Portfolio Management -11 Non Option HedgingStrategies

Question 1

What are examples of non-option hedging strategies?

Answer 1

Stop-Loss Orders
Short Sales
Short Sales Against the Box
Short Sales of Exchange Traded Funds
Selling Forward Contracts
Pre-Paid Forward Sale
Futures contracts
Offsetting Notional Principal COntract
Equity Swap

Question 2

hedging tools and techniques are virtually
unlimited in choice and flexibility, Some of the more popular or frequent situations where hedging tools and techniques might be indicated include:

Answer 2

1. Investors want to protect current security values
   from price decline when they must make
   quick decisions with limited information.
2. Situations when an investor is uncomfortable
   with a large percentage of value in a single
   stock—that is, a concentrated portfolio—but
   does not wish to sell and trigger capital gains
   taxes at the present time.
3. An investor has a large holding that is facing an
   almost certain dramatic movement up or down,
   but the question remains in which direction the
   stock will move.
4. An investor may own a large position in a stock
   that has trading restrictions due to Initial Public
   Offering (IPO) lock-up provisions, or trading
   restrictions imposed by the government or the
   company due to insider status or other factors.
   Hedging may allow this investor to control
   the risk of loss in a position that may have
   substantial value now, but may not when he
   is ultimately allowed to sell.
5. An individual with a short life expectancy due
   to advanced age or illness (or as spousal beneficiary
   of a marital trust) may wish to protect
   against a decrease in equity portfolio value (to
   protect the value of the assets for heirs), but
   may not wish to sell because the appreciated
   positions would receive a step-up in basis at
   death (and would incur substantial capital
   gains taxes if sold before death).
6. An individual may be in need of liquidity for
   a new home purchase, payments to creditors,
   or other cash flow needs, but does not wish
   to trigger capital gains taxes. By entering into
   a hedge strategy, the minimum value of the
   appreciated position can be fixed, providing
   an asset that can serve as collateral for loans.
7. Investment advisers, trust officers, investment
   managers, or other fiduciaries responsible
   for other people’s money want to meet their
   fiduciary duty to protect the value of the total
   portfolio—they can achieve this by diversifying
   and hedging against declines in the value of
   their clients’ investments.

Question 3

What is unsystematic risk?

Answer 3

Unsystematic risk is a company’s business risk that investors can eliminate by diversifying into many companies rather than just one or a few.

Question 4

What is systematic risk?

Question 5

What are systematic risk factors?

Answer 5

Even broad diversification within a sector, industry, or asset class still exposes investors to sector, industry, or asset-class risk factors as well as market-wide risk factors—what are called systematic risk factors.

Question 6

What is a derivative?

Question 7

What does the term spanning mean?

Answer 7

The concept of spanning is important to understanding hedging and is related to the concept of creating synthetic securities. A market or security is spanned if
investors can combine derivatives in that market or on that security to reproduce the risk and return characteristics of the underlying market or security. In other words, investors can create or exactly reproduce the returns on that market or security by creating synthetic
markets or securities.

Question 8

What are the tradeoffs of an equity swap?

Answer 8

There is counterparty risk involved because equity swaps trade OTC (over-the-counter: the process of trading securities via a broker-dealer network as opposed to on a centralized exchange like the New York Stock Exchange)

Question 9

Tradeoff of stop-loss orders?

Answer 9

One disadvantage of the stop-loss order concerns price gaps. If a stock price suddenly gaps below (or above) the stop price, the order would trigger. The stock would be sold (or bought) at the next available price even if the stock is trading sharply away from your stop loss level.

Another disadvantage concerns getting stopped out in a choppy market that quickly reverses itself and resumes in the direction that was beneficial to your position.

Question 10

Tradeoff of short sales?

Answer 10

Short selling has many risks that make it unsuitable for a novice investor. For starters, it limits maximum gains while potentially exposing the investor to unlimited losses. A stock can only fall to zero, resulting in a 100% loss for a long investor, but there is no limit to how high a stock can theoretically go. A short seller who has not covered his or her position with a stop-loss buyback order can suffer tremendous losses if the stock price runs higher.

For example, consider a company that becomes embroiled in scandal when its stock is trading at $70 per share. An investor sees an opportunity to make a quick profit and sells the stock short at $65. But then the company is able to quickly exonerate itself from the accusations by coming up with tangible proof to the contrary. The stock price quickly rises to $80 a share, leaving the investor with a loss of $15 per share for the moment. If the stock continues to rise, so do the investor’s losses.

Answer 10

Offsetting Notional Principal COntract

Answer 10

Short Sales Against the Box

Answer 10

Short Sales of Exchange Traded Funds

Answer 10

Pre-Paid Forward Sale

Answer 10

Futures contracts

Answer 11

Equity Swap

Answer 11

Offsetting Notional Principal COntract

Answer 11

Stop-Loss Orders

Answer 12

Short Sales

Answer 12

Selling Forward Contracts

Question 13

Trade off of Short Sales against the box?

Answer 13

While it was popular in the past, the short sell against the box has increasingly become a restricted practice after an SEC and FINRA crackdown.

