Question

Assume it is March 1 2020. A fund manager owns 1,000,000 shares of Airworks Growth Ltd. The manager is concerned that the market as a whole will be bearish over the coming 3 months (March 1 to June 1 2020). Airworks Growth’s stock is currently selling at $2.50 a share and its beta is 1.05. The stock is expected to pay no dividends over the next 3 months.

Required:

1. Construct a hedge using a stock index futures contracts that will protect, as best as possible, the value of shares owned by the fund manager in Airworks Growth against movements in the stock market as a whole. The current price (as at March 1) of the June 2020 stock index futures contract (with mandatory close out date of June 1) is 980. Each stock index futures contract has a ‘multiplier’ of $25 an index point.

Note: Clearly indicate whether to buy or sell the index futures contracts and the number of contracts (rounded to a whole number) you would enter into.

b.Evaluate the outcome of the hedge in part a. above if on June 1 the stock index futures price at the time of mandatory close out is 1,020.00 and Airworks Growth’s stock price is $2.60.

Answer 1

(a) Total value of shares = 1,000,000*$2.50 = $2,500,000

Beta = 1.05

To perfectly hedge the portfolio, we need to sell stock index futures equivalent to the beta times the total value of shares

Value of stock index to be sold = 1.05 * 2,500,000 = $2,625,000

The current stock index future has a multiplier of $25 and stock index spot value =980

Per stock index futures contract value = 25*980 = $24,500

To hedge, we need to sell 2,625,000/24,500 = 107.14286 contracts of stock index futures

Hence to hedge, the need is to sell 107 contracts of stock index futures

(b) Stock price value =$2.60

Value of fund manager's stocks = 1,000,000*2.60 = $2,600,000

Profit on fund manager's stocks since hedging on March 1 = $2,600,000- $2,500,000 = $100,000

Loss on stock index futures price = 107*25*(1020-980) = $107,000

Net loss due to hedge = $7,000