Derivatives
Assume you have AUD500,000 invested in an equal-weighted portfolio on April 1, 2022 for 3
months. The portfolio will comprise four Australian stocks: WDS, STO, KAR and BPT all of
which are from the oil exploration and production sector. Identify a major risk in your portfolio of
stocks to hedge with an appropriate futures contracts.
(5 marks)
Assessment criteria:
o Identification of major risk
o Methodology for identification of major risk.
o Rationale for selection of futures contract for hedging.
For a better hedge, you believe it is simultaneously necessary to align with the expected future
market state of the principal commodity. Using the term structure of futures contracts for the
principal commodity, assess the market risk over the three months period.
(5 marks)
Assessment criteria:
o Plotting the term structure
o Implication based on the curvature
o Potential market risk based on the curvature
Hedge your portfolio using the minimum variance hedge ratio.
(3 marks)
Assessment criteria:
o Rationale for using the minimum variance hedge ratio
o Calculation of minimum variance hedge ratio
o Correct implementation of hedge
At the end of the three months period, close all positions and evaluate the effectiveness of your
hedge.
(5 marks)
Assessment criteria:
o Correct liquidation of positions and calculations of profit/loss
o Full details of transactions captured in a table with appropriate narrative of all relevant
transactions that may occur in real world investment
o Effectiveness of the hedge and reasons why the hedge strategy worked/failed to work as you
expect
o Discuss how the hedge can be improved taking into account the shortcomings you identified
above
Now hedge your portfolio of Australian stocks with ASX SPI 200 Index futures over the same
three months period. Compare the results of this hedge with that using oil futures contracts above.
Briefly discuss the merits/demerits of both hedging methods.
(9 marks)
Assessment criteria:
o Correct implementation of hedge, showing full details of transactions
o Evaluation of the strategy in comparison to the minimum variance hedge earlier.
o Is one strategy necessarily superior than the other?
REPORT WRITING. Your report must document a complete discussion of the process outlined
above, including full details of transactions executed. Transaction costs must bear evidence that it
is a realistic figure. Good structure, presentation and concise writing skills are likewise important.
Your report length can be a MAXIMUM of word count of 3,000 words (size 12 font, 1.5 spacing),
including all discussion, graphs, tables and references.
Sample Solution
When investing in a portfolio of stocks, it is important to consider the impact that major risks could have on returns. In this case, the portfolio consists of four oil exploration and production companies (WDS, STO, KAR and BPT). One of the most significant risks associated with such investments is changes in oil prices due to fluctuations in demand or supply. As such, using futures contracts to hedge against these price fluctuations can help reduce potential losses and protect an investor’s return on investment.
In order to identify which type of futures contract would be most appropriate for hedging this particular portfolio, an analysis of both historical data and current market conditions must first be conducted. Specifically, one should look at recent trends in crude oil prices as well as how different types of future contracts react under different market scenarios (Davidson & MacKenzie 2018). Additionally, it would also be beneficial to assess the relationship between individual stocks within the portfolio and crude oil prices over time (Davidson & MacKenzie 2018). By doing so it may become apparent whether some companies are more exposed than others or if they all move together during periods of volatility.
Once a suitable future contract has been identified it will then need to be purchased at an appropriate quantity and strike price based on one’s risk appetite(Joshi 2016). For example ,if petrol futures contracts were determined best suited for Risk Aversion purposes then long positions could be taken providing protection against downward movements while still allowing upside participation if desired(Joshi 2016 ). Other strategies such as collar trading or buying put options may also prove useful when attempting minimize downside risk while also allowing partial up-side exposure .
In conclusion , selecting a suitable futures contract for hedging can greatly benefit investors by offsetting much potential losses caused by unanticipated deviations from expected outcomes . By assessing both historic patterns & current market conditions along with considering one’s own personal risk tolerance levels investors can make informed decisions regarding what type future contracts best suit their needs .
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