Practice questions (hedging strategies)

You are a manager with a $10 million portfolio of stocks. The portfolio has a beta of 1.2 when
calculated with the S&P 500 index. You are convinced that there will be a stock market correction in
the next three months. You want to hedge your portfolio against this anticipated market decline.
Currently, futures contracts on the S&P 500 are trading at 925 while the S&P 500 index is trading at
918.19. The size of a futures contract on the S&P 500 is $250.

a) What position should you take to hedge against a stock market correction? Why?

b) Calculate the number of futures contracts needed to eliminate risk from your portfolio

c) After taking your future position, the value of the S&P 500 Index rises to 925 while the futures
contract rises to 931.86. What is the profit or loss (in $) of your futures position?

d) Knowing that the return on your portfolio is directly proportional to that of the beta i.e.,
R port =β × R SP500 , what profit or loss (in $) would have been realized on the unhedged
portfolio?

e) What is the profit or loss (in $) of your hedged position?

 Solution

a) Short positions should be taken. If the stock market index decreases in value, our futures
position will make profits that will compensate for the losses incurred by our portfolio.

b) The number of contracts:

¿ VA 10000000
N =β × =1.2× =51.89
VF 250 ×925

which is rounded to the nearest whole number, i.e. 52 contracts.

c) Profit on futures position

Profit=N ×(F ¿ ¿ 0−FT ) ׿ ¿ ¿
¿ 52× ( 925−931.86 ) ×250 $=−89180 $

d) Profit on the unhedged portfolio:

 The S&P 500 return

925−918.19
R SP500 = =0.00741677
918.19

 Portfolio return

R port =β × R SP500 =1.2 ×0.00741677=0.00890012

 Profit

Profit=10000000 ×0.00890012=89 000

e) The profit of the hedged position

Profit hedged position=profit futures+ profit unhedged portfolio

¿−89 180+8 9 0 00

¿−180