A German investor holds a portfolio of British stocks. The market value of the portfolio is £20 million, with a ? of 1.5 relative to the FTSE index. In November, the spot value of the FTSE index is 4,000. The dividend yield, euro interest rates, and pound interest rates are all equal to 4% (flat yield curves).
a. The German investor fears a drop in the British stock market (but not in the British pound). The size of FTSE stock index contracts is 10 pounds times the FTSE index. There are futures contracts quoted with December delivery. Calculate the futures price of the index.
b. How many contracts should you buy or sell to hedge the British stock market risk?
c. You believe that the capital asset pricing model (CAPM) applies to British stocks. The expected stock market return is 10%. What is the expected return on this portfolio before and after hedging?
d. You now fear a depreciation of the British pound relative to the euro. Will the strategies above protect you against this depreciation? (Assume that the margin on the futures contract is deposited in euros.)
e. The forward exchange rate is equal to 1.4 € per £. How many pounds should you sell forward?