During the credit crisis that started in July 2007 there was a flight to quality, where financial
Question:
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.
Expert Answer:
