Textbook Case Problems ---Please see attachments

Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a two-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis’ portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading.

Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that’s the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditions—although some will drop more in price than others.

Jim has been following stock index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock index futures—in particular, the S&P MidCap 400 futures contract—as a way to protect (hedge) their portfolio of common stocks.

Questions

a. Explain why the Pernellis would want to use stock index futures to hedge their stock portfolio and how they would go about setting up such a hedge. Be specific.

1. What alternatives do Jim and Polly have to protect the capital value of their portfolio?

2. What are the benefits and risks of using stock index futures to hedge?

b. Assume that S&P MidCap 400 futures contracts are priced at $500 × the index and are currently being quoted at 769.40. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?

1. Say the value of the Pernelli portfolio dropped 12% over the course of the market retreat. To what price must the stock index futures contract move in order to cover that loss?

2. Given that a $16,875 margin deposit is required to buy or sell a single S&P 400 futures contract, what would be the Pernellis’ return on invested capital if the price of the futures contract changed by the amount computed in question b1?

c. Assume that the value of the Pernelli portfolio declined by $52,000 while the price of an S&P 400 futures contract moved from 769.40 to 691.40. (Assume that Jim and Polly short sold one futures contract to set up the hedge.)

1. Add the profit from the hedge transaction to the new (depreciated) value of the stock portfolio. How does this amount compare to the $375,000 portfolio that existed just before the market started its retreat?

2. Why did the stock index futures hedge fail to give complete protection to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.

d. The Pernellis might decide to set up the hedge by using futures options instead of futures contracts. Fortunately, such options are available on the S&P MidCap 400 Index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying S&P 400 Index. Now, suppose a put on the S&P MidCap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and a comparable call is quoted at 2.35. Use the same portfolio and futures price conditions as set out in question c to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. (Hint: Add the net profit from the hedge to the new depreciated value of the stock portfolio.) What are the advantages and disadvantages of using futures options, rather than the stock index futures contract itself, to hedge a stock portfolio?

Case -2

Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a 2-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis’ portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading.

Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that’s the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditions—though some will drop more in price than others.

Jim has been following stock-index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock-index futures—in particular, the S&P MidCap 400 futures contract—as a way to protect (hedge) their portfolio of common stocks.

Questions

a. Explain why the Pernellis would want to use stock-index futures to hedge their stock portfolio, and how they would go about setting up such a hedge. Be specific.

Pernellis thinks that the market will fall in the future and his portfolio would fall accordingly. Thus, he wants to eliminate the portfolio risks by using the stock index future contract.

Pernellis may set this strategy by short selling of the stock index future contract. For short selling Pernellis would required the number of future contract for short selling equal to his value of portfolio divide by current price of future contract x the lot size.

1. What alternatives do Jim and Polly have to protect the capital value of their portfolio?

They have other alternatives rather than stock index future contract such as:

They can buy a stock put option and they can write call option of the stock, they can buy index put and write the call option of stock index.

2. What are the benefits and risks of using stock-index futures as hedging vehicles?

The benefit is that they can reduce or eliminate the risk of portfolio and the risks is that they may requires more amount after buying or selling the stock Index future contract due to shortfall.

b. Assume that S&P MidCap 400 futures contracts are currently being quoted at 769.40. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?

No. of contracts required to hedge the portfolio = $375,000/(769.40 x 100) = 4.87

Or 5 contracts are required to buy or sell to set up the hedge.

1. Say the value of the Pernelli portfolio dropped 12% over the course of the market retreat. To what price must the stock-index futures contract move in order to cover that loss?

The portfolio value dropped = 12% of $375,000 = $45,000

No. of stock Index future contract should be shorted = 5

The stock index future must move to 90 pts [45,000/ (5 x 100)] in order to cover that loss.

1. Given that a $16,875 margin deposit is required to buy or sell a single S&P 400 futures contract, what would be the Pernellis’ return on invested capital if the price of the futures contract changed by the amount computed in part b1, above?

Margin deposit required = $16,875/-

Future contract changed by = 90

Gain from future contract = $90 x 100 = $9,000

Return of capital invested in future contract = $9,000/$16,875 x 100 = 53.33%

c. Assume that the value of the Pernelli portfolio declined by $52,000, while the price of an S&P 400 futures contract moved from 769.40 to 691.40. (Assume that Jim and Polly short sold one futures contract to set up the hedge.)

