Short Selling Security

March 2016: FIN 3103: Derivatives examples for second test

1. Option trading

On March 17th, 2016, Tata Motors Ltd shares are trading at Rs376. You want to trade using either 10 call or 10 put options. The June 2016 call option with exercise price (X) 400 is available with a premium of Rs 0.20 while the June 2016 put with the exercise price (Rs400) is available with a premium of Rs 24. NOTE: the options are maturing in June 2016, the option premium is quoted per share and you have to buy a contract which is based on 100 shares, so you have to pay Rs20 for one call contract and Rs2400 for one put contract.

1. In March 2016, you are pessimistic about the Indian Economy and you want to speculate on market decline with a major industry stock, specifically with the declining TATA motors shares. Decide what investment strategy you want to do. And why? Explain the cost and risk implications.

In deciding between the call or a put, you should : Consider the costs and benefits, the risk and return.

Make assumption: Are you risk averse? Or risk seeker? If you are risk seeker then you may write call, while if you are risk averse then take the put to limit your losses.  But given that the put is expensive here, you may try to find another put with lower strike price to reduce the cost of your hedging or write call.

B) You are quite optimistic about the Indian market, especially about Tata Motors Ltd. in June 2016.

Option trading with positive expectations (same set up as before, but you are a different trader with the opposite expectations).

Here the answer is quite clear, the call option is quite cheap, so you may just invest 20 Indian rupees, as a speculative investment.

Again, make assumption: Are you risk averse? Or risk seeker ? If you are risk seeker then you may short put. The long call positions a better option if  you are risk averse to limit your losses.

1. Trading futures –index futures

DJIA 30 index futures ($5 x Dow Jones) with June 2016 maturity is currently quoted at 17,457.5. (On the test you would have SP500 or SP500 mini futures for which you need to know the contract sizes as those are covered in the lecture notes).

1. As a mutual fund manager, you are already exposed to the market. You (and your clients) will benefit if the market goes up but you will suffer if the market goes down. How can you hedge you exposure. Currently your portfolio value 1,500,000 with portfolio beta of 1.2 (that means if the market, here using DJIA, goes down by 1% the portfolio goes down by 1.2%) . Using the DJIA index how what can you do to reduce the risk, or would you reduce the market risk? And if yes, how much?

Since you have an inherently long position in the market, if you want to hedge the market risk, you should short the index futures. By shorting the index futures if the DJIA goes down by 1, you earn a $5 profit. So let’s imagine the market goes down by 5%, that means a drop of 872 in the index value (to the level of 16584), in this case on one futures contract you would profit $5*872=4,360 . Now is that enough compensation to hedge you position? Your portfolio value is $1.5Million, if the market goes down by 5%, you lose 6 % of portfolio value, which translates to $900,000 (loss). So, one futures contract may not provide much hedging benefit. About 100 futures contract would bring in 436000, compensate for about half of the loss. As a portfolio manager you do not want to completely hedge risk, you want to have exposure to the market but you maybe want some downside hedge. What other derivatives can you use and how?