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 statements regarding the goal of a delta-neutral portfolio is most accurate? One example of a delta-neutral portfolio is to combine a:

a. Long position in a stock with a short position in call options so that the value of the portfolio does not change with changes in the value of the stock.

b. Long position in a stock with a short position in a call option so that the value of the portfolio changes with changes in the value of the stock.

c. Long position in a stock with a long position in call options so that the value of the portfolio does not change with changes in the value of the stock.

Short answer

a

Step-by-step solution

Definition of delta neutral portfolio

The delta neutral portfolio or metric get affected by the market movements with an objective to bring the net change to zero.

 Step 2: Calculation of number of call options written for delta neutral hedge 

Correct option:

A delta neutral portfolio may be created with various combinations. One of the goals of the delta neutral portfolio is to combine a Long position in a stock with a short position in call options so that the value of the portfolio does not get affected with changes in the value of the stock. Hence the correct option is option ‘a’.

Incorrect option:

Long position in a stock with short position in a call option is created in a portfolio in order to avoid the rapid changes in the prices of the stock and the risk factor. It doesn’t increase the volatility of the stock prices. Hence, option b. is a wrong option.

The objective of delta neutral portfolio is to create combination of long positions stocks with short positions call option. Option c. is not an example of delta neutral portfolio. Hence, it is an incorrect option.