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DECEMBER 13TH, 2009
By ADMIN
We earlier discussed hedging using futures contracts in the context of a business protecting the value of its inventory. We now discuss some hedging strategies available to portfolio managers based on financial futures. Essentially, an investment portfolio is an inventory of financial securities, and futures can be used to reduce the risk of holding a securities portfolio.
We consider the specific problem of an equity portfolio manager wishing to protect the value of a stock portfolio from the risk of an adverse movement of the overall stock market. Here, the portfolio manager wishes to establish a short hedge position to reduce risk and must determine the number of futures contracts required to properly hedge a portfolio.
In this hedging example, you are responsible for managing a broadly diversified stock portfolio with a current value of $100 million. Analysis of market conditions leads you to believe that the stock market is unusually susceptible to a price decline during the next few months. Of course, nothing is certain regarding stock market fluctuations, but still you are sufficiently concerned to believe that action is required.
A fundamental problem exists for you, however, in that there is no futures contract that exactly matches your particular portfolio. As a result, you decide to protect your stock portfolio from a fall in value caused by a falling stock market using stock index futures. This is an example of a cross-hedge, where a futures contract on a related, but not identical, commodity or financial instrument is used to hedge a particular spot position.
Thus, to hedge your portfolio, you wish to establish a short hedge using stock index futures.
To do this, you need to know how many index futures contracts are required to form an effective hedge. There are three basic inputs needed to calculate the number of stock index futures contracts required to hedge a stock portfolio:
The current value of your stock portfolio,
The beta of your stock portfolio,
The contract value of the index futures contract used for hedging.
You should be familiar with the concept of beta as a measure of market risk for a stock portfolio. Essentially, beta measures portfolio risk relative to the overall stock market. We will assume that you have maintained a beta of 1.25 for your $100 million stock portfolio.
You decide to establish a short hedge using futures contracts on the Standard and Poor’s index of 500 stocks (S&P 500), since this is the index you used to calculate the beta for your portfolio. From the Wall Street Journal, you find that the S&P 500 futures price for three-month maturity contracts is currently, say, 1,300. Since the contract size for S&P 500 futures is 250 times the index, the current value of a single index futures contract is $250 × 1,300 = $325,000.
You now have all inputs required to calculate the number of contracts needed to hedge your stock portfolio.
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NOVEMBER 16TH, 2009
By ADMIN
The single biggest problem with comparables may be the selection of appropriately comparable firms. Say, you own a little soda producer, the Your Beverage Corporation (YBC), with earnings of $10 million. You want to select public firms to use as your comparables from the universe of firms. Usually, this means publicly traded companies. So, which of the 10,000 or so publicly traded companies are most comparable to your firm (or project)? Are firms more similar if they are similar in assets, similar in their business products and services, similar in their geographical coverage, similar in their age, similar in their size and scale, etc.? Do they have to be similar in all respects? If so, chances are that not a single of the 10,000 firms will qualify!
Let us assume that after extensive research and much agonizing, you have identified the (same) three companies: KO, PEP, and CSG. Which one is most similar? You know that depending on which firm you select, your valuation could be $250 million (if Cadbury Schweppes, unlevered, was most similar), $410 million (if PepsiCo was most similar), or $500 million (if Coca Cola was most similar). Which shall it be?
Selecting comparables depends both on the judgment and on the motives of the analyst. In the YBC case, one analyst may consider all three firms (KO, PEP, and CSG) to be similar, but CSG to be most similar because it is the smallest comparison firm. She may determine a good P/E ratio would be 30. Another analyst might consider Coca Cola and Pepsi-Co to be better comparables, because they tend to serve the same market as YBC. He may determine a good P/E ratio would be 40. The owner of YBC may want to sell out and try to find a buyer willing to pay as much as possible, so she might claim Coca Cola to be the only true comparable, leading to a P/E ratio of 50. The potential buyer of YBC may instead claim Cadbury Schweppes to be the only comparable, and in fact attribute an extra discount to CSG: after all, YBC is a lot smaller than CSG, and the buyer may feel that YBC deserves only a P/E ratio of 10. There is no definitive right or wrong choice.
Another choice may be not to select either the P/E ratio of 10 or the P/E ratio of 45, but to “split the difference.” A reasonable P/E ratio that is better than either 10 or 45 may be 30. This might mean valuations of around $300 to $400 million. Unfortunately, though this may be the best solution, it is not a good solution.
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NOVEMBER 12TH, 2009
By ADMIN
To illustrate some problems with traditional theories, we could examine the behavior of the term structure in the last two decades. What we would find is that the term structure is almost always upward sloping. But contrary to the expectations hypothesis, interest rates have not always risen. Furthermore, as we saw with STRIPS term structure, it is often the case that the term structure turns down at very long maturities. According to the expectations hypothesis, market participants apparently expect rates to rise for 20 or so years and then decline. This seems to be stretching things a bit.
In terms of maturity preference, the world’s biggest borrower, the U.S. government, borrows much more heavily short term than long term. Furthermore, many of the biggest buyers of fixed- income securities, such as pension funds, have a strong preference for long maturities. It is hard to square these facts with the behavior assumptions underlying the maturity preference theory.
Finally, in terms of market segmentation, the U.S. government borrows at all maturities. Many institutional investors, such as mutual funds, are more than willing to move maturities to obtain more favorable rates. Finally, there are bond trading operations that do nothing other than buy and sell various maturity issues to exploit even very small perceived premiums. In short, in the modern fixed- income market, market segmentation does not seem to be a powerful force.
