An equity fund manager holds a portfolio comprising the largest UK stocks and benchmarks the FTSE 100 index.

They are concerned about the possibility of a sharp correction in UK equities within the next three months and would like you to evaluate their hedging choices.

FTSE 100 index daily prices, past twelve months. Source: Bloomberg

The fund manager has expressed a preference to use exchange-traded derivatives for liquidity and transparency.

1. Market Portfolio setup
   1. Use price data (for index and futures) of a date of your choice, between 11/05/2014 and the submission deadline. Quote the day you have chosen.

UKX

1. Size of the portfolio: Units of the FTSE 100 index held in the portfolio are your birthday times 1,000 (e.g. if you were born on 29/02/1992 the fund holds 29 x 1,000 = 29,000 units of the FTSE 100 index.
   (appropriate setup: 5 marks)

2. Hedging
   1. Explain the risk faced by the fund manager, and how futures could be used to hedge it. (15 marks)

Theory Section:

1. Index is always derivative based.
2. Why and how hedge could be used

1. Would June or September futures be most appropriate and why? (5 marks)
2. Want to make sure and protect the underlying assets (willing to take June to in comparison on September one)

1. How many futures should be bought or sold to hedge the position? Show your calculation. Use the appropriate tools to show an equation in your word processor. (5 marks)
2. It is necessary to introduce the theory before the calculation.

1. Confirm your result using the OSA (Option Scenario Analysis) function on Bloomberg. Show a screen cast of the function 32) Hedge position. What is the equivalent to the hedge ratio in the OSA function? (10 marks)

1. Show and explain, using the functions 33) Scenario Matrix and 35) Multi-Asset Scenario, the effect of your hedge on the profit and loss of your portfolio in different market scenarios. Show screen casts of your results. (10 marks)

1. Making reference to academic literature, discuss the use and limitations of the hedge ratio. (20 marks)

1. Are there any additional risks and considerations to be taken into account when using futures to hedge a portfolio in a situation like this? Discuss, making reference to academic literature. (20 marks)

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