Single Stock and Custom Basket Options in Fund Management

Abstract

This report provides an overview of the utility of single stock and custom basket options in fund management. It is shown that managers of active equity funds can limit possible negative return contributions of their over - and underweight positions via single stock options and thus help to hedge against underperformance of the fund relative to the benchmark.We highlight the fact that non-index equity portfolios are imperfectly hedged by index derivatives. In this context we describe an analysis that helps to quantify the risk associated with a portfolio-underlying mismatch, and discuss how this risk can be addressed via an option or future on a custom basket of stocks.We also discuss challenges in pricing single stock options and provide an overview of a single stock volatility skew calibration system developed at Peregrine Securities that addresses an important need for accurate volatility estimates. Using these single stock volatility skews, we are able to implement a simple procedure for the calculation of implied volatility for options on custom baskets.