Group Assignment

FNCE90011 Derivative Securities

Semester 2, 2018

Questions about this project: No questions about this project may be asked of either
academics or teaching assistants. Each group’s solution is to be the work of members of that
group only. If the project is unclear then discuss it within your own group. If you find that you
need to make any assumptions, then do so and write out each assumption explicitly as part
of your solution.

Group management: It is expected that all members of a group will make an equitable
contribution to the completion of the project, and on this basis, it is expected that all group
members will receive the same mark. Management of your group is your responsibility. We
recommend that you establish your norms and procedures for working effectively early and
deal with any problems that arise in time. In the event that members of a group inform us
that a member of their group has not contributed equitably, we will assign the marks within
that group on the basis of our own determination of an equitable outcome. Such an outcome
can involve different students from one group receiving different marks and those different
marks can involve zero marks for freeloaders.

Due date: The project is due at 11:59pm on Sunday 23 September 2018. The project is to be
submitted via the LMS Group Assignment page. Your answer must be typed using font size 12
with 1.5 line spacing and should not be longer than 11 pages, including the cover sheet. We
will stop reading after 11 pages. Be careful when designing your plots, and make sure all the
labels on both the x-axis and the y-axis are easily readable. Do not include any spreadsheets
in your answer.

Bonus question: Question k) offers 1 bonus point if answered correctly and if your score
without this bonus is not already 30 points.

1
Portfolio Hedging
The goal of this assignment is to investigate how index futures can be used in order to hedge
market risk. Our focus will lie on a particular source of market risk, i.e., price risk caused by
political uncertainty. In spring 2016, as a senior manager working for a prestigious retail bank,
you are in charge of helping a long-time client to effectively hedge her portfolio against losses
due to market turmoils following the United Kingdom’s 2016 ‘Brexit’ vote.

Data
In the Excel workbook available on the LMS, you will find the following data ranging from
March 23, 2015, to September 16, 2016:

1. Daily closing values of the FTSE 250 Index

2. Daily settlement prices of the FTSE 250 Index Futures
3. Daily closing prices in Pence (100 Pence = £1) of five FTSE-member stocks (CLI, SMP,
SGRO, WKP, and GPOR)

The FTSE 250 Index Futures have a contract multiplier of £2 per index point, i.e., if the index
closes at 10’000, a maturing futures contract’s delivery price equals £20’000. There exist four
possible delivery months: March, June, September, and December, where the third Friday of
a given delivery month corresponds to the respective contract’s last day of trading. FTSE 250
Index Futures are settled in cash based on the ‘Exchange Delivery Settlement Price’ of the
last trading day.

The time series of index futures settlement prices is constructed by rolling the front-month
contract (nearest maturity) over to the first back-month contract (second nearest maturity)
five trading days prior to the former’s last trading day. This is done for all but the last, i.e., the
September 2016 futures.

Background
On June 23, 2016, the United Kingdom (UK) voted in favour of a referendum that demanded
a withdrawal of the UK from the European Union (EU). During the months leading up to the
vote, a heated debate among politicians and economists was carried out regarding the long-
term economic consequences of a possible Brexit. Comprehensive studies trying to foresee
the impact of a Brexit on Britain’s economy reached inconclusive results, with predicted GDP

2
growth rates ranging from +1.55% to -5.50% (The Economist, 2016). However, most observers
agreed that a successful referendum would have the potential to massively disrupt financial
markets, both in the UK and worldwide (The Guardian, 2016).

Since the then prime minister David Cameron’s announcement of the referendum in mid-
February 2016, public polls had suggested a slight advantage for the ‘Remain’ (voting against
Brexit) over the ‘Leave’ campaign. However, this margin steadily decreased as the vote was
approaching and final online polls even gave the edge to Brexit supporters (Populus, 2016).

Here is where your expertise as an experienced wealth manager is required. Assume today is
June 23, 2016, i.e., the day of the referendum and the eve before voting results are
announced. A long-time client seeks your help in protecting her portfolio of FTSE 250-member
stocks against any market disruptions due to an unanticipated voting outcome.

