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 exchanged traded funds such 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 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 of 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 significant decrease in 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.