3.01 Australian Shares
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GFML is vulnerable to both market and unsystematic risk on the shares. The Australian shares under management by GFML have a Beta (β) of 1.15. This represents the market risk and indicates that when the market fluctuates 10%, the shares fluctuate 15%. This cannot be minimised through diversification. Unsystematic risk can be reduced through diversification (Investopedia, 2014).
The above table indicates that GFML’s market exposure to Australian shares is $100,000,000 being nearly 40% of its portfolio. This means that more can be gained or lost on Australian shares compared to how the other investments perform.
Shares are open to numerous risks, other than market movements, including interest rates, exchange rate fluctuations. This investment moves more volatile than the market, and makes up almost two-fifths of the funds held under management.
3.02US Shares
Global Funds Management Ltd (GFML) have an exposure in the US share market of $59,068,350.00 which amounts to 23.51% of total funds. The financial risks related to this US Portfolio are both foreign exchange rate risk and the value of the S&P 500 falling. The Beta for this portfolio is 1 which means that any price movement will be in the same direction as the market. Currently the U.S economy is experiencing a bullish market with S&P 500 hitting an all time high towards the end of September. This trend is expected to continue in the future so it will have a great impact on the returns of GFML Due to GFML being a Australian based investment company If the USD appreciates in greater proportion to that of the AUD as it is now then the value of that investment in AUD will decrease.
3.03 Short-term Interest Securities
“Bank accepted bills (BABS) are a bill of exchange that are guaranteed by the bank. This means that the accepting bank is obliged to pay face value of the bill to the holder on the maturity date”. The Bank accepted Bill that GFML invested in has an exposure of $20,000,000 which accounts for 7.96% of total funds. In terms of financial risk, increases in the Australian interest rates will have a negative impact for those investors of short-term interest securities.
https://www.commbank.com.au/content/dam/commbank/personal/apply-online/download-printed-forms/adb2760.pdf
https://www.banksa.com.au/corporate/financial-markets/treasury-investments/bbfaq
3.04 Long-term Fixed Interest Securities
There are two government bonds under management by GFML. One being a AUD$40m S&P/ASX Australian Government Bond, and the other being a USD$30m S&P U.S. Issued Investment Grade Corporate Bond.
These long term bonds already provide some security for GFML as government bonds are treated as risk-free investments, because they are backed by the government. However there are a couple of major risks faced by bonds: interest rate fluctuations, which have an inverse relationship with bond prices; and inflation risk, which occurs if the inflation rate exceeds the rate of return.
The market exposure of the Australian long-term bond is nearly 16% of GFML’s portfolio, and the market exposure that GFML is subject to on the US corporate bond is 12.82% with the value in AUD$ coming to $ 32,219,100 on 19th August 2014. The bonds have a relatively low exposure and are low risk by nature.
The Australian Interest Rate is currently at 2.5% and forecasting indicates that the rate will continue to decrease (RBA: Cash Rate Target, 2014). For GFML this means that the AUD$40m dollar holding in long term fixed interest securities will increase in value, assuming the interest rates do decrease.
(RBA: Chart Pack-Interest Rates, 2014)
In the USA, the interest rate is currently sitting at 0.25% (United States Fed Funds Rate | Trading Economics, 2014.), and research shows that interest rates in USA are expected to rise in the next two years (Mackenzie, M, Harding, R, 2014). For GFML this means that the value of the US holdings in long-term fixed interest security will fall.
3.1Hedging Recommendations
Recommend whether to hedge all, part or none of the exposures identified.
3.1.1 Australian Shares
Apart from diversification, the Australian shares are an excellent part of the GFML portfolio that can be hedged to minimise risk. Hedging the shares would reduce the likelihood that the beta does not have a negative impact on the already highly exposed shares. Hedging can be used to protect the shares from changes in interest rates, foreign exchange and commodities prices. And, as GFML owns the shares it should therefore hedge to minimise the financial implications of a decline in the market. The following graph (Figure 1) indicates the direction the market could move in the future, by following its declining trend. If GFML remains unhedged, the Australian Shares will lose their current value by the end of the year, assuming the market continues to depreciate.
Figure 3.1.1 (S&P AUST INDEX ASX 200 INDEX – Westpac Online Investing, 2014)
Another method of predicting the future market position is by looking at the price difference of current options compared with December option prices:
(Options – Detailed search results – ASX, 2014)
The December margin price is substantially higher than the current (October) price. In option margin pricing, this indicates that the value of the option has increased; meaning, that the market has continued to fall rendering the option more expensive as it is more secure (Selling options – ASX, 2014).
