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How can you Use Index Options to Hedge a Diversified Equity Portfolio?

Index options can be used to hedge equity portfolios, comprising different shares of one index, against a drop in prices.What is important here is that the portfolio to be hedged often does not correlate exactly with the index. To determine whether an index option can be used for hedging, and to determine the amount of options to be bought, the following factors must be taken into account:

The correlation measures the linear relationship between two variables such as a share and an index, for instance.The result, the (correlation) coefficient, can lie between

  • +1 = high correlation, performance of index and share are identical;
  •   0 = no correlation between price movements;
  • -1 = directly opposing movements.

A high correlation is required, if a portfolio is to be hedged with an index option.

The beta indicator measures the relative strength of the price movement of an individual share or portfolio compared to the index over a certain period of time.The Beta can be

  • higher than 1 (share fluctuates more than the index),
  • equal to 1 (share and index fluctuate to the same extent),
  • below 1 (share fluctuates less than index).

On the basis of the assumption that beta factors will remain constant in the future, more (beta >1) or less (beta < 1) options are bought for the hedge.

The number of index put contracts to be bought can be determined as follows:

Hedge ratio

 

Hedge ratio  =  Portfolio value x portfolio beta
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Index level x index multiplier

  

500,000 x 1,1  =  1.62
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6,500 x 5

 17 DAX put contracts with an exercise price of 6,500 are bought.

Alternatively, put contracts with a lower exercise price could also be purchased. See also "What are the advantages of hedging with an out-of-the-money put?" Falling share prices Constant share prices Rising share prices

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