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M041LON Financial Derivatives Trading - Cventry University

Part A

According to the article of FT.com entitled ‘Oil rises as US crude stocks retreat for third week' (26.04.2017), three major oil forecasting agencies (the US Energy Information Administration, the International Energy Agency, and the Organization of the Petroleum Exporting Countries) ‘forecast that the global oil market will be in deficit in the second half of this year if the cartel maintains its production cuts at its next meeting on May 25'. An extension of production cuts in combination the decline in the US crude stocks will put pressure to the markets and boost prices.

Based on the information above describe how financial derivatives (crude oil futures) could be used in risk management (hedging) and speculation. For your example, please use real data to support your opinion. 

Part B

Scenario

An equity fund manager holds a portfolio comprising the largest UK stocks and benchmarks the FTSE 100 index.
They are concerned about the possibility of a sharp correction in UK equities within the next three months and would like you to evaluate their hedging choices.  The fund manager has expressed a preference to use exchange-traded derivatives for liquidity and transparency.

1. Portfolio setup

a. Use price data (for index and futures) of a date of your choice, between 11/05/2014 and the submission deadline. Quote the day you have chosen.

b. Size of the portfolio: Units of the FTSE 100 index held in the portfolio are your birthday times 1,000 (e.g. if you were born on 29/02/1992 the fund holds 29 x 1,000 = 29,000 units of the FTSE 100 index.

2. Hedging

a. Explain the risk faced by the fund manager, and how futures could be used to hedge it. 

b. How many futures should be bought or sold to hedge the position? Show your calculation. Use the appropriate tools to show an equation in your word processor.

c. Confirm your result using the OSA (Option Scenario Analysis) function on Bloomberg. Show a screen cast of the function 32) Hedge position. What is the equivalent to the hedge ratio in the OSA function? 

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Introduction 

In this part of this report, the price of the future for the futures contract for a particular date will be chosen, and then the unit in the portfolio will be also be calculated. The risks which are faced by the fund manager will also be discussed and how future contract help in hedging those risks will also be discussed. In the end, the number of contracts needed for the portfolio will be calculated.

 Part B

1. Portfolio setup 

a. Use price data (for index and futures) of a date of your choice, between 11/05/2014 and the submission deadline. Quote the day you have chosen. 

The day chosen for getting price data of the FTSE 100 Future and FTSE 100 is 11th June 2019. Therefore, the delivery date of the futures contract will be 12th August 2019.  The price of 11th June 2019 is = 7358*£10 = £73580 as the closing index point of FTSE 100 Future on that particular date is 7358. Also, each index point value is £10 (ICE, 2019). The FTSE 100 index value in that particular date is 7398.5. 

b. Size of the portfolio: Units of the FTSE 100 index held in the portfolio are your birthday times 1,000 

The birthday falls on 28th August, and therefore, the unit of the FTSE 100 index in the portfolio will be =28*1000 = 28,000 units. 

2. Hedging 

a. Explain the risk faced by the fund manager, and how futures could be used to hedge it. 

There are different risk faced by the fund manager, and these risks should be minimised by the fund manager to ensure the fund of the client that has been invested by the fund manager in the market will be able to give good return to the investors. The first risk which is faced by the fund manager is the market risk, and under this risk, the fund manager faces a risk that the value of the investment that has been done by him decreases significantly due to different market factors like inflation or recession or any other market factor-like these (Vaidya, 2019). This risk can be hedged by the future by securing the required position needed on particular investment assets, which is selling the assets on through future contract at a particular price on a future date. 

The second risk that is faced by the fund manager is the Concentration risk, and under this risk, the fund manager faces the risk of investing a particular investment asset too much. This makes the fund performance highly dependable on that fund performance (Cleartax.in, 2019). To hedge this risk, the futures contracts can be used to fix the return on that asset by securing to sell the asset a particular price at a future period.

The third risk that is faced by a fund manager is the liquidity risk and the under this risk; the fund manager faces uncertainty as to whether he will be able to sell the investment asset in the market as in the planned date in the preferred price (HDFC fund, 2019). The fund manager can also remove this liquidity risk by making a future contract of the asset to sell it at a future particular at a particular price. The fourth risk that is faced by the fund manager is inflation risk. Under this risk, the fund manager also faces a risk that the investment will not be able to give more return than inflation, meaning there will be no real returns from the investment. The future can also hedge this risk is fixing a future contract in a future date, which will give a higher return than the inflation rate. 

The fifth risk that is faced by the fund manager is the currency exchange rate risk. Under this risk, the fund manager faces the high risk that the value of the currency which is in the reserve of the fund manager may decrease significantly or the value of the currency needed for operation may have increased significantly. Therefore, the fund manager risk getting the low value of the currency or needed to purchase the currency at an inflated price. This risk can be removed by future contract by making a futures contract to sell the currency at a future date at a particular value or making a contract to sell the currency at a particular price at a future date. All these are the risks faced by the fund manager and the ways by which the future can hedge these risks. 

b. How many futures should be bought or sold to hedge the position? Show your calculation. 

The number of units is 28,000 units 

The FTSE 100 value on 11th June 2019 is 7398.5. 

Therefore, the portfolio value is 28000*7398.5 = £ 207158000

The FTSE 100 Future on 11th June 2019 is 7358 

The value of each FTSE 100 future is £ 10. 

The Nominal value of each FTSE 100 Future contract = 73580  

Therefore, the equation form from this above information to calculate the number of units needed to the hedge the position of the portfolio is given below. 

=((number of units in the portfolio ×FTSE 100 index point))/((FTSE 100 fUTURE point ×value per unit ) )

=(28000×7398.5)÷(7358×10)

=207158000/73580 

=2815 future contracts 

As the equity fund manager holds the portfolio fund, and there is a high possibility of sharp connection in the UK stocks. Therefore, the position of the future for the equity fund manager will be a short position, which means the sold position in the future contract. Therefore, the 2815 future contract should be sold to hedge the position. 

Conclusion 

In this part of the report, the date chosen for future and index price had been chosen as 11th June 2019, and the FTSE 100 index value in that particular date is 7398.5, and the FTSE 100 future is 7358. Then the different risk faced by the fund manager had been identified, and some of those risks are liquidity risk, currency exchange rate risk, and many other risks like these. Then the number of future contracts had been calculated. 

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