3.1.2 US Shares
The US Sharemarket is in a good position at the moment with it currently being in a bullish market. “Recent news of unemployment rate down to 5.9%, which is the lowest level since 2008 has contributed to a rise in share prices.”(http://individual.troweprice.com/public/Retail/Planning-&-Research/T.-Rowe-Price-Insights/Market-Analysis/Weekly-Wrap-Ups). The US economy is expected to continue to improve over the next few months with increases in Gross Domestic Product growing 2.6% and consumer wages. With that been said GFML should protect its investment in S&P 500 in the unlikely event that share prices drop. To do this GFML should hedge 15 % of its US portfolio. The equities market is considered one of the most volatile markets so it is always a good idea to limit your risk exposure necessarily.
3.1.3 Short-term Interest Securities
The biggest factor when taking into consideration the investment in Bank Accepted Bills (BABS) is the fluctuation in interest rates. The Reserve Bank of Australia (RBA) has kept the cash rate at a steady 2.5% since july 2013 and according to economic expert Diana Mousina they will stay this way till early 2015. “On UBS forecasts the central bank is expected to raise interests rate in May 2015 to 2.75% and to 3% in June 2015 as the labour market recovers. But until then the, interst rate is likely to remain static”. Due to the short nature of this investment it is unlikely that interest rates will affect the value of the BAB. However in the scenario that interest rates were to increase earlier then expected then GFML would lose value on their investment due to missing out on the more prosperous market rate. Therefore it would be a good strategy if GFML hedged 15% of there exposure in case of the rise in interest rates.
3.1.4 Long-term Fixed Interest Securities
It is possible to hedge long term securities. The main source of risk comes from interest rate changes, because government and corporate bonds are fixed interest securities their values fluctuate based on the Interest Rate. There is an inverse relationship between the value of bonds and the movements of the Interest Rate; when interest rates rise, bond values decrease.
Interest Rate risk in bonds can be minimised by taking on a security that has a converse relationship with interest rates; when interest rates rise, value of security also rises.
Forecasting for the Australian Interest Rates indicates that they are likely to decrease in the future, this will result in the Australian Bond held by GFML will increasing in value. Therefore, It is not vital that GFML has to hedge their position, but they still can to protect the portfolio value from an unforseen event which decreases the value of the bonds.
The UD Dollar ETF price graph below shows that the share price has sharply appreciated in the last month, indicating that the USD is getting stronger compared to the AUD. This also indicates that interest rates will rise in the future, if conditions continue. Based on this, GFML should either hedge the entire value of the US Bonds, or close their position in them.
(USD – Westpac Online Investing, 2014)
3.2Derivative Recommendations
Recommend/explain which derivative instruments to implement the recommended hedges.
3.2.1 Australian Shares
There are number of derivative instruments available when hedging shares: options, futures, and forwards can all be used. As GFML owns $100,000,000 of Australian Shares, it would welcome a rise in the market, whereas a fall in the market would be unwelcomed. To hedge against a future fall in the market, GFML should purchase (long) a put options contract on the S&P ASX 200 index. The put option allows GFML to sell the index at a price specified in the contract. This means that if the price decreases below the strike price, the index shares can be sold at the price in the contract instead of the spot price. Although there is an initial outlay to purchase the option contract (Premium), the benefit of the Put option is that it provides the certainty of a guaranteed sale at a predetermined selling price upon maturity. This gives GFML more stability in calculating its investments because the cost is already factored in and the selling price is known. Another benefit is, assuming the index appreciates rather than depreciates; the option does not need to be exercised. The premium has already been paid, and GFML can elect to sell at the hypothetical higher price.
3.2.3 Short-term Interest Securities
GFML holding in short term interest securities means that we are looking at the volatile nature of the next 3 months and hedging to prevent any increase in interest rate. Based on the research conducted into Australian interest rates we can say that the central bank is likely to increase interest rates in the second quarter of next year however for next 90 days interest rates are likely to remain the same. None the less if GFML were to hedge their exposure to the market they would in this case sell (go short) Bank Accepted Bill futures offered on the Sydney Futures Exchange (SFE).
3.2.2 US Shares
There are various derivative instruments that GFML can use to hedge against its underlying. Instruments used for hedging include futures forwards options or swaps. In this case GFML would be best suited towards using options seeing as with futures there is always a margin cost that needs to maintained every time the spot price falls and this could be costly to the firm in the long run. To hedge this investment it is recommended that GFML purchase (long) a put options contract on the S&P 500 index. This means they can lock in the price of the underlying at the given strike price whilst paying a premium which they will get back if it is sold before the expiry date. In other words GFML has bought the right to sell the option at a specified price at a future date.
3.2.4 Long-term Fixed Interest Securities
Hedging against Interest Rate risk for the Australian long term bond can be accomplished by taking short positions in a futures contracts for the bond. Taking a short in a futures contract position will protect GFML from an increase in interest rates; increasing interest rates will reduce the value of the bond held under management.
