What role does the duration statistic play in hedging with interest rate futures? ANSWER: Duration measures the interest rate risk contained in the portfolio. Knowing this statistic enables the portfolio manager to determine the of needed to alter “magnitude” the portfolio risk as desired. reviewing some reference material, your supervisor finds the following statement: both stock index futures and put options can be used to reduce the risk of a stock “While portfolio, futures contracts are cheaper to use. The trade-off is between the option premium and the symmetric/asymmetric return distributions.” Explain why a futures contract might be a cheaper means of reducing portfolio risk than using put options. Explain how the return distribution of a portfolio hedged with index futures differs from the return distribution of a stock portfolio hedged with put options. ANSWER: You pay a premium for put options, but not for futures contracts. Futures returns are symmetric; protective puts are not. With a protective put you have transferred the portion of the return distribution that contains large losses. You manage a portfolio that is currently 75% stock, 25% bonds. You determine that 300 S&P 500 stock index futures would completely hedge the stock portion of the portfolio, and that 100 T-bond futures would completely hedge the bond portion. At present, you have no open futures positions. You decide to change your asset allocation to 50% stock, 50% bonds. Calculate the number of contracts of each type of futures contract you would buy or sell (state which) in order to achieve the desired mix without changing the underlying portfolio. ANSWER: Stock: From 75% to 50% is a one-third reduction, so use 300/3 = 100 futures. Sell 100 SPX futures Bonds: from 25% to 50% is a 100% increase. Buy 100 T-bond futures
What role does the duration statistic play in hedging with interest rate futures? ANSWER: Duration measures the interest rate risk contained in the portfolio. Knowing this statistic enables the portfolio manager to determine the “magnitude” of needed to alter the portfolio risk as desired. reviewing some reference material, your supervisor finds the following statement: “While both stock index futures and put options can be used to reduce the risk of a stock portfolio, futures contracts are cheaper to use. The trade-off is between the option premium and the symmetric/asymmetric return distributions.” Explain why a futures contract might be a cheaper means of reducing portfolio risk than using put options. Explain how the return distribution of a portfolio hedged with index futures differs from the return distribution of a stock portfolio hedged with put options. ANSWER: You pay a premium for put options, but not for futures contracts. Futures returns are symmetric; protective puts are not. With a protective put you have transferred the portion of the return distribution that contains large losses. You manage a portfolio that is currently 75% stock, 25% bonds. You determine that 300 S&P 500 stock index futures would completely hedge the stock portion of the portfolio, and that 100 T-bond futures would completely hedge the bond portion. At present, you have no open futures positions. You decide to change your asset allocation to 50% stock, 50% bonds. Calculate the number of contracts of each type of futures contract you would buy or sell (state which) in order to achieve the desired mix without changing the underlying portfolio. ANSWER: Stock: From 75% to 50% is a one-third reduction, so use 300/3 = 100 futures. Sell 100 SPX futures Bonds: from 25% to 50% is a 100% increase. Buy 100 T-bond futures