Your client has been implementing a simple value-investing buy and hold strategy: at the
market close of the first trading day in 2016 (January 4), she invested close to £1,000,000 into
an equally weighted portfolio consisting of the five FTSE 250 stocks with the then lowest P/E
(price-earnings) ratio. In particular, she invested approximately £200,000 each in CLS Holding
PLC (Ticker: CLI), St Modwen Properties PLC (SMP), Segro PLC (SGRO), Workspace Group PLC
(WKP), and Great Portland Estates PLC (GPOR).1

After recovering from some substantial early losses, your client is worried about yet another
big future loss due to markets’ reaction to the outcome of the referendum. Hence, she asks
you to set-up a hedge against her portfolio’s market risk. She expects the hedge to be in effect
at the close of trading on June 23, 2016, since first reliable voting results are to be expected
late during the night.

Remark: For simplicity, you may ignore any margin payments and related interests associated
with futures trading. For instance, if you trade contracts at the end of trading on June 23,
2016, and close out your futures position at the end of trading on June 30, 2016, you only
have to account for the daily gains or losses that are realized at the end of each of these five
trading days, i.e., June 24, 27, 28, 29, and June 30.

1
Specifically, she bought whole number of shares in each stock, such that each stock position was worth as
close to £200,000 as possible.

3
Questions
Carry out all computations to at least 4 decimal places. Report dollar numbers to the nearest
cent. Report a number of futures contracts to the nearest whole number of contracts.

a) Plot the full time series of daily closing values of the FTSE 250 Index and indicate the
date of the Brexit vote, i.e., June 23, 2016. (1 point)
b) Plot (i) the full time series of daily closing values of the index and (ii) the full time series
of daily settlement prices of the FTSE 250 Index Futures in one figure (against the same
timeline) and indicate the date of the Brexit vote. Compute and comment on the
correlation between these time series. (2 points)
c) At the end of trading on June 23, 2016, making use of all prior trading data, compute
the variance-minimizing hedge with respect to the index. Report the position in
futures contracts to be taken in order to minimize the market risk from holding a long
position in the index worth £34,667.02. (2 points)
d) Compute the daily payoffs from your hedging position in c), assuming the futures
position is closed out after five trading days, i.e., at the market close on June 30, 2016.
For simplicity, further assume that one can invest into fractions of the index. Plot the
time series of (i) the unhedged index and (ii) the hedged index position from January
4, 2016, 2 to September 16, 2016, and indicate both the date of the Brexit vote and the
end of the hedging period. Report the final value of the hedged index position on
September 16, 2016. (4 points)
Hint: 1. The value of the unhedged index position on January 4, 2016, is £34,244.30.
You have to use the subsequent index returns in order to compute the
evolution of the unhedged index position.
2. During the time of the hedge, the hedged index position consists of both the
index and the accumulated payoffs from the futures position. After the futures
position has been closed out, its accumulated payoffs are invested in the index
(potentially including fractions). Hence, you have to use the index returns in
order to compute the evolution of the hedged index position after the hedge
has been closed out.

