Managing equity price risk : a comparison of the use of portfolio rebalancing and derivatives as risk management tools

Abstract

The last 40 years have been characterized by rash growth of volumes of international and national markets of derivative finance instruments or derivative markets. In turn, this striking expansion of derivatives suggests that market participants have been utilizing these risk management tools since they provide a widespread array of gains with respect to social, economic and financial milieus. This dissertation aims to carry out a cost benefit analysis of hedging equity price risk mainly through two main methods; portfolio rebalancing and hedging using a predetermined amount of futures contracts which make up the perfect asset price risk hedge ratio. In addition, factors that influence a rebalancing strategy are identified. Portfolio rebalancing motives are an old topic in risk management theory. They are powerful risk management strategies which mainly involve buying or selling portfolio components to ultimately achieve a desired asset allocation. Major rebalancing strategies were looked into extensively, thereby identifying the costs and benefits brought about by each strategy. The literature also debates on hedging as a risk management tool. Chapter 2 of the dissertation looks at a general overview of the financial evolution in association with a literary analysis of portfolio rebalancing and hedging with futures. A detailed observation of the various rebalancing styles is also conducted in Chapter 3. The remaining parts are based on pilot studies carried out by various analysts and comparisons between hedging using futures versus portfolio rebalancing. A look at the importance that risk management will take in the future is also taken.