Morningstar Advisor - Winter 2008 - (Page 23) choose between a known cash flow today and an uncertain outcome over a time horizon. From a portfolio-management perspective, the ability to buy or sell the upside or downside relative to a predetermined value and the ability to trade cash flow today for a range of future expected returns are very powerful concepts. Between the abilities to adjust the bounds of risk and to adjust the timing of cash flows, investors can simultaneously manage the risk/return trade-off of a portfolio and the timing of the cash flows of those returns. Let’s solidify these concepts with an example. I’ll keep things simple by discussing only stocks and options, ignoring fixed-income investments. If we put 100% of a stock portfolio in a market index fund, we have a broad range of outcomes in the short term. We can bound those outcomes by selling the upside and using the proceeds to buy protection from the downside. Let’s say that bounding the outcomes down to zero risk generates the Treasury rate of return of 5% over the duration of the option. This 5% return is shown on the probability distribution of outcomes for the index, at left (graph A). Now, if we’re willing to accept more risk, we can relax those bounds, selling the upside above, say, a 15% return over the next year and using the proceeds to buy downside protection against a decline of more than 5% (graph B). As we can see, we’ve accepted some risk, highlighted in red, no more than 10% downside relative to Treasury rate, in exchange for the chance for an additional 10% upside above the Treasury rate, highlighted in green. Further, by shifting this band around relative to today’s price, we can generate some cash today in exchange for accepting more risk or giving up upside. For example, we could sell the upside above a 10% return, pay for our downside protection below a 5% drop, and keep the remaining proceeds from the sale of the upside and generate a few percentage points of cash flow today (graph C). We can see that we’re selling a little wedge of our upside for cash today. The cash we get is equal to the net area that we’ve sold of the probability distribution. As we can see, options allow the management of both the risk/return profile and cash flows of the same portfolio. We can also use index options as a hedge to MorningstarAdvisor.com 23 http://MorningstarAdvisor.com
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.