses – which strike?

Current price:  Rs.56 Investment:  10 lakhs

z: 0.93 (loss cap)Maturity:  1 year

Strike Premium

40 1.20

45 1.70

50 2.30

55 3.20

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60 4.90

65 6.80

70 10.20

75 14.70

80 18.80

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Homeworks: Ch.17 P6, P11, P15; Ch.20 P9Homeworks: Ch.17 P6, P11, P15; Ch.20 P9

Also see problems on Valuation uploaded along with this.

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