financial derivatives group5.doc

Financial Derivatives Investment Competition Final ReportLu Yang, Shen Yuan Yuan, Wang Meng Group Monday 12.30 5This report is composed of three parts separately explaining initial choice for stocks, commodities and bonds. Then it tells the hedging process using options and futures.All of all, before we do the competition, our group members had a talk to determine which type of investors we were. Its risk-averse and we want to avoid risks. Because its the direction to decide our investments components and hedging strategy. Then we should be prudential in choosing our components of stocks, commodities and bond. It is based on macro-economy, which are our knowledge of companies, world subjects and policies. Apart from macro-economy, we also need technical analysis. Both of these consist our views to the past events and current trends to determine which individual financial product we should purchase. Second, taking in charge of the process in which we hedge and knowing details of different derivatives contracts are the most thing we learn from this competition. Hedging acts as insurance to lower our initial portfolios market risk. But there is still too much risk in it, such as basisi risk we should notice seriously. Thirdly, we must consider adjustments of our financial products of which will be sold out in time in case of any changes in price which is the opposite of our determination during the 3 months. Basic rational of our investment portfolio is Markowitz portfolio which is less correlation meaning risk spreading less to each other. We diversify our risk within portfolio via 10 stocks of totally irrelevant different areas. As graphs 1 showing, the minimum variance portfolio is the goal we pursuit. Graphs 1 We attempt to calculate and refer to the Sharpe Ratio for measuring portfolio historical performance, Treynor ratio to compare well-diversified portfolios and Information ratio checking the risks being taken. But too much barriers came to us when we need data like market return and volatility of our portfolios so we gave up. We think environment-protective, financial area or medical are focuses in different areas based on our information and tuition of economy thesis. Besides this, basically we pick out the following 10 stocks from different areas with some technological analysis from the graphs on the LSE exchange.Table 1 Stock Portfolio3i Group plc10,000.00 shares362.90Aviva plc10,000.00 shares494.50Babcock International Group PLC1,000.00 shares1,034.35Barclays PLC10,000.00 shares213.10BP plc10,000.00 shares428.50Bunzl plc1,000.00 shares1,644.00Friends Life Group Ltd10,000.00 shares296.00St. Jamess Place plc10,000.00 shares668.00Whitbread plc1,000.00 shares4,136.26Associated British Foods plc1,000.00 shares2,569.00After a week, we found some of our stocks performing bad outcomes so we must need to hedge using options. Since we have bought stocks, so we must long put in case price decreases. Giving the example of Aviva plc. On the 17th Oct, we bought one share of 494.5 pounds. After several days, we found its price went down a little. So we were worried about this and decided to long put option. We checked the Yahoo. Finance website to find a number of options on the Aviva. Looking back and forth, we decided to choose the option CUA traded in Liffe, option contract name is GB0002162385.The strike price is 540 pounds and option fee is 12.25 pounds per share. Why we chose this option among lots of options? Because we needed to estimate the range of profit of option. Since the European put options minimum price is and maximum price is, we need to fix the strike price around the 494.5 pounds. When strike price is too small, there is no need to long the put and when too big, this option doesnt exist. So the strike price must be larger than the sum of initial stock price plus option fee, which is the CUA we chose. Graphs 2Operation process: If future stock price is higher than 494.5pounds, we will earn a profit when we only lose the 12.25 pounds and also the 0.5% fee is too small .In contrast, if the stock price is lower than the 494.5 pounds, we will start the put option and make a profit at the strike price540 pounds, the X in the long put graph. Lets assume that future price is 480 which is lower than the 494.5 pounds. We lose pounds per share. Firstly, and fee is. At the final day, and fee is . the initial cost is . Final profit is. So the net profit is. But if we have the put option acting as a guarantee then the outcome is changed. Initial cost is still 4,969,725. Final day we sell stock at the rice at 540, then final outcome is and fee is. So earning is. So net income is which is a positive outcome. Compared to the market price 480, we earned pounds per share, removing the fee is 59.7 per share. Thats the option function. Another stocks use the same strategy. The net profit was in the table 2.The first excel is showing the initial stock choice and the staring price plus the transaction fee.Table 2 Stocks Net ProfitTable 3 tells the selling day what we earned.Table 3 Stocks EarnTable 4 means the cost we paid for the option hedging.Table 4 