US Bond should be hedged using Eurodollars. This can be done by taking a short position in a UD Dollar Exchange Traded Fund (ETF). The USD ETF is bought as shares, but behaves like a derivative used to hedge a bond. The USD ETF moves in conjunction with the Interest Rate changes in the United States of America (USA). The US bond is a fixed interest security, thus, its value changes inversely with Interest Rate fluctuations in the USA. Taking a short position in the ETF will hedge against an Interest Rate increase because the ETF shares will provide rising value whilst the value of the bond falls.
4.0 Hedging Strategies
Depending on above recommendations
Must show all calculations
4.01 Australian Shares
- Exposures to be hedged
Australian Shares = $100,000,000
- Proportion of Exposure to be Hedged
When deciding how much of the portfolio to hedge, the decision should reflect GFML’s opinion on how much the market will decline; how much of its portfolio value it is willing to lose (How to Hedge Your Portfolio, 2014). Various sources indicate that it is best to hedge between 5-20% of the portfolio depending on what the view of the market is (NASDAQ, 2014).
If we look at Figure 3.1.1, we can see that the Index declined around 7% during the last month. Assuming that a similar trend continues, we will take a view to hedge 95% of the Australian Shares. Meaning that the minimum value the shares can be allowed to fall to is:
= $100,000,000 * 0.95
= $95,000,000.00
However, the Beta of the shares must also be factored in, since the beta is 1.15, this will be multiplied by the assumed market decline percentage (How to Hedge Your Portfolio, 2014):
= (1-0.95) x 1.15
= 6%
Therefore, the minimum value the shares can be allowed to fall to (the exposure to be hedged) is:
= $100,000,000 x (0.95 x 1.15)
= $94,000,000.00
- Which derivatives will be used?
Long Put options will protect the share value against a forecasted fall in the market. To determine the number of long put option contracts to purchase on the S&P ASX 200 Index:
- Number of derivative contracts
= $94,000,000 / (Index Value * Index Point Value)
= $94,000,000 / (5,318.2 * $10)
= 1,767.52
- 1,768 put option contracts need to be purchased to hedge 5% of Shares value.
Assuming:
- S&P ASX 200 index as at closing 03/10/14 = $5,318.20 (S&P AUST INDEX ASX 200 INDEX – Westpac Online Investing, 2014).
- Each index point is equal to AUD$10.
- 1 share per contract, i.e.: 1 index per contract
(Options contract specifications – ASX. 2014)
- Contract duration (months)
The put option that should be purchased is one that expires on December 18 2014. They are only exercisable only on expiry day (Options – ASX, 2014). This is recommended so that the contract can be entered into immediately, and because it is a short time period; not subject to long-term price movements and can therefore revise hedging strategy sooner.
- Prices at time of recommendation
Figure 4.01 below shows the prices of put options for six strike prices.
Figure 4.01:
(S&P AUST INDEX ASX 200 INDEX – Westpac Online Investing, 2014)
We would recommend buying a put option with a strike price slightly lower than the current price of $5,318.2; i.e. a strike price of $5,300.00 to hedge against a decline in the market. This would cost $125 per contract, total put option cost:
= 1,768 * $125
= $221,000
4.02US Shares
- Exposures to be hedged
US Shares = $55,000,000
- Proportion of Exposure to be Hedged
Due to the increasing nature of the US Share Market GFML will only hedge 15% of the total portfolio.
=$55,000,000 x 0.15
=$55,000,000 – $8,250,000
=$46,750,000
Therefore minimum value that shares are allowed to fall by is $46,750,000
- Which derivatives will be used?
Short Put Options should be implemented
- Number of derivative contracts
Current S&P 500 index price = 1967.9
1 index point = $25
1 share per contract = 1 index point
No. of contracts = $46,750,000/ ($1967.9*25)
= 950 contracts
(Options contract specifications – ASX. 2014)
- Contract duration (months)
For GFML to hedge it exposure it should enter into a short position with a contract that expires on December 18
- Prices at time of recommendation
Cost per contract = $100
No. of contracts = $950
Therefore the price of hedging 15% using a put option = 100*950
= USD $95,000
4.03 Short-term Interest Securities
- Exposures to be hedged
AUD $20,000,000
- Proportion of Exposure to be Hedged
AUD $20,000,000 X 0.15 = $3,000,000
- Which derivatives will be used?
