Scenario:
Let’s say a fund manager achieved returns of 15% on his portfolio over the last 10 months compared to a market return of 10%. The portfolio is a close approximation of the KLSE Composite Index. The fund manager is concerned that there is a strong chance of the market moving down over the next two months. He seeks to preserve the majority of the returns.
Solution:
One possible solution is to use a put option on the KLCI. Assume the following data as at 30 April:
Fund size: | RM 10 million |
Portfolio beta: | 1.0 |
Current Composite Index: | 1130 |
Current June KLCI Futures: | 1140 |
| KLCI Options | Premium |
| 1075 put | 20.00 |
| 1100 put | 28.00 |
| 1125 put | 38.00 |
| Number of contracts to be purchased | = |  |
| = |  | |
| = | 87 contracts |
The fund manager decides to use at-the-money puts for downward protection. He subsequently purchases 87 June 1125 puts at 38 points, an outlay of RM 330,600 (87 × 38 × 100).
Profit Pay-off Diagram
As can be seen, the hedged position has removed the risk of loss from a fall in the market. The trade-off for this reduced risk is the outlay of RM 330,600 (3.3% of the portfolio). Since the fund has a 5% buffer between the portfolio performance and the benchmark index, the fund remains ahead of the measure. The fund also has the prospect of significant outperformance if the fund manager’s view of the market proves to be correct.
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