Seeking Alpha
Portfolio strategy
Profile| Send Message|
( followers)  

A 'Relatively Safe' Bank Loses Almost A Quarter Of Its Market Value

In a Seeking Alpha article written on October 26th ("Hedging 6 'Relatively Safe' Foreign Banks"), we screened VectorVest for the foreign bank stocks in its universe that had the highest Relative Safety rankings. We noted that, although these banks had the highest Relative Safety rankings among foreign banks, the 'safest' bank at the time, Brazil's Itau Unibanco Holding S.A. (NYSE:ITUB), only had a Relative Safety score of 1.20 on a scale from 0 to 2.

India's ICICI Bank Ltd. (NYSE:IBN) had a slightly lower Relative Safety score at the time: 1.09. In that article, we included a screen capture of the optimal puts to hedge it against a greater-than-20% decline. As the chart below shows (click to enlarge images), IBN declined by more than that -- 24.2% -- between October 26th and Monday's close.

Hedging IBN -- Then And Now

In this post, we'll look at the current optimal puts to hedge ICICI Bank Ltd. against a greater-than-20% drop over the next several months, and also the current costs of hedging a few other foreign banks for comparison. Before that, we'll take a look at how a previous hedge on ICICI Bank Ltd. against a greater-than-20% decline reacted as the underlying stock fell more than 24%. First, a reminder about optimal puts and decline thresholds.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" is the maximum decline you are willing to risk. Another way of thinking about it is this: the percentage you can tolerate losing. In this case, since we're using 20% as a decline threshold, we are indicating that we could tolerate a 20% loss, but not a loss greater than that. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

The Optimal Puts To Hedge IBN On October 26th

These were the optimal puts to hedge 100 shares of IBN against a greater-than-20% drop over the next several months on October 26th.

The ask price of those put options was $2.10. As the screen capture above shows, to be conservative, Portfolio Armor calculated the initial cost of the options contract (1 contract = 100 put options) on that ask price. In practice, though, an investor could probably have purchased those puts at some price between the bid and the ask price.

The screen capture below shows those same put options as of Monday's close. Note that the bid-ask spread of $4.75 by $4.85.

Limiting Downside With A Hedge

Here's what our hypothetical IBN investor's underlying stock + option hedge would have looked like on October 26th:

Option Hedge: 1 contract (100 puts) of IBN120317P00030000 at the ask of $2.10 = $210

Underlying Stock: 100 shares of IBN @ $34.81 per share = $3,481

Total on October 26th = $3,691

And here's what our hypothetical IBN investor's combined position (underlying stock + option hedge) would have looked like on Monday, December 12th:

Option Hedge: 1 contract (100 puts) of IBN120317P00030000 at the bid price of $4.75 = $475.

Underlying Stock: 100 shares of IBN @ $26.31 = $2,631

Total on December 12th = $3,106

Net Decline Of Hedged Position As IBN Drops 24.2%: 15.8%

Remember that, on October 26th, by buying the optimal puts to hedge against a greater-than-20% decline, our hypothetical IBN investor was indicating that he was willing to tolerate a 20% decline-- but not a larger one. Let's say he decided to sell both his shares and his hedge on Monday, December 12th, after the stock had declined 24.2% from October 26th. What loss would he have incurred? The difference in value between his combined positions on October 26th and December 12th was ($3,691 - $3,106) = $585, which represents a 15.8% decline. So, in this case, the hedge he bought to protect himself against a greater-than-20% decline would have actually protected him against a greater-than-15.8% decline, when the underlying stock had dropped by more than 24%.

The Optimal Puts To Hedge ICICI Bank Ltd. Now

Below is a screen capture showing the optimal put option contract to hedge 100 shares of IBN against a greater-than-20% decline as of Monday's close. Note that this is a different options contract, with a later expiry date, and lower strike price than the one in the screen capture above, as this is a hedge against a 20% drop from a lower share price. Note also that the cost of hedging has increased as the underlying stock has dropped.

Hedging Costs As Of Monday's Close

The hedging costs in the table below are as of Monday's close, and are presented as percentages of position value. They have been rounded up to the nearest 10th of a percentage point. There were no optimal contracts for HDFC Bank Limited (NYSE:HDB) or Bancolombia, S.A. (NYSE:CIB) because the cost of hedging each of those banks against a greater-than-20% decline was itself more than 20% of position value.

Symbol

Name

Hedging Cost

(ITUB)

Itau Unibanco Holding S.A.

9.78%**

(NYSE:BBD) Banco Bradesco, S.A. 13.7%**

(HDB)

HDFC Bank Limited

No Optimal Contracts

(NYSE:BAP) Credicorp, Ltd. 7.51%*
(IBN) ICICI Bank Ltd. 11.0%**
(CIB) Bancolombia, S.A. No Optimal Contracts

*Based on optimal puts expiring in May, 2012

**Based on optimal puts expiring in June, 2012

***Based on optimal puts expiring in July, 2012

Source: Limiting The Downside Risk Of Investing In Foreign Banks