ASX Bank Accepted Bill Futures ($1,000,000) Each
- Number of derivative contracts
3 contracts @ 1,000,000 each
- Contract duration (months)
3 months (90Days) expires in March
- Prices at time of recommendation
Rate will be locked in at 2.69% (100 – 97.310)
= 1,000,000 / 1+[0.0269(90/365)] – 1,000,000 / 1+[0.0270(90/365)]
= 993,413.67 – 993,393.93
= $19.74
If interest rates rise, the loss on the underlying Bank Accepted Bill will be will be offset by a $19.74 income per 0.01% increase in interest rate, per contract
http://www.asx.com.au/prices/asx-futures.htm.
4.04 Long-term Fixed Interest Securities
- Exposures to be hedged
$40,000,000 AUD S&P/ASX Australian Government Bond
USD$30m S&P U.S. Issued Investment Grade Corporate Bond
$ 32,219,100
- Proportion of Exposure to be Hedged
To protect against unlikely interest rate rise, only need to hedge a minor proportion of Australian Bond exposure, say, 5%, because forecasting indicates interest rates will fall:
= $40,000,000 x (1-0.95)
= $2,000,000
- Which derivatives will be used?
Australian: 3 YEAR TREASURY BOND FUTURES
- Number of derivative contracts
Australian:
Current futures price = $107.13 x1000
$107,130
FV = $100,000
Coupon = 4.74%
5.24 years bond duration (modified duration)
Duration at maturity = 6.39 years
Yield to maturity = 3.04%
Number of Contracts:
=
= 15.309
àsell 15 contracts
- Contract duration (months)
3 years, starting in either March/June/September/December
- Prices at time of recommendation
http://www.betashares.com.au/products/name/u-s-dollar-etf/#each-overview
http://www.asx.com.au/asx/research/companyInfo.do?by=asxCode&asxCode=USD
BetaShares U.S. Dollar ETF (USD)
Shares in fund
Short position
(US Dollar ETF | BetaShares, 2014)
- Exposures to be hedged
USD$30m S&P U.S. Issued Investment Grade Corporate Bond
$ 32,219,100
- Proportion of Exposure to be Hedged
All, based on forecasting. US interest rates to increase, USD to appreciate.
Treat buying ETF’s same as buying shares, to hedge the bond need to decide amount of value exposure to be hedged.
- Which derivatives will be used?
Short BetaShares U.S. Dollar ETF (USD) shares
- Number of derivative contracts
Sell equal value of bond, in shares:
= $ 32,219,100 / 11.2
= 2,876,705.36
- Short 2,876,705 shares in the ETF
- Prices at time of recommendation
(US Dollar ETF | BetaShares, 2014)
iNAV – Indicative Net Asset Value
(USD – Westpac Online Investing, 2014)
S&P/ASX Australian Government Bond
(S&P/ASX Australian Government Bond Index, 2014)
If interest rates rise, the loss on the underlying Australian Government bond will be offset by a $30 income per 0.01 increase in interest rate, per contract (ASX 3 and 10 Year Treasury Bonds Futures and Options, 2014).
PUT EACH STRATEGY IN TABULAR FORMAT
5.0 Combination Strategies
For the Australian Shares
5.1 First Combination Strategy
- Involving more than one Option contract
- Still think market will decline slightly
- Therefore, Butterfly Put
- Buy 1x Put @ K1
- Sell 2x Put @ K2
- Buy 1x Put @ K3
Current Price = $5,318.2
3 strike prices prices from graph:
OTM (K1) = $5,300
ATM (K2) = $5,325
ITM (K3) = $5,350
- Retain upside benefits of option hedging
- Reasonably effective hedge
- Minimising option premiums
- Keep premiums limited to a reasonable amount
5.1.1 Advantages and Disadvantages
Then use actual option data to HYPOTHETICALLY demonstrate
- Australian ASX 200 @ date of expiry
- 10% lower than at time of implementation
- 5% higher than at time of implementation
5.2 Second Combination Strategy
- Involving more than one Option contract
- EG: Butterfly Spread
- Retain upside benefits of option hedging
- Reasonably effective hedge
- Minimising option premiums
- Keep premiums limited to a reasonable amount
5.2.1 Advantages and Disadvantages
Then use actual option data to HYPOTHETICALLY demonstrate
- Australian ASX 200 @ date of expiry
- 10% lower than at time of implementation
- 5% higher than at time of implementation
6.0 Recommendations and Conclusion
7.0 References
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Mackenzie, M, Harding, R, 2014. Economists revise forecasts for US interest rates. The Financial Times, [Online]. 177, 177. Available at: http://www.ft.com/intl/cms/s/0/d4515d80-06ba-11e4-ba32-00144feab7de.html#axzz3FJZZjhtI [Accessed 03 October 2014].
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S&P U.S. Issued Investment Grade Corporate Bond
(S&P U.S. Issued Investment Grade Corporate Bond Index, 2014)
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