Question #96

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 46

Status: Unattempted

Part of Context Group: Q96-99 First in Group
Shared Context
- Fairfax has heard people talking about "making a portfolio delta neutral." What does it mean to make a portfolio delta neutral? The portfolio: A) is insensitive to stock price changes. B) is insensitive to interest rate changes. C) is insensitive to volatility changes in the returns on the underlying equity. Gina Davalos, CFA is a portfolio manager for the Herron Investments. She is interested in hedging the equity risk of one of her clients, Lou Gier. Gier has 200,000 shares of a stock with the symbol QJX that he believes could take a dive in the next 9 months. Davalos gathers the following information to suggest potential strategies to offset the potential loss. Each option contract is for 100 options. General Information: QJX Current Stock Price $100.00 Risk-free rate 5.0% QJX Dividend Yield 0.0% Time to Maturity (years) 0.75 Option Information: Strike Price $100.00 Value of Call $12.09 Delta on Call Option 0.6081 Value of Put (years) $8.41 Equity Swap Information: Terms 9 months Settlement frequency Quarterly Fixed rate 6.0% Return on QJX Variable Futures Information: Terms 9 months Current Futures Price $105.50
Question
In order to create a delta-neutral hedge using put option contracts, Davalos would most accurately need to:
Answer Choices:
A. buy 2,000 contracts
B. buy 5,103 contracts
C. sell 510,271 contracts
Explanation
The delta of a put option is the delta of the corresponding call option minus- 1. The delta of a QJX put option is thus –0.3919. The number of put options needed is 200,000 / – 0.3919 = –510,334 options or approximately 5,103 contracts per 100 shares. Gier is long the stock, to hedge with puts Davalos should also take a long position in the puts.
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