Question 3. Hedging Using Derivatives

• Assume that you are a hedge fund manager, who has been investing in a stock market portfolio tracking the performance of the S&P index (e.g., through exchange-traded funds such as SPY). The value of your portfolio is about $ 1 million USD.
• Assume that the stock market is currently experiencing high volatilities and uncertainties. You predict that there will be a significant decrease in the stock market prices (with at least 20% to 30% decrease) and an increase in volatility over the next 6 months.
• Assume that you cannot sell any of the stock investments in the stock (spot) market due to market restrictions such as short-selling constraints. In addition, your clients do not want to sell their stock market investments due to transaction costs and reinvestment costs.
• There are futures and options contracts based on the underlying a stock market index (the S&P index) or SPY; these futures and options are traded in the Chicago Mercantile Exchange (CME) Group and Chicago Board Options Exchange (CBOE).

• Answer the following questions:

  Given the above information, discuss two (2) examples of derivatives trading strategies (using either futures or options) that can hedge against the risk of a significant decrease in the stock market index (the S&P index) or SPY.

  Importantly, explain your hedging strategy (including the information of the derivatives contracts, the underlying, trading position, etc.) as clear as possible.