Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

During the credit crisis that started in July 2007 there was a flight to quality, where financial institutions and investors looked for safe investments and

During the credit crisis that started in July 2007 there was a ‘‘flight to quality,’’ where financial institutions and investors looked for safe investments and were less inclined than before to take credit risks. Financial institutions that relied on short-term funding experienced liquidity problems. One example is Northern Rock in the UnitedKingdom, which chose to finance much of its mortgage portfolio with wholesale deposits, some lasting only 3 months. Starting in September 2007, the depositors became nervous and refused to roll over the funding they were providing to Northern Rock, i.e., at the end of a 3-month period  they would refuse to deposit their funds for a further 3-month period. As a result, Northern Rock was unable to finance its assets.It was taken over by the UK government in early 2008. In the US, financial institutions such as Bear Stearns and Lehman Brothers experienced similar liquidity problems because they had chosen to fund part of their operations with short-term fund.

 

Mr Rebello portfolio manager for Milestone Funds is well aware of what is stated above.  He fears that similar scenes will play debilitating role in  the prevailing Covid pandemic scenario. His fear is vindicated by the recent poor performance of mutual funds and one of them being on the verge of bankruptcy.

 

Milestone Funds is a major private fund. It receives money from wealthy private investors and invests in equity securities in the Indian stock market. Its aim is to provide positive return to the investors even when the market is doing poorly, and it uses derivatives securities to hedge the equity price risk. On July 1, Mr.Rebello is considering as to what he should to do hedge his portfolio, as it is envisaged that the Indian market might not do well over the next six months. The value of the portfolio on July 1 is INR 500 million. He has collected the following information, which is tabulated as follows:

Table 1 Sector-wise Portfolio Composition on June 1

Sector

Percentage Investment

Banking

22%

IT

26%

CFMG

12%

PSE

10%

Energy

5%

Pharma

5%

Industrial

20%

 

Table 2 Top Securities in the Portfolio and Percentage Investment

 

Company

Percentage Investment

Reliance

2.6%

Tata Power

2.4%

Mahindra and Mahindra

2.0%

Tata Motors

1.6%

Bharti Airtel

1.2%

ONGC

1.0%

 

Mr Rebello is considering both index futures and single stock futures to hedge the portfolio. He has collected information on single stock futures and stock index futures in the NSE on July 1. Table 3 provides details of the futures on the NSE on July 1.

Table 3 Details of the Futures on the NSE

Name of Futures

LotSize

Current Spot Value (INR)

Price of Futures Expiring on September, 30 (INR)

Price of Futures Expiring on December, 30

(INR)

S&P CNX Nifty

50

5,395

5,269

5,222

Bank Nifty

50

8.975

8,484

8,740

CNX IT

100

5,325

4,952

5,262

Reliance

700

2,245

2,090

2,153

Tata Power

200

1,460

1,370

1,411

Mahindra and Mahindra

312

940

837

862

Tata Motors

850

590

497

512

Bharti Airtel

500

480

446

460

ONGC

225

1,285

1,198

1,233

 

He has estimated the following information about his portfolios in relation to the indexes, as shown in Table 4:

Table 4 Relation Between Portfolio Owned and Indexes

Correlation between the total portfolio with CNX Nifty

0.60

Correlation between banking sector portfolio owned and Bank Nifty

0.96

Correlation between IT sector portfolio owned and CNX IT

0.98

Beta of total portfolio with respect to CNX Nifty

1.25

Beta of banking sector portfolio with Bank Nifty

1.02

Beta of IT sector portfolio with CNX IT

0.97

Risk-free rate

6%

 

 

Mr Rebello is looking at the following hedging possibilities:

▪ Hedge only the IT-sector portfolio with the CNX IT futures

▪ Use all of the hedges above.

 

The expected values of the various spot values on September, 30and December, 30 are shown in Table 5:

 

Table 5 Spot Values of Various Assets on September, 30 and December, 30

 

Name of the Futures

Spot Price on September, 30 (INR)

Spot Price on December, 30 (INR)

S&P CNX Nifty

5,120

5,180

Bank Nifty

8,438

8,695

CNX IT

4,937

5,300

Reliance

2,150

2,142

Tata Power

1,340

1,425

Mahindra and Mahindra

820

890

Tata Motors

522

495

Bharti Airtel



470

420

ONGC

1,220

1,156

 

Required:

For each of the strategies listed above, 


Calculate and tabulate the expected value of the portfolio on September, 30 and December, 30.

Step by Step Solution

3.44 Rating (144 Votes )

There are 3 Steps involved in it

Step: 1

The solution ... blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Document Format ( 2 attachments)

PDF file Icon
63620442f350c_234478.pdf

180 KBs PDF File

Word file Icon
63620442f350c_234478.docx

120 KBs Word File

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Financial Markets and Institutions

Authors: Jeff Madura

12th edition

9781337515535, 1337099740, 1337515531, 978-1337099745

More Books

Students also viewed these Accounting questions