Risk Management Applications of Forward and Futures Strategies INTRODUCTION The preferred approach regarding risk management is that companies should take risk in those areas in which business has expertise and comparative advantage and avoid risks in areas which are not related to their primary lines of business i.e exchange rate risk, interest rate risk However, risk management is not only hedging risk; rather, it involves managing risk i.e reducing or increasing risk exposures, i.e changing risk exposures to the desired level STRATEGIES AND APPLICATIONS FOR MANAGING EQUITY MARKET RISK Stock market is more volatile compared to bond market However, stock market has higher liquidity relative to the bond market (i.e long-term and corporate bonds and municipal bonds) Risks associated with stock market volatility can be managed by using futures contracts which are generally based on stock market indices (not individual stocks) 3.1 Hedging: Hedging refers to a risk management approach in which a market position is taken to protect against undesirable outcomes Example: Consider a stock with beta of 1.20 (ignoring any assetspecific risk) and beta of benchmark index is 1.0 It represents that the stock is 20% more volatile than the index If a stock has beta of 0.85 (ignoring any asset-specific risk), it represents that the stock is 15% less volatile than the index Measuring and Managing the Risk of Equities NOTE: When using futures based on broad stock market indices, they provide the best way to manage the risk of diversified equity portfolios Beta measures the risk of a diversified stock portfolio i.e it measures the relative riskiness of a stock portfolio compared to a benchmark (market) portfolio e.g S&P 500 S&P 500 Index is used as a proxy to represent the market portfolio; however, it does not truly represent the true market portfolio Beta is a relative risk measure It is used to measure only the risk that cannot be eliminated by diversifying a portfolio i.e systematic, non-diversifiable or market risk A portfolio that is not well diversified could contain additional risk known as nonsystematic, diversifiable or asset-specific risk where, CovSI= covariance between the stock portfolio and the index σ2I= variance of the index • Risk associated with broad market movements is known as Systematic risk e.g changes in interest rates by the Federal Reserve • Risk associated with a specific company is known as nonsystematic risk e.g labor strike on a particular company This risk can be managed by diversification and by using options • If the covariance is positive, the portfolio and the index tend to move in the same direction • If the covariance is negative, the portfolio and the index tend to move in the opposite direction Given that there are no futures contracts on the true market portfolio, beta of a stock portfolio should be measured relative to the index on which the futures contract is based Beta is similar to duration Formula to compute Beta: β = CovSI / σ2I Covariance measures the extent to which two assets (i.e portfolio and the index) move together Dollar beta of the stock portfolio = beta of stock portfolio × market value of the stock portfolio = βs S Futures dollar beta = beta × futures price = βf f where, Beta plays a critical role in risk management Limitation of Beta: Beta measures only systematic risk not non-systematic risk; therefore, it represents a limited measure of risk βf = Futures contract beta • Beta of Futures contract is often assumed to be 1.0 However, it is not necessarily equal to 1.0 Thus, –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 28 Reading 28 Risk Management Applications of Forward and Futures Strategies it is preferably specified as βf • Value of the futures is zero at start of each day because it is marked to market at the end of each day; therefore, combination of stock and futures, if the target beta is achieved, is BTS To achieve desired/target level of beta exposure The following relationship holds: βT S = βs S + Nfβf f • Manager must sell 12 futures contracts to decrease the beta to the desired level Now assume manager wants to completely hedge i.e βT = ିଵ.ଷ $ଽ,ଷ, Number of futures contracts = ቀ ቁ × ቀ ቁ ଵ.ହ $ଶଶ, =–52.3377 ≈ –52 • Manager must sell 52 futures contracts to completely hedge away the equity risk where, βT = Desired beta or a target beta ΒS= Current portfolio beta S = stock portfolio value f = futures price* βf = Futures contract beta Nf = Number of futures contracts i.e B − Bୗ S N = ൬ ൰൬ ൰ B F ୈୣୱ୧୰ୣୢ ୣ୲ୟ େ୦ୟ୬ୣ ୭୰୲୭୪୧୭ ୟ୪୳ୣ Nf = × ୳୲୳୰ୣୱ ୣ୲ୟ FinQuiz.com Effectiveness of Futures Contract to hedge risk: Futures contract can be used to hedge the risk only associated with the relationship between the stock portfolio and the index on which the futures contract is based ୳୲୳୰ୣୱ ୡ୭୬୲୰ୟୡ୲ ୰୧ୡୣ *Actual futures price = Quoted futures price × Multiplier Example: Quoted futures price = 1225 and Multiplier = $250 Then, Actual futures price = 1225 × $250 = $306,250 • When futures price is simply stated, multiplier is taken as Observe that: • This implies that to hedge the risk of the portfolio consisting of small-cap stocks, futures contract based on large-cap index (i.e S&P 500) should not be used The appropriate approach is to use futures contract based on small-cap index In addition, index futures typically are based only on price indices and they not reflect payment and reinvestment of dividends This implies that dividends