Option HedgingTable 5 is our final stock profit. It consists of three parts. One is initial purchasing cost. Second is the selling income and the third is the option fee.Table 5 Stocks Profit What worth noticing is the BP plc stock, which is the only bad company performing a lower price than the initial price. So its also the one that needs put option to protect investors from losing too much money in the stock market. We used the strike price 440 instead of the market price 424.1 pounds to calculate the final earning .So compared to the concurrent market price 424.1, we earned pounds per share. When compared to our initial buying price 428.5, we earned 11.5 pounds, not considering the transaction fees or the option fee.We bought 10000 shares at the price of 428.5 pounds and. Transaction fee is .Total cost is pounds. When we selling it, we got and transaction fee is. So we got .Since the option price per share is 9.5 pounds, so we need to remove the pounds from our income. So the final income is pounds. Another 9 stocks are all having a satisfactory performance whose final prices are all higher than the initial price. In this circumstance, we only have to take a burden of the option fee. For example the Aviva plc stock, initial price is 494.5 pounds, leading the initial cost is . Transaction fee is pounds and the sum of cost is pounds. When we sold it at the price 506 pounds, we got pounds. Apart from the option price. The final profit is pounds.Bondsl EnvironmentAfter the financial crisis and European debt crisis in 2008, the bonds market show a depression and market supply also reduce dramatically until the latter half of 2013. In 2013, the economy of Europe started to emerge from recession. And GDP OF Great Britain has also shown a highest growth rate for the past few years (increased 1.9%). Therefore, we expected the bonds we bought at October can gain profit in total. However, out of our calculation, the economic environment is not stable, indeed, majority of bond present a significant decline since the early November. l Risk preference: risk aversionWe bought both long-term and short- term bonds to spread risk. Meanwhile, we contracted the portfolio by technical analysis. Through these two approach we bought ten bonds from London exchange stock. l The stock we select in round 1:Table 6SymbolNameTypeDate Shares Price() cost(including fee) T19GB00B39R3F844 1/2% 19Oct 17, 2014100,000.00113.2011,320,500.57TR27GB00B16NNR784 1/4% 27Oct 17, 201410,000.00120.551,205,550.60TR32GB00048930864 1/4% 32Oct 17, 2014100,000.00122.2612,226,500.61T40GB00B64605054 1/4% 40Oct 17, 2014100,000.00125.2112,521,500.63TR38GB00B00NY1754 3/4 38Oct 17, 201410,000.00133.661,336,650.67TS20GB00B058DQ554 3/4% 20Oct 17, 2014100,000.00116.3811,638,500.58T16GB00B0V3WX434% 16Oct 17, 2014300,000.00106.1731,852,500.53We spend 96258800 in total. (See table 6)l Reason for selection:Generally, in this August the bond market in UK fall in the bottom since last August. So we highly expect the bond market could be recovered in the last half year. With T19 and T40, for example, we made the decision to buy T19 based on the past 3 months. At 06th Oct it showed a strong upward trend above the support2 line. And it went up a lot than MA1 and MA2, the moving average line. So it will catch the resistance2 line in future for it had a low volatility of 0.1628.the performance (ytd) of 1.17% and performance(weekly) 0.18% both are higher than UK FTSE ALL Share which are -0.92% and -0.31%. In addition, it has a short period, relatively. Although the impact of government bonds period for short-term holding turns out to be small, we still more inclined to the less period ones. In the respect of T40, we also focus on the last 3 months. At 13Oct it shows a strong upward trend above the support 2 line. And it went up a lot than MA1 and MA2, the moving average line. So it will catch the resistance2 line in future for it had a low volatility of 0.3655.the performance(ytd) of 10.27% and performance(weekly)0.38% both are higher than UK FTSE ALL Share which are 7.49% and -0.31%.Unfortunately, from October to November, the price of whole government bond market decreased. The bonds we bought also got a heat. We think it may caused by the drop of GBP exchange rate, the decline of commodity price and the decrease of consumer price inflation. However, the situation came better in half of November. Gross value of the bonds we select in rise. And according to the claim requirements, we bought two futures for hedging: WBZ4 Commodity and GZ4 Commodity. Symbolcost(including fee)Sell PriceTotal Sellname of futuresvalue per futurescost of futures（include fee）selling pricetotal value of futuresGain of futureT19 11,320,500.57 113.41 11,341,300.00 WBZ4 Comdty 103,980.00 2,567,364.05 103,930.00 25,661,295.06 12345.47TR27 1,205,550.60 122.78 1,227,750.00 G Z4 Comdty 117,140.00 147,993.37 117,640.00 1,486,250.67 -6316.94TR32 12,226,500.61 125.19 12,519,300.00 G Z4 Comdty 117,140.00 1,885,782.72 117,640.00 18,938,319.92 -80492.7T40 12,521,500.63 128.92 12,892,000.00 G Z4 Comdty 117,140.00 2,530,304.28 117,640.00 25,411,046.23 -108,003.43 TR38 1,336,650.67 