2
I.e., the date your client put together her portfolio.

4
 e) Compute the number of shares of each stock in your client’s portfolio by rounding to
the nearest integer. Compute3 and plot the time series of the portfolio values from its
initiation (January 4, 2016) until the end of the available time series (September 16,
2016) and indicate the date of the Brexit vote. Based on all available data from March
23, 2015, to September 16, 2016, compute and comment on the correlation between
the portfolio values4 and the futures prices. (3 points)
f) At the end of trading on June 23, 2016, making use of all prior trading data (starting
from March 23, 2015), compute the variance-minimizing hedge for your client’s
portfolio. Report the position in futures contracts to be taken in order to minimize the
portfolio’s market risk. Explain any differences relative to your answer in c). (3 points)
g) Compute the daily payoffs from your hedging position in f), assuming the futures
position is closed out after five trading days, i.e., at the market close on June 30, 2016.
For simplicity, further assume at this point that one can also buy fractions of individual
shares. Plot the time series of (i) the unhedged portfolio and (ii) the hedged portfolio
from January 4, 2016, to September 16, 2016, and indicate both the date of the Brexit
vote and the end of the hedging period. Report the final value of the hedged portfolio
on September 16, 2016. (3 points)
Hint: During the time of the hedge, the hedged portfolio consists of both the portfolio
itself and the accumulated payoffs from the futures position. After the futures
position has been closed out, its accumulated payoffs are invested in the
portfolio (potentially including fractions of shares). Hence, you have to use the
initial portfolio returns in order to compute the evolution of the hedged
portfolio after the hedge has been closed out.
h) Repeat g) for a 15-day hedging period instead of a five-day hedging period. Compare
and discuss the differences in accumulated hedging payoffs and final (hedged)
portfolio values. (4 points)
Hint: Split the 15-day hedging period into three five-day subperiods and look at their
respective accumulated hedging payoffs. This will make it easier to see how the
overall hedging performance evolves over time.

3
Only use these computations for plotting. You are not asked to report the daily portfolio values.
4
Assuming your client had held the same number of shares from March 23, 2015, to September 16, 2016.

5
 i) Now, assume your client would also like to speculate on an increase in the FTSE 250
Index volatility following the Brexit vote. Therefore, you suggest her to purchase a
short-term at-the-money European straddle on the index. Moreover, let us assume
the following holds:
- Time to maturity of the straddle: 10 trading days (assume one year consists of
250 trading days)
- The continuously compounded risk-free interest rate equals 0.5% p.a.
- The FTSE 250 Index’s continuously compounded dividend yield equals 2.5%
p.a.
At the end of trading on June 23, 2016, what is the value of such a straddle with a
contract multiplier of £1 per index point? (3 points)
Hint: You can assume that all the assumptions of the Black-Scholes-Merton model
hold. Use the daily index log-returns between March 23, 2015, and June 23,
2016, in order to estimate the index’s annualized volatility.
j) Explain [in words] the difference between a straddle and the futures hedging
strategies used before. (1 point)
k) Had your client made a profit from purchasing the above straddle on June 23, 2016,
and holding it until maturity? If yes, how much (in present value terms as of June 23,
2016)? (BONUS)
l) Online trading game. (4 points)
The online trading game will consist of one practice and four trading rounds:

Mon 10/11/2018 Wed 12/11/2018 Thu 13/11/2018 Fr 14/11/2018 Mon 17/11/2018

20:00 – 21:00 20:00 – 21:00 20:00 – 21:00 20:00 – 21:00 20:00 – 21:00

Practice Round 1 Round 2 Round 3 Round 4

It is important that you participate in all of these rounds. In order to set your group
password5 for the trading platform, please fill-in this form before 11.59pm on Friday
September 7, 2018: https://goo.gl/forms/OkOjdX62QGRVHqa93.
Detailed instructions regarding the trading game will be uploaded to the ‘Assessment’
section on LMS by Friday September 7, 2018.

5
For this purpose, please create a new password that can be used by all group members. Do not reuse any of
your existing passwords.

6
References
- McGee, Suzanne, 2016, ‘Why US financial markets may not be immune to Brexit’s
ripple effects’ in US money blog, The Guardian (June 19, 2016), accessible at:
https://www.theguardian.com/money/us-money-blog/2016/jun/19/brexit-us-stock-
market-investors-companies
- Populus, 2016, ‘EU referendum: the latest polls and predictions’, accessible at:
https://www.populus.co.uk/2016/06/eu-referendum-latest-polls-predictions/
- The Economist, 2016, ‘The Brexit briefs, Our guide to Britain’s EU referendum’,
accessible at:
https://www.economist.com/sites/default/files/EconomistBrexitBriefs16.pdf