Question 14

What are the tradeoffs of offsetting notional principal contracts?

Answer 14

Any amounts received under an NPC must be recognized by the taxpayer in accordance with the rules governing the recognition of such payments in the Treasury Regulations, which may override the taxpayer’s normal method of accounting for U.S. federal income tax purposes.

Answer 15

Short Sales

Question 15

What are good-till-cancelled or
standing orders with brokers to sell (or buy) a security held long (short) if the price moves below (above) a specified value?

Answer 15

Stop-Loss Orders

Answer 15

Short Sales Against the Box

Answer 15

Short Sales of Exchange Traded Funds

Answer 16

Selling Forward Contracts

Answer 16

Pre-Paid Forward Sale

Question 16

What strategy is a standardized, legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future?

-The buyer of this agreement is taking on the obligation to buy and receive the underlying asset when the futures contract expires.
-The seller of this agreement is taking on the obligation to provide and deliver the underlying asset at the expiration date.

Answer 16

Futures contracts

Answer 16

Offsetting Notional Principal COntract

Answer 16

Equity Swap

Question 16

Tradeoff of Short Sale of Exchange Traded Funds?

Answer 16

For example,
the investor mentioned in the previous section could
sell short the S&P Energy sector to hedge against his
position in Exxon Mobile. This would not protect him
from the company-specific risks for Exxon Mobile, but it
would perhaps ensure better protection from the sector
risks of Exxon Mobile, as compared to when Chevron
was used for the short side of the position.

Question 16

What are the tradeoffs of futures contracts?

Answer 16

-No Control Over Future Events: Natural disasters, unexpected weather conditions, political issues, etc can completely disrupt the estimated demand-supply equilibrium.

-Leverage Issues: High leverage can result in rapid fluctuations of futures prices.

-Expiration Dates: The contracted prices for the given assets can become less attractive as the expiration date comes near; a future contract may even expire as a worthless investment.

Question 16

Tradeoff of Forward Contract?

Answer 16

It requires tying up capital. There are no intermediate cash flows before settlement. 2) It is subject to default risk. 3) Contracts may be difficult to cancel.

Question 16

Tradeoff of pre-paid forward sale?

Answer 16

Investors may receive an up-front payment of 75
percent to 95 percent of the value of their stock rather
than the traditional payment for the full contract amount
at the time the contract matures.

Generally, the investor
making the forward sale has no obligations to the
counterparty until the expiration of the transaction.
The amount of the up-front payment may be affected
by several factors, including the term of the transaction
(generally, more discount of the upfront payment
with longer terms), the level of an investment’s upside
potential (less discount or even a premium if the upside
potential is substantial), prevailing interest rates (more
discount with higher interest rates), and other market conditions

Question 16

Tradeoff of futures contract?

Answer 16

no control over future events, price fluctuations, and the potential reduction in asset prices as the expiration date approaches.

Question 16

Tradeoffs of Pre-Paid Forward Sale

Answer 16

-For instance, the contract should be well drafted in line with the stock lending provision, also known as Section 1058, so that the PVFC does not constitute a sale till maturity.
-In addition, Investors should avoid situations where the shares that were pledged under the contract are construed to be an actual loan to a financial institution as the IRS views the prepayment taxable at the time of receipt.
-Also, the IRS requires a PVFC transaction to reflect the principle of time value of money, which would mean a higher amount of gain recognized by the investor and consequently liable to a corresponding interest expense amount.

Question 16

Offsetting Notional Principal Contract/Equity Swap

Answer 16

This arrangement should run afoul
of the constructive sale rules, because it is essentially
equivalent to the sale of the stock at its current price
and the purchase of the bond index.

Question 16

Which strategy is a good-till-cancelled or standing orders with brokers to sell (or buy) a security held long (short) if the price moves below (above) a specified value, that trader used to limit potential loss?

Answer 16

Stop-Loss Orders

Question 16

What strategy involves selling securities borrowed from a third party, in which it is sold to the market, where short-sellers rely on the drop in the security in hopes of buying it for less than the initial sale price to gain profit?

Answer 16

Short Sales

Question 16

What strategy involves selling short securities that are also hold long in a portfolio?

Answer 16

Short Sales Against the Box

Question 16

Which strategy involves investors to buy long or sell short certain baskets of stocks that include broadly diversified correlation for market and industry or asset class risks?

Answer 16

Short Sales of Exchange Traded Funds

Question 16

What strategy involves selling a negotiated privately or traded over-the-counter to deliver a security at a specific time in the future, at a specific price?

Answer 16

Selling Forward Contracts

Question 16

Which strategy is suitable for investors who have legal restrictions or practical limitations on selling their stock where there are no obligations to the counterparty until the expiration of the transaction?

Answer 16

Pre-Paid Forward Sale

Question 16

What is an agreement where both sides of the transaction have the obligation to either buy or sell depending on whether they are “long” or “short” in the transaction?

Answer 16

Futures contracts

Question 16

Which strategy involves the holder of a security or bundle of securities agrees to pay substantially all of the investment yield or he holder of a security or bundle of securities agrees to pay substantially all of the investment yield?

Answer 16

Offsetting Notional Principal Contract