QUESTION 1 (Mid-Term June 2020) (26 MARKS)

Aaron who is a university graduate and currently hold high-paying jobs. He is an avid investor in the stock market for a couple of years and his portfolio currently worth nearly RM200 million. Started from last March 2020, the market is declining due to Covid 19. He feels fear about this condition and need to protect his portfolio before the market going down further. He has studied the market and economic news very carefully. He believes this situation will last for long period of time and since it affects not only to Malaysia economic but globally as well.

Assume he decides to hedge 85% of his portfolio with three months futures contract on the Kuala Lumpur Composite Index (KLCI), Today is early of March 2020 currently is trading at 1,368. The spot month, the next month, the next two months and the next three months for KLCI futures are traded at 1,380, 1375, 1363 and 1,357. Currently the beta is twice volatile than the market.

Required

1. What do you think should Aaron do to protect his investment?

(3 marks)

2. Outline appropriate hedging strategy he should enter and why?

(3 marks)

(CLO3:PLO5:C4)

3. Analyze either he able to get benefits from this hedging if after three-months, unexpectedly both markets converged at 1,381.

(10 marks)

4. If the market is recovery before his expectation, what is(are) the possibility(ies) could be occurred to his portfolio? Support your argument with example (if any).

(4 marks)

e. What is(are) the differences between hedging and spreading? Do you think Aaron can enter as a spreader as in the above case?