The client is assumed to have a global portfolio and his investment objective is 13% return with 5% risk. The client is hoping to potentially realize this security within 1 year that can be found in either ASX or NYSE.
China and Base Metals are 2 attractive investment opportunities
China is the best place to invest and Base Metal is the best sector to invest. Referring to the appendix table 1:IMF & table 2:Euromonitor, the global economy is growing at 3% while only China is expected to exceed 5% economic growth for 2009 and has the largest consumption rate, growing more than 5% annually. Therefore this indicates enormous potential investment opportunities. Although China has opened up its economy, foreign direct investment is heavily regulated. Therefore, investing in a market supported by China economic growth is more optimum than investing in the Chinese market. The future trend for growth will be in Base Metals (Euromonitor 2009). Base Metals such as iron and copper is rising because of 2 reasons. Firstly, the emerging nations are growing and will require base metal for building infrastructures such as road and bridges(IMF 2009). Secondly, the G8 has coordinated a fiscal spending which includes infrastructure investment to keep the economies from deteriorating(IMF 2009).
Recommendation of security: BHP
BHP is chosen because it fits the selected investment opportunities and the clients’ criteria. Refer to appendix: graph 3: Australia Mining Market Share, China imports 68.5% of the Australia Mining Industry Production (Datamonitor 2008). This implies that China expansion will propel this industry, in which BHP is the market leader. Furthermore, BHP is seeking to expand its capacity from June 2009 (E&MJ 2009), and the base metal prices have risen 40% higher overtime (Creamer 2009). In addition, BHP is listed in both the ASX and NYSE, satisfying the client’s geographical investment needs. Ben Bernanke have declared that the technical recessions are over, implying that the global economy is bottoming out (Christine Seib 2009). Given strong dependence on global economic growth, BHP economic performance is likely to grow at least close to the industry compounded annual growth rate at 13.2%(Datamonitor 2008). Deciding the market to trade affect not only the return after execution costs but also the expected return of that security in US$.
Trading with Market Understanding
Considering critical factors like the platform trading mechanism, settlement period, information asymmetry and implicit cost, trading BHP stock in the ASX is more cost effective because of lower implicit cost given other factors are not significantly different.
For the same dollar, ASX provide greater liquidity with higher turnover and greater volume of trade than NYSE because the ticks are $0.05(Zheng 2008) and $0.0625(NYSE) respectively. Moreover, trading BHP in ASX indicate lower implicit cost because its daily volume trade in ASX [14,596,700] is twice as much as one in NYSE [3,951,360]. Computed table 4 in appendix further confirms when BHP has a 3.41% greater relative bid-ask spread in NYSE over ASX. Furthermore, (Michael Aitken 1994) indicates that bid-ask spread account up to 30% of transaction cost in ASX. Neither exchange minimise significant opportunity cost for liquidating the security cost because both have the same settlement period [T+3]. Information efficiency impact the price of BHP but there is no significant difference between the 2 exchanges. Transparency is not an issue because both markets are order driven(Jones 2009) & (Zheng 2008).
Given the portfolio for trading BHP is worth at least US$20million, block trade is preferred to reduce opportunity cost and to limit market impact cost. The minimum block trade for both exchanges is $1million (NYSE 2008) & (Zheng 2008), implying the trader can trade more blocks of BHP shares in ASX than in NYSE upon considering their respective tradable values of BHP. Despite the recent introduction of NYBX to perform anonymity block trading, physical ‘upstairs’ trading is still the dominant form of block trading in NYSE. In addition, Block trading tends to be less disguised in NYSE compared to ASX (Bessembinder 2004). In other words, broker’s identities are better concealed in ASX than NYSE. Hence trading in ASX is better because stealth trading is more effective and that will reduce the market impact cost. Last, although derivatives are also traded on this portfolio, majority of the trade is BHP stock. In addition, the critical factors to trade the BHP options are not significantly different between the 2 exchanges to warrant trading BHP stock in ASX and the option in NYSE. Hence, BHP stock and its option, will be traded in ASX.
Given that BHP will be traded in AUD$, AUD/USD futures will be used to hedge the currency risk. AUD/USD futures will be traded in the Chicago Mercantile Exchange because it is the largest FX market, comparing with NYSE and ASX, to trade AUD/USD and it also generates the lowest bid-ask spread, a major composition of implicit costs. ASX has only AUD/USD warrant with only 1 warrant dealer for this security. NYSE has 80 million future contracts while CME has 5737 million future contracts. NYSE’s bid-ask spread is 9 basis points(Euronext 2009) while CME’s is 0.21 basis points(CME 2009). Unlike trading BHP stock and options, trading futures require putting in a margin worth approximately $2 million in this case to reduce counterparty risk of defaulting.
