Case: JIM AND POLLY PERNELLI TRY HEDGING WITH MARKET-INDEX FUTURES
Jim Pernelli and his wife, Polly, live in Townsville. Like many young couples today, the Pernellis are a two-income family; Jim and Polly are both university graduates and hold well-paying jobs. Jim has been an avid investor in the sharemarket for a number of years and over time has built up a portfolio that is currently worth nearly $175 000. The Pernellis' portfolio is well diversified, although it is heavily weighted in shares of high-quality, large companies. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading. Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that's the problem, because Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and doesn't believe the retreat will be of major magnitude or cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the shares in his portfolio will be adversely affected by these market conditions-though they certainly won't all be affected to the same degree (some will drop more in price than others). Jim has been following market-index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use the ASX 200 Index futures contract as a way to protect (hedge) their portfolio of shares.
QUESTIONS
1. Explain why the Pernellis' would want to use market-index futures to hedge their share portfolio, and note how they would go about setting up such a hedge. Be specific.
a. What alternatives do Jim and Polly have to protect the capital value of their portfolio?
b. What are the benefits and risks of using market-index futures for such purposes (as hedging vehicles)?
2. Assume that ASX 200 futures contracts are currently being quoted at 3256. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?
a. Say the value of the Pernellis' portfolio dropped 12% over the course of the market retreat. To what level must the market-index futures contract move in order to cover that loss?
b. Given that a $7000 margin deposit is required to buy or sell a single ASX 200 futures contract, what would be the Pernellis' return on invested capital if the price of the futures contract changed by the amount calculated in part (2a)?
3. Assume that the value of the Pernellis' portfolio declined by $32 000, while the level of an ASX 200 Index futures contract moved from 3256 to 2776. (Assume that Jim and Polly short sold two futures contracts to set up the hedge.)
a. Add the profit from the hedge transaction to the new (depreciated) value of the share portfolio. How does this amount compare to the $175 000 portfolio that existed just before the market started its retreat?
b. Why did the market-index futures hedge fail to give complete protection to the Pernellis' portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.
4. What if, instead of hedging with futures contracts, the Pernellis decide to set up the hedge by using futures options? Now, suppose a put on the ASX 200 Index futures contract (strike price = 3250) is currently quoted at 58, and a comparable call is quoted at 23.5. Use the same portfolio and futures price conditions as set out in part 3 to determine how well the portfolio would be protected.