Page 225 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT
P. 225

Security Analysis and Portfolio Management




                    Notes          3.  Every equity portfolio has exposure to the market index. Hence, the fund may choose to
                                       sell index futures, or buy index put options, in order to reduce the losses that would take
                                       place in the event that the market index drops.
                                   The regulatory concerns are about (a) the effectiveness of the hedge and (b) its size.
                                   'Hedging' a   1 billion equity portfolio with an average beta of 1.1 with a   1.3 billion short
                                   position in index futures is not an acceptable hedge because the over hedged position is equivalent
                                   to a naked short position in the future of   0.2 billion. Similarly, 'hedging' a diversified equity
                                   portfolio with  an equal short position  in a  narrow sectoral index would not be acceptable
                                   because of the concern on effectiveness. A hedge of only that part of the portfolio that is invested
                                   in stocks belonging to the same sector of the sectoral index by an equal short position in the
                                   sectoral index futures would be acceptable.
                                   'Hedging' an investment in  a stock  with a short position in another stocks' futures is not an
                                   acceptable hedge because of effectiveness concerns. This would be true even for merger arbitrage
                                   where long and short positions in two merging companies are combined to benefit from deviations
                                   of market prices from the swap ratio.
                                   Hedging with options would be regarded as over-hedging if the notional value of the hedge
                                   exceeds the underlying position of the fund even if the option delta is less than the underlying
                                   position. For example, a  2 billion index put purchased at the money is not an acceptable hedge
                                   of a  1 billion, beta=1.1 fund, though the option delta of approximately   1 billion is less than
                                   the underlying exposure of the fund of  1.1 billion.
                                   Covered call writing is hedging if the effectiveness and size conditions are met. Again the size
                                   of the hedge in terms of notional value and not option delta must not exceed the underlying
                                   portfolio.

                                   The position is more complicated if the option position includes long calls or short puts. The
                                   worst-case short  exposure  considering  all  possible expiration  prices should  meet the  size
                                   condition.

                                   8.3 Portfolio Rebalancing

                                   The use of derivatives for portfolio rebalancing covers situations where  a particular desired
                                   portfolio position can be achieved more efficiently or a lower cost using derivatives rather than
                                   cash market transactions. The basic idea is that the mutual fund has a fiduciary obligation to its
                                   unit holders to buy assets at the best possible price.

                                   Thus if it is cheaper (after adjusting for cost of carry) to buy a stock future rather than the stock
                                   itself,  the fund  does have a fiduciary  obligation to  use stock  futures unless  there are other
                                   tangible or intangible disadvantages to using derivatives. Similarly, if a synthetic money market
                                   position created using calendar spreads is more attractive than a direct money market position
                                   (after adjusting for the credit worthiness of the clearing corporation), the fund would normally
                                   have a fiduciary obligation to use the calendar spread. If a fund can improve upon a buy-and-
                                   hold strategy by selling a stock or an index portfolio today, investing the proceeds in the money
                                   market, and  having a locked-in price  to buy  it back  at a  future date,  then it  would have  a
                                   fiduciary obligation to do so.

                                   8.4 Myths and Realities about Derivatives

                                   Derivatives increase speculation and do not serve any economic purpose. Numerous studies of
                                   derivatives activity have led to a broad consensus, both in the private and public sectors that
                                   derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost,




          220                               LOVELY PROFESSIONAL UNIVERSITY
   220   221   222   223   224   225   226   227   228   229   230