Value of portfolio declined by = $52,000

Future contract moved by = $78 [769.40 – 691.40]

Gain from short selling of future contract = 78 x 100 = $7,800/-

1. Add the profit from the hedge transaction to the new (depreciated) value of the stock portfolio. How does this amount compare to the $375,000 portfolio that existed just before the market started its retreat?

Depreciated value of portfolio = $375,000 - $52,000 = $323,000/-

Profit from the short selling of future contract = $7,800

Value of hedged portfolio = $323,000 + $7,800 = $330,800/-

Loss from portfolio or declined value of portfolio = $375,000 - $330,800 =$44,200/-

2. Why did the stock-index futures hedge fail to give complete protection to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.

 The stock index hedge future fails to give complete protection to the Pernelli portfolio because Pernelli didn’t use right hedge ratio. There are 5 number of stock index future required to hedge the portfolio:

No. of stock index future contract required = Value of portfolio (375,000)/ (100*500) = 5 contract (approximately)

But Pernelli used only one stock index future.

It may not possible to obtain perfect (dollar to dollar) protection from these types of hedges. Pernilli could get maximum protection by using the right hedging ratio that is by short selling of 5 stock index future contracts then:

Gain from the short selling of stock index future = $70 x 100 x 5 = $35,000/-

Declined value of portfolio = $52,000, she could get protection of $35,000 against her portfolio loss.

d. What if, instead of hedging with futures contracts, the Pernellis decide to set up the hedge by using futures options? Fortunately, such options are available on the S&P MidCap 400 Index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying S&P 400 Index. Now, suppose a put on the S&P MidCap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and a comparable call is quoted at 2.35. Use the same portfolio and futures price conditions as set out in part c to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. (Hint: Add the net profit from the hedge to the new depreciated value of the stock portfolio.) What are the advantages and disadvantages of using futures options, rather than the stock-index futures contract itself, to hedge a stock portfolio? Value of portfolio = $375,000

Strike price = 769

Value of stock index future contract put option = $5.80

Value of stock Index future contract call option = $2.35/-

Multiplier = 500 times

No. of contracts needed to fully protection of this portfolio = $375,000/(769 x 500) =1 contract (approximately)

Cost of put option = $5.80 x 1 x 500 = $2,900

Premium received in selling a call option = $2.35 x 500 = $1175

Net premium paid = $2,900 - $1175 = $1,725/-

The stock Index future moves 70 pts down:

The proceeds from put option = 2 x $5.80 x 500 = $5,800/-

Option premium paid (put) = $2,900

Net proceeds from the both options = $2,900 + 1175 = $4,075/-

Value of hedged portfolio = $375,000 - $52,000 + $4,075 = $327,075/-

Advantages & disadvantages of using future stock index option rather than using a stock index future:

1) Stock index future option contract requires less investment amount rather than the future contract.

2) Stock Index future option contract may not eliminate whole risk of the portfolio because the premium of options reduced rapidly through the time passes and if the movement of index option is slow or doesn’t move anymore the price of buying a option would be zero but selling a option would be beneficial.

3) The stock index future contract may reduce almost loss of the portfolio.

4) The stock index future contract requires higher margin than the option contract and sometimes needs more amount of money due to shortfall.

Conclusion:

We have seen through the above cases and an example from the real world that the hedging is a most important strategy in today’s world. The investors should manage the risk and reward ratio. Investing in the equity is risky because it has a risk of market fall due to weak economic conditions of the country and world. Currently, Investors are worry to invest in the equity, Stock prices of banking and reality sector companies have fallen almost 50% and other stocks have fallen to almost 20%. Investors are not looking to invest in the equity funds they are withdrawing the investment amount from the equity and investing in the other alternatives such as they are investing in the debt funds rather than investing in the equity funds.

Overall conclusion is that an investor should not invest in a one fund only. Investor should invest in a multiple assets such as Equity plus debts plus cash etc.

Asset allocation is the most important part and decision in the portfolio management. Thus investors should distribute their allocation vary carefully to the various funds.

Investor must choose one of the hedging strategies for the equity portfolio to reducing the risk and for safeguarding against the decline.

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