Stocks to hedge with appropriate futures contracts case study

Assume you have AUD500,000 invested in an equal-weighted portfolio on April 1, 2022, for 3 months. The portfolio will comprise four Australian stocks: NCM, NST, EVN, and PRU all of which are from the gold exploration and production sector. Identify a major risk in your portfolio of stocks to hedge with appropriate futures contracts.

Assessment criteria:

• Identification of major risk
• Methodology for identification of major risk.
• The rationale for the selection of futures contracts for hedging.

Hedge your portfolio of Australian stocks with ASX SPI 200 Index futures over the same three months period.

Assessment criteria:

• The rationale for using the hedge ratio
• Calculation of the hedge ratio
• Correct implementation of the hedge, showing full details of transactions in a table with the appropriate narrative of all relevant transactions that may occur in the real-world investment
• Correct liquidation of positions and calculations of profit/loss
• Effectiveness of the hedge and reasons why the hedging strategy worked/failed to work as you expect
• Discuss how the hedge can be improved taking into account the shortcomings you identified above

For a better hedge, you believe it is simultaneously necessary to align with the expected future market state of the principal commodity. Using the term structure of futures contracts for the principal commodity, assess the market risk over the three months period.

Assessment criteria:

• Plotting the term structure
• Implication based on the curvature
• Potential market risk based on the curvature

Based on your analyses of the term structure, determine a target beta to hedge again with ASX SPI 200 Index futures over the same three months period. At the end of the period, close all positions and evaluate the effectiveness of your hedge. Compare the results of this hedge with that using the portfolio beta. Briefly discuss the merits/demerits of both hedging methods.

Assessment criteria:

• The rationale for using the target beta
• Correct implementation of the hedge, showing full details of transactions
• Evaluation of the strategy in comparison to the portfolio hedge earlier.
• Is one strategy necessarily superior to the other?

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