Future Contract Hedging

Given Information

Value of Equity Portfolio = HKD 360mn = HKD 360,000,000

Hang Seng Index closing value (June 1 2015) = 29,800

Hang Seng Index Futures (September contract) = 30,000

Contract Multiplier = HKD 50

Margin Requirement = HKD 91,850 per contract

Answer to Part (a)

As Alex is already holding an equity portfolio (is long on his portfolio) and would like to hedge his investment against any market correction, Alex should go short on Hang Send Index Futures

Value of the Portfolio = HKD 360,000,000

Value of one HSI September Futures contract = HKD 50 * 30,000 = HKD 1,500,000

As nothing is mentioned, we assume that the Equity portfolio mirrors the Hang Seng Index and has a Beta of 1. Which implies that the return on the portfolio has a linear relationship with the index

Number of contracts to hedge = Optimal Hedge Ratio * (Current portfolio value/Value of one HIS September contract)

Since, the Beta of the portfolio is 1, the optimal hedge ratio will be 1

Number of contracts to be shorted = 1 * (360,000,000/1,500,000) = 240

Margin to be deposited = 240 * 91,850 = HKD 22,044,000

Answer:- Alex should short 240 contracts of September HIS Futures by paying the required margin of HKD 22,044,000 in order to hedge his portfolio against market fall

Answer to Part (b)

Settlement Price of HIS September Futures on July 10 2015 = 28,800

Alex’s gain on short position of index futures = (30,000-28,800) * 50 * 240

= HKD 14,400,000

Thus, without taking the portfolio value into account, Alex’s profit from shorting of HSI futures contract is HKD 14,400,000 (Note:- The margin money deposited for getting into the contract gets refunded when the trade is in profit and gets adjusted in the event of a loss. So, Alex will get his margin money back and the calculated figure here is his net profit from shorting of index futures)

Explanation of Hedging Mechanism...