Most Effective Trading Strategy
BHP is currently trading below its expected value and its expected price range is between $35.40 and $42.4 because capital asset pricing model predicted BHP to price at $38.90, given expected risk and return is 9.0% and 14.8% respectively, considering the current trading price is $36.29(GoogleFinance 2009) as at 2nd Oct’09. Multiplying EPS by PE ratio will price BHP at $38.23(Finanalysis 2009), so further implying that BHP is worth buying now. A covered call position is recommended to cap the risk and return to meet the client’s need at 13-25% return with a risk of 5%. Shorting put exhibits the same payoff pattern as taking a covered call position but there is not enough puts to be short in the ASX market to generate a significant value of investment. Shorting the call with the exercise price from a range of $44-$49(ASX 2009) with maturity dating Sep-Oct 2010, will mean receiving that premium and also offloading BHP at maturity to lock in the return, reducing market impact cost as well as improving liquidity for cash on BHP stock. Graph 5 in appendix supports the effective employment of stealth trading at 10a.m. or 4:30p.m because these 2 slots indicate the highest trade liquidity, implying low market impact cost. Special crossings: block trades of equity, that take place off-market at any time is preferred over on-market trading because it allow transaction of more than $1 million and also allow anonymous trading before this trade is reported to ITS. Trading with more than 1 brokerage firms means more distribution channels to trade and so more possibility to trade at lower cost via information participation with them. [Refer to table 6] analysis recommend 3 brokerage firms because of their easy to trade platform, over the phone trade service and also easy to understand and low explicit costs. Since the current trading price is lower than the expected price, placing a market order will be more efficient than limit order. However, placing market order should be monitored constantly to avoid buying out of $38.90 per share. This is because ASX, an order driven market does not guarantee that $38.90 will be the price at which the trade will be executed. This is reinforced by the fact that the limit order book is governed by price-time priority. One way to improve trade is to start negotiating with the brokers at the beginning or end of the day to determine the price range and if it is within the expected price, then an order of about $1 million will be placed via special crossing at the end of the day. At the same time, if the market trade is beginning to trade above $42, the expected exit price at maturity, then a limit order can be set at $38.90 after considering all the execution cost. Such limit order helps to fill the order during on-market trading hours to lower opportunity costs overtime albeit marginally. Although BHP volume is heavily traded at the 2 time slots, BHP price range is also the widest during those periods [refer to appendix: Graph 5]. Such volatility affect limit orders to buy BHP stock at $38.90, because high volatility means the probability of limit orders getting executed is low. Prior to this, the number of call options short will pre-determine the amount of stocks to buy for 2 reasons. Firstly, this prevents naked call position where the downside risk is unlimited. Secondly, the number of call options constraint the number of stocks to buy because of the need to match delta. In addition, the number of options contracts that is available in the market is smaller, narrowing the range of stocks to buy, and so making the decision to buy the quantity of stocks easier. Currency trading should be given to Deutsche bank because it is the market leader in trading FX (Euromoney 2009), implying better FX risk management and also lower brokerage fees. In addition, the focus to making return is on the cover call position of BHP.
Dynamic hedging is done monthly by adjusting the value of stock to the number of calls shorted. Delta is the indicator for hedging, so a positive change in delta indicates buying more BHP stock and vice versa. The downside of adopting a covered call position on BHP is the entire value of the equity. To prevent that, Percent drawdown method is chosen to limit losses from trading BHP. An exit at all cost will be executed if the instrument drops in value by more than 10% for 2 consecutive days. Under this scenario, a robust analysis will be done within 24 hours to ensure that the source of this shock is systematic to avoid unnecessary material losses on BHP securities. Currency risk is also monitor by constantly watching for economic indicators such as GDP, government budget deficit and interest rate. To further cap the expected dollar return, taking a short future position on AUD for USD at the current available rate US$1.15/AUD is recommended but will also limit the upside of AUD appreciation against USD.
Performance Measurement of Trade
The average price measure and the implementation shortfall will be used to evaluate trade performance. Average price measure is chosen because it is unbiased in estimating prices by a random trader, so trade performance can be monitored over different brokerage firms’ services in executing the trade. Implementation shortfall is chosen to compensate the shortfall of the average price measure: to measure opportunity costs and this helps to review the performance of the current planned trade tactics. Pre-trade execution measurement is not effective because it can be manipulated while Post-trade execution measurement is limited to identify important implicit costs like opportunity cost and market impact cost.
