Use the following case in answering Problems 10 – 15 :
Mark Washington, CFA, is an analyst with BIC. One year ago, BIC analysts predicted that the U.S. equity market would most likely experience a slight downturn and suggested delta-hedging the BIC portfolio.
As predicted, the U.S. equity markets did indeed experience a downturn of approximately 4% over a 12-month period. However, portfolio performance for BIC was disappointing, lagging its peer group by nearly 10%. Washington has been told to review the options strategy to determine why the hedged portfolio did not perform as expected.
BIC owns 51,750 shares of Smith & Oates. The shares are currently priced at $69. A call option on Smith & Oates with a strike price of $70 is selling at $3.50 and has a delta of .69. What is the number of call options necessary to create a delta-neutral hedge?
The call option is a financial instrument that provides the buyer the right to attain an asset at a specified price within the specified timeline.
Number of call options for delta hedge = No. of shares / delta
= 51,750 / $0.69
= 75,000 options
A manager is holding a $1 million bond portfolio with a modified duration of eight years. She would like to hedge the risk of the portfolio by short-selling Treasury bonds. The modified duration of T-bonds is 10 years. How many dollars’ worth of T-bonds should she sell to minimize the risk of her position?
In each of the following cases, discuss how you, as a portfolio manager, could use financial futures to protect a portfolio.
a. You own a large position in a relatively illiquid bond that you want to sell.
b. You have a large gain on one of your long Treasuries and want to sell it, but you would like to defer the gain until the next accounting period, which begins in four weeks.
c. You will receive a large contribution next month that you hope to invest in long-term corporate bonds on a yield basis as favorable as is now available.
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