Question

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.

Which of the following best explains a delta-neutral portfolio? A delta-neutral portfolio is perfectly hedged against:

a. Small price changes in the underlying asset.

b. Small price decreases in the underlying asset.

c. All price changes in the underlying asset.

Short answer

Option c.

Step-by-step solution

Definition of delta neutral portfolio

A delta neutral portfolio is a strategy that uses multiple positions to ensure that the various positive and negative deltas are balanced out and the overall delta becomes zero.

Validation of data neutral portfolio  

This portfolio is perfectly hedged against price change in underlying assets but any large asset price change will make this hedge imperfect. This implies that any large price change of underlying asset cans overall portfolio value.

Therefore the correct option is ‘c’.

Any small variation or changes in the underlying asset will not hedge the portfolio, so a. and b. are incorrect options.