Nett Expected Return
[Refer to table 9] Investing in a covered call position on BHP and shorting USD/AUD future will generate an expected return from 9.58% to 16.97% after factoring in the explicit cost of trading options and stocks. [Refer to table 7] Liquidating BHP at its expected exit price, based on the call exercise prices, gives the current range: AUD$22,825,550-$23,854,488. Note that the brokerage fee for equity is 0.15% of the equity value, indicating insignificant explicit cost as compare to the tax rate: one that tax 30% on the 50% of the capital gain(ATO 2009). After shorting the current available USD/AUD future at 0.8724 by the 23rd Sep’10 and taking out the explicit cost, the cash from selling BHP stock will be in the range: USD$19,915,390-$21,393,879. [Refer to table 8] Because each option contract stands for 1,000 shares, 507 of calls will be short. This also means that the received premium is small [US$466.17-$872.97] compare to the outlay requirement to long BHP stock as well as margin requirement to short USD/AUD future.
Summary and Conclusion
When the market upturns, investors will move in herds to invest for better returns and to hedge against inflation. Prior to that, taking a covered call position on BHP, and hedging with a currency future is the optimum choice to meet the reward-to-risk ratio: 4.33 given the upcoming economic powerhouse, China fuelling the Base Metal Industry where BHP is the leader. Therefore, the next step is to commit to this line of action by contacting Andrew, the investment manager who will roll out this action plan to assure your return will be in the range: 9.58% -16.97% after factoring in the explicit cost of trading options and stocks. In addition, loss control measures will be taken to protect 80% of the initial capital. Monthly performance review will be sent to you on the trade performance and the securities’ performance, so that the trade strategy will be effectively executed based on fundamental analysis.
|Computed Table 4: ASX and NYSE Computed Bid-Ask Spread|
|ASX Average Relative Bid Ask Spread||9.59%|
|NYSE Average Relative Bid Ask Spread||13.00%|
|ASX:BHP Avg Vol (3months):||14,596,700|
|NYSE:BHP Avg Vol (3months):||3,951,360|
|ASX: BHP Mkt Cap||212.82B|
|NYSE: BHP Mkt Cap||191.64B|
|Source: NYSE.com, ASX.com|
|Computed by Andrew Liew subject to compouding error.|
|Table 6: Brokerage Firms Fees and Selection Criteria|
|Brokers||CMC Markets||Etrade||Morrison Securities||Average|
|Brokerage Fees for Equity||0.22%||0.13%||0.10%||0.15%|
|Brokerage Fees for Option including CH fees||0.55%||0.60%||0.70%||0.62%|
|Online Trading Platform||√||√||√|
|Allow transaction > $1 million||√||√||√|
|Table 7: Breakdown of the Expected US$ Return of Equity|
|Initial Value (USD)||18,000,000.00|
|Current Exchange rate (AUD/USD)||1.10|
|Initial Value (AUD)||19,731,420.00|
|Expected Entry Price||38.90|
|Maximum Entry Price||40.00|
|Expected Traded Volume||507,234.45|
|Expected Value at Maturity||22,825,550||23,840,019||24,347,253||24,854,488|
|Nominal Exchange rate (USD/AUD)||0.8724|
|Expected Final Value||19,913,010||20,798,033||21,240,544||21,683,055|
|Maximum Expected Return||8%||13%||15%||18%|
|Minimum Expected Return||-2%||3%||5%||7%|
|Brokerage fees for equity||0.150%|
|Tax rate (50% of capital gain) @30%||0.14%||0.81%||1.15%||1.48%|
|Value after explicit cost||19,915,390||20,660,589||21,028,723||21,393,879|
|Table 8: Breakdown of Call Premium received|
|Maturity Date||24rd June 2010|
|No. of option contracts||507.23|
|Brokerage fees for option||0.62%|
|Net Value Received||1,000.65||758.68||620.05||534.35|
|Net Value Received (US$)||872.97||661.87||540.93||466.17|
|Table 9: Overview of Expected Dollar Return|
|BHP Selling Price||45.00||47.00||48.00||49.00|
|Equity Value after explicit cost||19,915,390||20,660,589||21,028,723||21,393,879|
|Option Premium after explicit cost||872.97||661.87||540.93||466.17|
|Total Value Received||19,916,263||20,661,251||21,029,264||21,394,345|
|Initial Margin Requirement for currency future||2,000,000|
|Final Value Received||21,916,263||22,661,251||23,029,264||23,394,345|
|Nett Expected Return||9.58%||13.31%||15.15%||16.97%|
ASX, 2009. Quotes on BHP options dating Jun-Oct 2010.
ATO, 2009. Tax Policy on Securities Investment in Australia. URL www.ato.gov.au/capital-gain-tax
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Euromoney, 2009. FX Poll 2009: Embattled banks boost by performance in booming FX market. In: Euromoney, Europe
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NYSE, 2008. NYSE Equities Quick Reference Guide. URL http://www.nyse.com/pdfs/nyse_equities_QRG.pdf
Zheng, J.P.a.H., 2008. An Introduction to the Securities Market. In: Reuben AFaS (ed.) An Introduction to Trade Execution, Arbitrage and Dealing in Australian Security. Perason Education, Sydney, p. 9.