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Hedging Canadian Content against a Global Break Down

Richard Croft
July 9, 2012
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4 minutes read
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First the backdrop…

We rarely hear much out of the fringe countries in the eurozone but last week, Finland’s Financial Minister Jutta Urpilainen shared an incisive point of view. She intimated in the Finnish financial daily Kauppalehti, that her country will not be a part of an “integration model in which countries are collectively responsible for the debts and risks of member states.”

Coming from one of the few countries in the eurozone to retain its triple-A credit rating, that position effectively kills any notion that Eurobonds are a politically palatable solution. And reinforces the following points I made in my June 18th post “Grease!”…

Greece is simply the poster child that marks out the chasm between have and have not States revealing the eurozone for what it is… economically incompatible. In time it will become politically unpalatable as economics will cause the electorate in the “have” States to reject further handouts.

Beyond that, Ms. Urpilainen may have “unintentionally” revealed a point of view that maybe the only way to save the eurozone is to ensure that weaker members exit the eurozone… either by choice or by force! In my mind, if eurozone leaders could move that line to reasoning to center stage it may actually stabilize the crisis and restore global growth.

Unfortunately the feigned poker faces of eurozone leaders is an attempt to buy time hoping that by some process of osmosis the eurozone economy rights itself! It won’t of course, but until politicians are faced with economic reality in the form of a disintegrating “euro currency” global markets – particularly commodity based economies like Canada – will remain in a prolonged period of stagnation.

Now for some investment possibilities…

To hedge yourself in the current backdrop you might want to look at the new SXO index options which is the mini index option contract on the S&P/TSX 60 index. The index closed last Friday at 666.45.

Typically the cost of an option is calculated as the per share price multiplied by 100. Unfortunately when dealing with options on a high priced underlying instrument such as the S&P/TSX 60 index, that can be quite expensive. While it works well for large institutional traders it is not of much use to retail investors.

The SXO mini contract deals with the cost issue by changing the underlying multiplier from 100 to 10. So, for example, the SXO August 670 calls with a closing bid of $14.45 translates into a value of $144.50 per contract ($14.45 x 10 = $144.50 per contract) as opposed to the typical $1,445.00 per contract.

You can use SXO to hedge your Canadian portfolio (i.e. buying puts) to enhance your cash flow (i.e. short call strategy) or to replace your current Canadian portfolio with a limited risk call option (i.e. stock replacement strategy; long call).

To calculate how many contracts would be required to hedge, overwrite or replicate your Canadian content, use the following formula;

Number of SXO option contracts = Portfolio value x Beta of the portfolio
S&P/TSX 60 strike x $10

Putting the formula into practice, if your Canadian portfolio is valued at $100,000 with a beta of 1.2 (i.e. your portfolio is approximately 1.2 times as volatile as the Canadian index), the number of required SXO contracts that matches your portfolio is 18 (rounded) calculated as follows;

$100,000 x 1.2
670 x $10
= $120,000
$6,700
= 17.91

In the current environment, traders might consider using SXO options to hedge their exposure to the eurozone chaos by purchasing SXO puts or selling SXO calls against a Canadian portfolio.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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