will accrue on the stocks but the index used to hedge risk does not reflect any dividends However, it does not adversely affect the effectiveness of the futures 3.2 • When the goal is to increase the beta, βT>βs and the sign of Nf will be positive which indicates that futures should be bought in order to increase the portfolio beta • When the goal is to decrease the beta, βT the cost of borrowing But when gain < cost of borrowing, leveraged position magnifies the losses Example: Manager will receive $10 million after months The manager wants to invest 60% in equity and 40% in debt Equity beta = 1.5 Bond duration = Stock index futures price = $200,000 with beta = 1.05 Bond futures price = $98,000 with duration = and yield beta = Objective: To create Pre-investing: It is a strategy in which futures contracts are used to create or add exposure that converts a yetto-received cash into a desired synthetic equity or bond exposure This strategy is useful to use when the investor might not have the cash to invest at a time when the investment opportunities are attractive We know: Long underlying + Short futures = Long risk-free bond Long Underlying = Long risk-free bond + Long futures Long underlying + Loan = Long Futures • It implies that an outright long position in futures is similar to a fully leveraged position in the underlying • So, by taking long position in futures, investor effectively borrows against the cash that he/she expects to receive in the future • When cash is eventually received, the investor will close out the futures position and invest the cash in the underlying • Risks: Taking a leveraged long position in the market is similar to speculating that the market will • Equity position = $10 million × 60% = $6 million and ã Bonds position = $10 million ì 40% = $4 million number of Equity contracts = ቀ ଵ.ହି ଵ.ହ ቁ ൈ ቀ $,, $ଶ, ቁ = 42.86 ≈ long 43 contracts number of Bonds contracts = ൈ ቀ ସି ହ ቁ ൈ ቀ $ସ,, $ଽ଼, ቁ = 32.65 ≈ long 33 contracts Practice: Exhibit 7, & 9, Volume 5, Reading 28 Practice: Example 7, Volume 5, Reading 28 STRATEGIES AND APPLICATIONS FOR MANAGING FOREIGN CURRENCY RISK Companies are affected both by the exchange rate uncertainty itself and also by its effects on their ability to plan for the future e.g a parent company not only needs to predict its foreign subsidiary’s sales but also needs to predict the exchange rate at which it will convert its foreign cash flows into domestic cash flows Predicting foreign exchange rates with much certainty is extremely difficult; therefore, companies prefer to manage exchange rate risk with the use of derivatives Types of Foreign Exchange Rate Risk: 1) Transaction Exposure: It is a foreign exchange risk when foreign transactions are made For example, • Risk that contracted future cash flows i.e foreign currency receipts become less valuable in terms of domestic currency when foreign currency depreciates or • When planned purchases i.e foreign currency payments become more expensive when foreign currency appreciates 2) Translation Exposure: It is a risk that multi-national corporations face due to decline in the value of their assets denominated in foreign currencies as a result of foreign currency depreciation when they are converted into their domestic currency at an appropriate Reading 28 Risk Management Applications of Forward and Futures Strategies exchange rate Managing translation exposure requires a focus on accounting 3) Economic Exposure: It is a risk faced by a domestic exporter when domestic currency appreciates relative to foreign currency and negatively affects its competitiveness Similarly, a domestic importer faces economic exposure when domestic currency depreciates relative to foreign currency To manage economic exposure, investors need to forecast demand in the light of competitive products and exchange rates 5.1 Managing the Risk of a foreign Currency Receipt Currency Exposure Position in Foreign Currency Action taken to hedge Currency Risk Receiving Foreign Currency Long Sell Forward Contract Paying Foreign Currency Short Buy Forward Contract Example: A firm expects to receive a payment in British pounds worth ₤10 million Payment will be received in 60 days Current spot exchange rate = $1.45/ ₤ 60-days forward exchange rate = $1.47/ ₤ A firm is long foreign currency because it expects to receive foreign currency Therefore, a firm should take short position in a forward contract i.e using forward contract a firm will receive (after 60 days): 10,000,000 ì $1.47/ = $14,700,000 ã This amount will be received by the firm irrespective of exchange rate at that time Practice: Exhibit 10 & 11, Volume 5, Reading 28 Practice: Example 8, Volume 5, Reading 28 resulting from uncertainty of exchange rate e.g risk of depreciation of foreign currency when we have long position in foreign currency, we need to sell forward contracts on the foreign currency 5.3 Managing the Risk of a Foreign-Market Asset Portfolio Investor has following choices available: 1) Hedge local/foreign equity market return and leave the currency risk unhedged 2) Hedge both local/foreign equity market return and the currency risk i Use futures contract on the foreign equity portfolio to lock in the future value of the portfolio (ignoring any currency risk) ii By hedging foreign equity portfolio, investor will be able to know the number of units of the foreign currency that he/she will need to convert to his/her domestic currency