CIPM Experts Review Course Reading: Measuring Investment s of Portfolios Containing Futures and Options Futures Overview Agreement to exchange an asset at a specified price and time in the future. No initial exchange of money. Traded on public exchanges, so terms are standardized, and settlement is guaranteed. Collateral is posted to enter into the agreement. Price changes are marked to market on a daily basis, and difference will be moved between collateral accounts, so the value of the contract remains zero. Futures use a notional value, which equals the price of a new contract times a contract multiplier. 1
Notional Adjustments for Futures Assume a portfolio with $1,000,000 in stock, and $400,000 in cash. Additionally, $200,000 in futures ($400 500) are purchased by depositing $200,000 in a margin account. Beg. MV Physical MV Futures Impact Notional MV Stocks 1,000,000 +200,000 1,200,000 Cash 400,000 200,000 200,000 Total 1,400,000 0 1,400,000 Notional Adjustments for Futures End of Period: Stock has appreciated to $1,016,000, futures have increased to $410/contract, and $5,000 in margin cash receipts is received. Additionally, $4,000 in dividends and $2,400 in money market interest is received. Finally, $1,200 is received for income on the cash component of the notional stock position. Beg. MV Physical MV Futures Impact Notional MV Stocks 1,016,000 +205,000 1,221,000 Cash 405,000 205,000 200,000 Total 1,421,000 0 1,421,000 2
Notional Adjustments for Futures Income: Stock has appreciated to $1,016,000, futures have increased to $410/contract, and $5,000 in margin cash receipts is received. Additionally, $4,000 in dividends and $2,400 in money market interest is received. Finally, $1,200 is received for income on the cash component of the notional stock position. Beg. MV Physical MV Futures Impact Notional MV Stocks 4,000 +1,200 5,200 Cash 2,400 1,200 1,200 Total 6,400 0 6,400 s with Futures Remember: = Profit Capital Notional Stock = Adj. EMV + Notional Inc. = 1,221,000 1,200,000 + 5,200 1,200,000 = 2.18% 3
s with Futures Remember: = Profit Capital Notional Cash = Adj. EMV + Notional Inc. = 200,000 200,000 + 1,200 200,000 = 0.60% s with Futures Remember: = Profit Capital Hedged Portfolio = Adj. EMV + Notional Inc. = 1,421,000 1,400,000 + 6,400 1,400,000 = 1.96% 4
Options Overview Give the holder the right, but not the obligation, to execute a specified transaction, at a specified price, at some point in the future. American style options can be executed at any point until the expiration date. European style option can only be executed on the expiration date. Call options give the right to buy a security, and Put options give the right to sell a security. Options are the classic case of buying and selling insurance. Options Overview The value of the option changes with the value of the underlying asset, but the change is asymmetric. Sensitivity to the price of the underlying is measured by Delta Options deep out of the money may have little correlation to the underlying (δ 0.0). Options deep in the money may have perfect correlation to the underlying (δ 1.0). Options at the money will be about half (δ 0.5). 5
Accounting for options Full Exposure Method: Incorporates hedge ratios for each individual option More useful for attribution Most accurate Partial Exposure Method: Only option value is used in notional market value. Simpler, does not require knowledge of individual positions. Notional Adjustments for Options Beginning of Period Facts: $1,000,000 in stock $400,000 in cash Purchase $4,000 ($4 1,000) in call options Strike price of $100 Hedge ratio is 0.5. Beg. MV Physical MV Options Impact Notional MV Stocks 1,000,000 +50,000 1,050,000 Options 4,000 4,000 0 Cash 396,000 46,000 350,000 Total 1,400,000 0 1,400,000 6
Notional Adjustments for Options End of Period Facts: Stock MV appreciate to $1,016,000 Calls increase to $9.50/contract Hedge ratio changes to 0.6 Stock price increases to $110 Dividends received is $4,000 Income on notional options is $276 End. MV Physical MV Options Impact Notional MV Stocks 1,016,000 +66,000 1,082,000 Options 9,500 9,500 0 Cash 396,000 56,500 339,500 Total 1,421,500 0 1,421,500 Notional Adjustments for Options End of Period Facts: Stock MV appreciate to $1,016,000 Calls increase to $9.50/contract Hedge ratio changes to 0.6 Stock price increases to $110 Dividends received is $4,000 Income on notional options is $276 End. MV Physical MV Options Impact Notional MV Stocks 4,000 +276 4,276 Options 0 0 0 Cash 2,376 276 2,100 Total 6,376 0 6,376 7
s with Options Remember: = Profit Capital Notional Stock = Adj. EMV + Not. Inc. CF = 1,082,000 1,050,000 + 4,276 10,500 1,050,000 = 2.45% Δ in Notional Adj. (56,500 46,000) s with Options Remember: = Profit Capital Notional Cash = Adj. EMV + Not. Inc. CF = 339,500 350,000 + 2,100 ( 10,500) 200,000 = 0.60% Δ in Notional Adj. (46,000 56,500 ) 8
s with Options Remember: = Profit Capital Hedged Portfolio = Adj. EMV + Notional Inc. = 1,421,500 1,400,000 + 6,376 1,400,000 = 1.99% 9