Hedging Strategy: Options and Future Marketing

Hedging is an investment position taken by an investor to counterweigh potential losses, which another investment is likely to cause. A number of financial instruments such as swaps, options, future contracts, forward contracts, insurance, and stocks can construct it. It is the process of decreasing risks using derivatives. It is also the process of dealing with the risk of price changes in assets by offsetting such risks in the financial markets using financial instruments. It can vary in complexity depending on the number and the type financial instruments used (Reilly & Brown, 2007).

The analysts’ report about a possibility of the market staying flat can be mitigated by subjecting each stock in the portfolio to an 18 month Holding Period Analysis. The holding period return is the amount or return realized from an investment during the period within which the investor holds it. HPR is sometimes referred to as holding period yield (HPY) and can be computed for any asset. Holding period return helps an investor to evaluate what he gets as actual return and what he gets as expected return from an investment. HPR for Intel, for example, is then computed as follows (Liu & Wang, 2010).

HPR = Income

Historical cost Or HPR = Income + (current value – initial value)]/Initial value

Expected Dividends = Probability x Dividends

= 0.25*4.5 + 0.45*4.0 + 0.25*3.5 + 0.05*2

= 1.125+1.8+0.875+0.1

= 3.9

Therefore, HPR = {[3.9+ (112-110)]/110}

= 0.0053

It therefore follows that the investor has received a total return of 0.00% from this investment from the time it was acquired to date. The probability that this investment is viable is 0.00% in the short term. Probability distribution like in this case can be skewed (Elton, Gruber & Brown 2006).

Analysis of companies

The companies are spread across different industries that have potential for growth. In technology, the portfolio has IBM, Cisco Systems, Hewlett-Packard, and Intel. These companies have huge potential for growth because of the digital revolution, which is still unfolding. The companies’ internal strategy is also a pointer to the immense growth that they will experience. Hence, they are a good bet. In the construction industry, the portfolio has Caterpillar Inc and Chevron Corporation. The construction industry is growing quite fast. The companies are operating globally where the potential is even greater with the burgeoning economies and increasing population. The Home Depot falls in this category too. Coca-Cola is a global company that manufactures and sells beverages. Its strategy and market focus are unrivalled. DuPont and ExxonMobil are in the energy sector, another area that is growing fast.

Explanation of the strategy’s risks and rewards

Holding assets that are perfectly correlated negatively reduces the investment risk. Efficient portfolios provide the highest expected return on an asset for any degree of risk. The investor should ensure that he or she holds those assets that will minimize his or her risk. He or she should therefore diversify his risk (Solnik, 2000). The diversifiable risk is that risk which the investor can be able to eliminate if he or she could hold an efficient portfolio. The non-diversifiable risks on the other hand are those risks that still exist in well-diversified and efficient portfolios. The investor therefore seeks to eliminate the diversifiable risk (Elton, Gruber & Brown, 2006).

The Capital Asset Pricing Model (CAPM) defines the correlation of risk and rate of return on assets in a diversified portfolio.

Ri = RF + [E (RM – RF)] ß

Where:

  • Ri is required return of security i
  • RF is the risk free rate of return
  • E (RM) is the expected market rate of return
  • ß is Beta.

Therefore, looking at the case in hand, we calculate the expected return given the prevailing conditions (Levich, 2001).

Portfolio I

Ri = RF + [E (RM – RF)] ß

= 8 + [13(13-8)] (25/100)2

= 12.06%

The required rate of return for this security is therefore 12.06% and anything that gives below this rate should be rejected.

Portfolio 2

Ri = RF + [E (RM – RF)] ß

= 8 + [18(18-8)] (28/100)2

= 22.11%

The required rate of return for this security is therefore 22.11% and anything that gives below this rate should be rejected. It therefore follows that the percentage of funds to be applied in portfolio 2 should be greater than that in portfolio 1. In case the client would wish to invest in both portfolios, then he should apply a bigger percentage to portfolio 2. The percentage of the fee charged should not affect the investors’ expected rate of return. This means that they should consider it as an expense before computing the investors’ expected rate of return (Fama, 1970).

The portfolio is likely to experience occasions of high and low risk. Some of the factors may not be in the control of the portfolio manager. Fixed income in form of the bonds in the portfolio mitigates risk but also reduces the chance for higher rewards.

The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) assumes that investors are rational and they choose among alternative portfolios based on each portfolio’s expected return and standard deviation. In addition, CAPM assumes that investors do not like taking risk and their goal is to maximize wealth. Additionally, such investors have homogeneous expectations with regard to asset return. In this case, all assets are marketable and divisible. In other words, it is believed under this model that the capital market is efficient and perfect (Das, Markowitz & Scheid, 2010).

The CAPM is given as follows:

Ri = RF + [E (RM – RF)] ß

Where:

  • Ri is required return of security i
  • RF is the risk free rate of return
  • E (RM) is the expected market rate of return
  • ß denote Beta.

If we graph ßi and E (Ri) then we can observe the following relationship:

graph

All correctly priced assets will lie on the security market line. Any security off this line will either be overpriced or underpriced. The security market line therefore shows the pricing of all assets if the market is at equilibrium. It is a measure of the required rate of return if the investor were to undertake a certain amount of risk. The above diagram indicates that as long as you need additional returns, there is an additional risk that is associated with it. Treasury bills and bonds are considered less risky since they have a fixed rate of return and a fixed period of investment and every investor is assured of this return. The risk-averse investors mostly undertake this kind of investment. Therefore, the portfolio is in perfect shape balancing between risky and less risky returns (Das, Markowitz & Scheid, 2010).

Conclusion

The above strategy will grow the portfolio. The stocks the investor selected are from growing industries and the companies represent the highly focused and progressive members. Additionally, the treasury bonds are a mitigating factor of risk. Use of financial tools such as Holding Period Return analysis and CAPM helps in managing the portfolio. They indicate a positive likelihood of performance of the portfolio.

References

Das, S., Markowitz, H. & Scheid, J. (2010). Portfolio optimization with mental accounts. Journal of Financial and Quantitative Analysis, 45(1): 311-334.

Elton, E., Gruber, M. & Brown, S. (2006). Modern portfolio theory and investment analysis. New York: John Wiley.

Fama, E. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2): 383-417.

Levich, M. (2001). International financial market. New York: McGraw-Hill.

Liu, Z. & Wang, J. (2010). Value, growth, and style rotation strategies in the long- run. Journal of Financial Service Professional, 4(1): 67-90.

Reilly, K. & Brown, C. (2007). Investment analysis and portfolio management. New York: Southwestern Thomson.

Solnik, B. (2000). International investments. New York: Longman.