Workshop 7 (week 8): The cost of hedging against the 'unknowns'

In this workshop we want you to work out the cost of hedging the tail risk (the 'unknowns') of a trading portfolio.

Note that banks can and often do hedge their tail risk, say anything beyond the 99% threshold risk value (VaR) using options.To get some sense of the cost of doing so,we require you to look at (say) the equity part of the trading portfolio of the bank and estimate the cost of creating a3-month hedge.Note that some of the cost of the hedge can be reduced by also writing a call option.

Method:

1. Obtain the value of the full investment of the bank in say equities.

2. Assume that all investments are in S&P500.

3. Compute the 99% VaR(3-months). Express this as a percentage.

4. Compute the cost of buying a put option that hedges anything beyond the VaR threshold value.Quotes for S&P500 index put options with the right strike price and maturity can be obtained from the exchanges.

End.