at the hedge termination date Investors can use forward contract to hedge the exchange rate/currency risk 3) Hedge neither the local/foreign equity market return nor the currency risk NOTE: It is not possible to leave the local equity market return unhedged and hedge the currency risk i.e to hedge currency risk, investor must hedge local equity market return • Hedging only the market risk generates return equal to foreign risk-free rate • Hedging both the market risk and exchange rate risk generates return equal to domestic risk-free rate This implies that neither strategy is feasible to use in the long-run These strategies can be used only in the shortrun by investors who have foreign market investments and want to temporarily alter a position without liquidating the portfolio and converting it to cash Practice: Exhibit 12, Volume 5, Reading 28 Hedging Exchange rate risk: An equity investment in the foreign market is subject to both equity (market) risk and foreign exchange risk • To manage equity/market risk i.e risk of decrease in foreign market investment, we need to sell futures contracts on foreign market index • To reduce foreign exchange risk i.e volatility FinQuiz.com Practice: Example 9, Volume 5, Reading 28 Reading 28 Risk Management Applications of Forward and Futures Strategies FinQuiz.com FUTURES OR FORWARDS? Futures Forwards • Standardized contracts • All terms (except price) are set by futures exchange • Guaranteed by clearinghouse against default • Requires margin deposits and daily settlement of gains and losses • Regulated by federal authorities • Conducted in a public arena i.e futures exchange • Futures trade on active secondary markets • Reported to the exchanges and regulatory authority • They represent fully leveraged positions • Both futures and forwards have initial value of zero and offer linear pay-offs • Customized contracts • Terms are set by the parties according to their needs • Subject to default risk • Pay the full value of the contract at contract expiration • Forward contracts are not cleared through an exchange and are not marked to market However, parties may decide to use margin deposits and occasional settlements to reduce default risk • Unregulated • Conducted privately • Forward contracts not trade in secondary markets • Not reported to the public or regulators • Hedging a specific portfolio using Forwards contracts is a more costly approach relative to futures but provides a better hedge • They represent fully leveraged positions • Both futures and forwards have initial value of zero and offer linear pay-offs E Generally, investors prefer to use less costly standardized futures contracts instead of relatively costly customized forwards contract in spite of better hedge provided by forwards F Foreign currency should be hedged using Forward contracts because foreign currency forward contracts have greater liquidity relative to foreign currency Futures market Forward contracts are preferred by investors when they are exposed to specific currency transactions G When investors want to maintain privacy of the transaction, forward contracts are preferred to use H Some investors use different hedging instruments to meet requirements of regulatory bodies i.e when regulation prevents use of credit risky instruments i.e forward contracts and OTC options, investors should use Futures or exchange-listed options Futures and Forwards versus Options: • Many organizations are not permitted to use futures or forwards because they represent fully leveraged positions These firms can use options, which are not fully leveraged • Futures or forwards are exposed to greater loss potential whereas the maximum loss borne by an investor in options is limited to the option premium paid • Both futures and forwards have initial value of zero and offer linear pay-offs whereas, options require cash investment at the start (i.e option premium) and offer non-linear pay-offs i.e investor can gain from favorable movements and avoid unfavorable movements Preferred instruments to use in different situations: A When risks are associated with very specific dates e.g a loan in which interest rates are reset, Forward contracts should be preferred Because futures contract has specific expirations B When investors not require a perfect hedge and transaction costs are a concern, risk of bond portfolios can be managed using Treasury Bond Futures C When investors have the flexibility with respect to the horizon date, Treasury bond futures can be used to manage risk of bond portfolios D Generally, risk of equity portfolios is managed by using stock index Futures because equity investors usually require only satisfactory protection against market declines rather than a perfect hedge Practice: End of Chapter Practice Problems for Reading 28 &FinQuiz Item-set ID# 8812, 8805 & 8798 ... portfolio = ($40,1 03, 000 / $38 ,500,000) – = 00416 = 4.16% The combined positions (stock and futures contracts) result in portfolio value= $40,1 03, 000 + $33 8, 937 .50 = $40,441, 937 .50 Rate of return... –10,000,000 (1. 03) 0.5 / (1425 ì $250) =28. 49 28 ã Manager need to sell 28 contracts Step 2: Actual amount of synthetic cash created = V*= (28 × 1425 × $250) / (1. 03) 0.5 = $9, 828, 659 • After... long 43 contracts number of Bonds contracts = ൈ ቀ ସି ହ ቁ ൈ ቀ $ସ,, $ଽ଼, ቁ = 32 .65 ≈ long 33 contracts Practice: Exhibit 7, & 9, Volume 5, Reading 28 Practice: Example 7, Volume 5, Reading