137.44 1,374,350.00 G Z4 Comdty 117,140.00 250,964.27 117,640.00 2,520,354.88 -10,712.15 TS20 11,638,500.58 116.60 11,659,800.00 WBZ4 Comdty 103,980.00 3,166,415.73 103,930.00 31,648,931.21 -15,226.08 T16 31,852,500.53 105.94 31,782,900.00 WBZ4 Comdty 103,980.00 3,182,837.25 103,930.00 31,813,067.50 -15,305.05 TR30 1,284,350.64 131.27 1,312,720.00 G Z4 Comdty 117,140.00 181,660.79 117,640.00 1,824,361.88 -7,754.00 TR37 1,389,450.69 144.64 1,446,400.00 G Z4 Comdty 117,140.00 220,164.13 117,640.00 2,211,038.78 -9,397.48 TR22 11,487,500.57 115.66 11,565,800.00 G Z4 Comdty 117,140.00 871,833.08 117,640.00 8,755,544.12 -37,213.30 We bought sell futures for two bonds: TS20 and T16, because they fall in price (use for stop loss). On contrary, the rest ones we bought put futures and expect put futures can bring a higher profit. And through the calculated hedging ratio we drive the consequence of the future number we need to buy.Table 7Actually, we have a deficit in this turn of hedging, we loss 278075.644. However, due to the gain of the bonds, in the end, we make a profit at 4568502.16. (See table 7)CommoditiesWe have 100 million pound to purchase for commodities First we choice Brent Oil at International Petroleum Exchange (IPE). In year 2013, human use 91 million barrel (91,170,000) every day. Since June 2014, the international oil price go down more than 20%. There are many reason effect the price like ISIS attack in the Iraq, America and Europe sanction against Russia, surplus of oil production in most oil-producing country and United States product more shale oil. There are five commodity market and two future market have oil exchange. Brent oil is exchange at IPE, Wext Texas Intermediate is exchange at New York Mercantile Exchange (NYMEX), the crude oil price in Dubai and daily package price from Organization of the Petroleum Exporting Countries (OPEC) are all go down. But the price must be stopped go down. If it continue, there are many problem will happen like Venezuela debt default, the highest financial deficit in Saudi Arabia history. We believe the oils repaid will return. Second we choice copper at London Metal Exchange (LME). 70% of the copper production trade in the world is in accordance with the LME official market. We use technical analysis to analysis in nearly three mouth the copper price. And it has a sign of double bottoms. We think the price rise in a sort team.Third we choice aluminium at LME. Aluminium is the largest consumption light metal, which production and combustion is second only to steel, is the second metal in the world. In 2013, the production of aluminium reached 46.5 million tons. After technical analysis, we decided to buy aluminium.Fourth we choice silver. At year 2011, there are currently about 137,400 tons of silver keep in reserve, and is increased about 2% annual growth rate. The supply of silver annually is 4,200 tons. The annual output of new silver is hold about 62% of annual supply. Because of silver is oversupply, and after technical analysis, we decided sell short of silver.All of detail of commodities we choice is at the following table 8 (include other six commodities that we choice based on technical analysis and world situation). Table 8NameTypesharesPrice($)cost(inclusing fee)ETFS COMMODITY SECURITIES LIMITED ETFS CORNBuy1,000,000$1.23$1,236,150.ETFS COMMODITY SECURITIES LIMITED ETFS WHEATBuy1,000,000$1.07$1,075,350ETFS COMMODITY SECURITIES LIMITED ETFS LEAN HOGSSell Short-1,000,000$1.02$1,028,115ETFS COMMODITY SECURITIES LIMITED ETFS ALUMINIUMBuy1,000,000$3.43$3,447,150Pacific Ethanol IncBuy1,000,000$11.11$11,165,550ETFS COMMODITY SECURITIES LIMITED ETFS DAILY LVG SUGARBuy1,000,000$10.42$10,472,100ETFS COMMODITY SECURITIES LIMITED ETFS COCOABuy1,000,000$3.67$3,678,300ETFS COMMODITY SECURITIES LIMITED ETFS DAILY LVG COPPERBuy1,000,000$10.34$10,391,700ETFS COMMODITY SECURITIES LIMITED ETFS DAILY LVG SILVERSell Short-1,000,00$9.95$9,999,750ETFS OIL SECURITIES LIMITED ETFS BRENT OILBuy1,000,000$55.27$55,546,350The total cost is 108,040,515 million United States Dollars. (68,170,636.32 million pounds) (See table 8)Currency SwapsSince July 2014, the rate of GBP/USD is go down from 1.71607. Because of appreciation of exchange rate so we decide do not use currency swaps to protect our asset. FuturesWe have 10 million pound to purchase for features.Our strategy is not only us futures to hedge commodities, but also increase the value because of leverage effect.First we choice Crude Oil Brent (CBZ14) at Intercontinental Exchange (ICE). As it is a hedge and the prices of crude oil and world situation do not have a sign it will raise up. The future contract is 1000 barrel (42,000 US liquid gallon). We decide sell short 1,000 contracts. Because the delivery date is at December 2014, so we buy 1,000 amount at the last trading day.Second we choice is Grade A Copper (LME: CAD) at LME. It is continuous. The future contract is 25,000 pounds and we buy the copper commodity, so that we sell short 40 contracts.Third we choice US SUGAR NO.11 (ICE US) at NYE. The size of contract is 112,000 pounds, so we sell short 9 contracts.Table 9 Futures (code)QUALITYTy