Q-bank delta hedging question

John Williamson is a recently retired executive from Reston Industries. Over the years he has accumulated $10 million worth of Reston stock and another $2 million in a cash savings account. He hires Frank Potter, CFA, a financial adviser from Star Financial, LLC, to help him with his investment strategies. Potter has a number of interesting investment strategies for Williamson’s portfolio. Many of the strategies include the use of various equity derivatives. Table 2: Option Characteristics ____________Reston S&P 500 Stock price $50.00 $1,400.00 Strike price $50.00 $1,400.00 Interest rate 6.00% 6.00% Dividend yield 0.00% 0.00% Time to expiration (years) 0.5 0.5 Volatility 40.00% 17.00% Beta Coefficient 1.23 1 Correlation 0.4 Table 3: Regular and Exotic Options (Option Values) ___________Reston S&P 500 European call $6.31 $6.31 European put $4.83 $4.83 American call $6.28 $6.28 American put $4.96 $4.96 Table 4: Reston Stock Option Sensitivities ____________Delta European call 0.5977 European put -0.4023 American call 0.5973 American put -0.4258 Williamson would like to consider neutralizing his Reston equity position from changes in the stock price of Reston. Using the information in Tables 3 and 4 how many standard Reston European options would have to be bought/sold in order to create a delta neutral portfolio? A) Buy 497,141 put options. B) Sell 497,141 put options. C) Buy 370,300 call options. D) Sell 370,300 call options.

A?

yeah, normally you go and take the 200k shrs and divide by .5977 = write 334,616 calls. if you took 1 - .5977 to be a put ratio i guess, then 200k/ (1-.5977) = 497,141 puts, you’d obviously be a buyer to hedge. i wasn’t aware you could play ball like this but given those choices and not the sell 334,616 calls I’d shoot A also?

Your answer: D was incorrect. The correct answer was A) Buy 497,141 put options. Number of put options = (Reston Portfolio Value / Stock PriceReston) / −DeltaPut Number of put options = ($10,000,000 / $50.00) / −0.4023 = −497,141 meaning buy 497,141 put options. Selling put options does not deliver any downside protection, but it aggravates the losses when the stock decreases in value. Buying call options will increase the exposure to Reston. *********************************************** Well done. I thought we had to sell calls using this strategy, so I pick D without doing any calculations. It appears that we can go long puts also. We couldn’t go long calls or short puts though because that would offer no protection…sound right to you guys?

unless you were short the stock looking for a hedge, yep. no brainer you can knock out 2. you’re long, only way to hedge is write calls or buy puts. had to be one of those. i def went for calls 1st here, didn’t get the number I liked, tinkered and the puts one seemed to work.

bannisja Wrote: ------------------------------------------------------- > unless you were short the stock looking for a > hedge, yep. no brainer you can knock out 2. > you’re long, only way to hedge is write calls or > buy puts. had to be one of those. i def went for > calls 1st here, didn’t get the number I liked, > tinkered and the puts one seemed to work. I did the same.

Great. Makes sense. Hey banni…what was the answer to your swap question?

mwvt9’er- i still can’t do swaps questions. i hope the test is all delta hedging all the time. : ) i have some gaping holes in my derivs knowledge that i may or may not plug up depending on time constraints. right now, a solid review of equity is more important to me than getting the swap question perfect.

Niblita75 Wrote: ------------------------------------------------------- > bannisja Wrote: > -------------------------------------------------- > ----- > > unless you were short the stock looking for a > > hedge, yep. no brainer you can knock out 2. > > you’re long, only way to hedge is write calls > or > > buy puts. had to be one of those. i def went > for > > calls 1st here, didn’t get the number I liked, > > tinkered and the puts one seemed to work. > > > I did the same. I am glad I had this question. It makes sense now, but I would have screwed up for sure on the exam. Schweser doesn’t even mention you can use a long put to hedge the long stock position. Perhaps they would think a level II candidate should understand that without an example, but they don’t know me!

which question?

Oh…sorry, I looked back and it wasn’t your thread. Not sure why I thought it was…

bannisja Wrote: ------------------------------------------------------- > mwvt9’er- i still can’t do swaps questions. i > hope the test is all delta hedging all the time. > : ) > i have some gaping holes in my derivs knowledge > that i may or may not plug up depending on time > constraints. right now, a solid review of equity > is more important to me than getting the swap > question perfect. It clicked for me when I started using a timeline per slouiscar’s suggestion. I can kill those things now. If you get back to them and have trouble, look me up, I should be able to walk you through one.

i just ignore them. dinesh’s from today? i looked, i wrote a few #'s down, i laughed, cried, cursed my headache and seeing the last call lights at the bar last night, and then just went back to equity qbank. i’m getting pretty good at SS12 finally. FCFF and FCFE I had ignored for a while… finally came back to it today and if I can remember a few formulas for them and easy P/BV, P/S, etc, I think this just might be ok. I need to review the rest of equity, tighten it up. so yeah, swaps- i take the entourage approach- DENY UNTIL YOU DIE.

I had this question before. I don’t like it because you don’t have enough cash to buy all the puts you need create a delta neutral position. I reported it to schweser a week ago and have yet to receive a reply.

i’m sure our fine friend john williamson’s broker would let him go on margin for the extra $500k or so… especially for married puts.