FBMKLCI-HG and CN

I Hedge My Portfolio With FBMKLCI-HG. Then I Hedge FBMKLCI-HG With FBMKLCI-CN

Publish date: Wed, 7 Jan 2015, 11:21 AM 

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The continued decline of crude oil price made me nervous. Yesterday I belatedly jumped in to buy FBMKLCI-HG at 27 sen (used to buy before at 18 sen, but sold off with no profit at more or less the same price).

1. Why Buy HG ?

The purpose is to hedge my portfolio.

For discussion sake, let's assume that I have a RM1 million portfolio (RM100,000 is not a good size to demonstrate the magnitude of the problem).

In order to effectively hedge a RM1 million portoflio, I estimated that I need at least 200,000 FBMKLCI-HG (available at 27 sen yesterday).   

According to HG's conversion features (667 to 1 and exercise price of RM1,800), every 100 points decline in KLCI index should result in gain of RM15,000 (for every 100,000 HG held).

If I have 200,000 HG, every 100 points drop in Index will give me RM30,000 gain.

But why bother with RM30,000 for a RM1 million portfolio ? That is only 3% of its value !!!

The reason is because I bought HG not for small 100 to 200 points corrections. I bought it for melt down scenario such as 1997 / 1998. 

I am not afraid of KLCI Index dropping by 200 points. That kind of decline is a correction, not a crisis. The system will still be functional. I have structured my portfolio to include good quality (in my opinion) stocks with low PER, strong balance sheet and high dividend yield. As long as they continue to announce good quarterly results and declare dividends regularly, they should be able to rise against a 200 points Index decline and deliver me a surplus by end of the year.

The scenario I am trying to hedge against is the 1997 / 1998 scenario whereby the entire financial / economic system went into a seizure. Things spinned put of control, resulting in bankruptcies, bad debts, margin calls, negative economic growth and total financial meltdown.

In 1997 / 1998, the KLCI declined by 900 points from 1,150 to 250 points. If that happens again today, my humble 200,000 HG will deliver me a gain of RM270,000. Plus the RM54,000 my original principal, I will get back RM324,000.

And this RM324,000 is available for reinvestment when KLCI is at 250 level. Jut imagine the impact !!!

Of course, in today's case, the Index might never decline by so much. But you get the general idea.

2. But HG Has Flaws ....

How nice, now I can finally sleep well ?

Unfortunately, things are much more complicated than that.

According to my calculation above, I need to spend RM54,000 to effectively hedge a RM1 million portfolio.

If KLCI reverses its trend (you never know, tomorrow war might break out in the Middle East and oil price moves back to USD80 per barrel), HG might lose its entire value.

We are talking about RM54,000. In Malaysia, you can buy a family car with that. Even though I am comforted by the coverage HG provides me against total wreckage of portfolio, the possibility of losing a family car by end of the year (when HG expires) is now keeping me awake at night.

That was the exact reason why few months ago I was not able to hold on to my HG when it was trading at 18 sen. Every time the KLCI Index strengthens, I can sense butterflies in my stomach (ultimately I succumbed to the fear and liquidated it without making any profit).

And I wasn't just being paranoid. According to my observation so far, THE KLCI INDEX HAS A POSITIVE BIAS. I believe there are big players behind it that want to make sure it stay high. I don't know who they are, it could be ExF, Khaxanxh, Barixxn Naxxoxal, or god knows who.....  

By buying put warrants, I am going against big and powerful forces who have the resources and the will power to act against me.

On top of that, HG is now frothy. It is now trading at 31 sen, but according to its conversion features, its fair value now should only be 14 sen (being 1800 - 1707 / 667). The premium of 17 sen is susceptible to turn of sentiment. Without KLCI moving upwards, as long as fear is out of the picture, there is high likelihod HG will revert to its equilibium value of 18 sen to 20 sen.

All these issues are keeping me awake at night.

Until I discover FBMKLCI-CN..........

3. Using CN To Mitigate The Risk Associated With HG

CN has the follwoing conversion features :-

(1) expiring 30 November 2015 (exactly the same as HG !!!). This is considered reaosnable for me for hedging purpose.

(2) market price now 6 sen.

(3) exrcise price RM1800.

(4) coversion ratio 667 : 1.

Based on current price of 6 sen, CN is trading at premium of 7% only (being 0.06 x 667 + 1800 / 1707). I believe 3 to 4 sen is the rock bottom price (time value of money).

Based on gut feeling, I match 2 CN with 1 HG.

For 200,000 units of HG, I bought 400,000 CN.  

Based on 6 sen, cost of investment is RM24,000.

With that in place, I am at peace with myself.

Now I no more feel nervous everytime KLCI stabilises or started to strengthen (nor will I be unduly stressed when Index heads south, as HG will kick in to provide protection). 

I don't know whether the strategy makes sense or not.

It is a bit convoluted. But it defiitely makes me feel better.

I intend to keep this arrangement in place until November 2015. Beyond that, have to play by ear.

That's all for today. Have a nice day.