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Required: Assume that you are a recently appointed hedge strategist with GFML and that you have been requested to prepare a report for presentation to GFML's Investment Strategy Committee at its next meeting. You have been specifically requested to address the following issues:
(a) To identify and list the specific financial risk exposures faced by GFML with respect to the asset categories listed in the above schedule (please limit the financial risks to what is taught in this unit). Bear in mind that GFML is an Australian based fund and that most of its investors are Australian residents. In this section you MUST discuss the outlook (forecast) for the each underlying
variable and the related risk exposure. You need to provide adequate justification for your responses.
(b) To make firm recommendations on whether or to hedge all, part or none of the exposures identified in part (a) above. You MUST provide some explanation for each of your recommendations. (You are not required to specify the type of derivative to be used to hedge in response to this question).
(c) To make recommendations on which derivative instruments (for example, options, futures, etc) to use to implement the hedges that you have recommended in part (b) above. Once again, you MUST explain your recommendations. You are NOT required to propose details of how to implement your hedge recommendations in this part.
(d) Independently of your responses to part (d), propose ONE option 'spread or combination strategy' that involve more than one option contract for the Australian equities portfolio. GFML's management has expressed a desire to retain some of the upside benefits that hedging with options can permit but without paying a lot of money in option premiums. That is, your recommended strategies should provide a 'reasonably effective' hedge but keep the option premium payment limited to a 'reasonable amount' (it does not have to be zero!). As the strategist, it is up to you what you consider 'reasonable' for this purpose. You must also describe the benefits and possible shortcomings of your proposed option strategies. You need to use actual prices from the ASX website.
This assignment analyses the various types of risk faced by different asset classes which investors hold. It deeply reflects upon the suitability of futures contracts and options contracts under different circumstances and the risk requirements of the investors. Moreover, a bull call option strategy has been proposed which combines two types of call options to bring down the cost of hedge. The benefits and drawbacks of such strategies have been emphasized.
Identification of risk exposures under various asset classes
The various types of risks faced by GFML with respect to each asset category listed, along with justification are cited in the following points below: –
- By investing in Australian shares with portfolio beta of 1.15 with respect to S&P ASX 200 shows that the portfolio is expected to increase or decrease more than the index as the portfolio beta is more than 1 which indicates that the asset is more volatile (Bartram, Brown, & Fehle, 2009). The portfolio beta here measures the risk of the fund arising from exposure to a benchmark for the fund, rather than from exposure to the entire market portfolio.
- By investing in US shares with portfolio beta of 1 with respect to S&P 500 indicates that the portfolio is expected to move as per indices and the asset is neither less nor more volatile (Bartram et al., 2009). But the financial risk involved in investing in US shares is of exchange rate risk or currency risk (Bartram et al., 2009). GFML is an Australian based fund and most of its investors are Australian residents but their investment in US securities is in US dollars and they will receive dividends and the value of their stock in US dollars, so they are exposed to exchange rate fluctuation risk, that is, if the exchange rate changes then the amount to be received alters.
- There is no risk involved in investment in bank accepted short term bills as they are invested in Australian banks. In future, since the probability of default by government is almost zero, there's no risk exposure (Bartram et al., 2009).
- There is no risk in long term fixed interest bonds that have been invested in Australia but the amount of $30m which has been invested in US bonds are exposed to exchange rate risk (McDonald, Cassano, & Fahlenbrach, 2006). In future, if the interest rates of US fall, GFML would lose money.