I cannot understand this answer in hedge fund strategies

CFA Level III
#1

Blockquote
Ling Chang, a Hong Kong-based EMN manager, has been monitoring Pepsi- Co Inc. (PEP) and Coca-Cola Co. (KO), two global beverage industry giants. After examining the Asia marketing strategy for a new PEP drink, Chang feels the marketing campaign is too controversial and the overall market
is too narrow. Although PEP has relatively weak earnings prospects compared to KO, 3-month valuation metrics show PEP shares are substantially overvalued versus KO shares (relative valuations have moved beyond their historical ranges). As part of a larger portfolio, Chang wants to allocate $1 million to the PEP versus KO trade and notes the historical betas and S&P 500 Index weights, as shown in the following table.
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Discuss how Chang might implement an EMN pairs trading strategy.
Answer:
Chang should take a short position in PEP and a long position in KO with equal beta-weighted exposures. Given Chang wants to allocate $1 million to the trade, she would take on a long KO position of $1 million. Assuming realized betas will be similar to historical betas, to achieve an equal beta-weighted exposure for the short PEP position, Chang needs to short $846,154 worth of PEP shares [= –$1,000,000 / (0.65/0.55)]. Only the overall difference in performance between PEP and KO shares would affect the performance of the strategy because it will be insulated from the effect of market fluctuations. If over the next 3 months the valuations of PEP and KO revert to within normal ranges, then this pairs trading EMN strategy should reap profits.
Blockquote

Since the ratio to be market neutral is 13 -11 for KO and PEP stocks, why aren’t we buying $6.5 million of KO stocks using the cash from selling short $5.5 million of PEP stocks and using the additional $1 million? Can anyone explain this?

#2

It’s not a well-written vignette.

Apparently, the $1 million is meant as a maximum for any one position, rather than a maximum net position.

The real exam will be clear on such points . . . and all others, as well.

#3

I get it. Thank you

#4

My pleasure.

#6

Ling Chang’s approach to implementing an EMN pairs trading strategy involves a sophisticated understanding of relative valuations and market dynamics. By choosing to short PepsiCo (PEP) and go long on Coca-Cola Co. (KO), Chang is leveraging the disparity in valuation metrics between these two industry giants. Her strategy reflects a nuanced view of the market, recognizing PEP’s current overvaluation compared to KO’s more stable position.

Given the decision to allocate $1 million to this trade, Chang’s method ensures that the exposure to market-wide movements is balanced by equalizing the beta-weighted exposures. This involves shorting PEP shares worth $846,154 to counterbalance a long position in KO of $1 million, based on historical beta ratios. This approach isolates the strategy’s performance to the relative difference between the two stocks, minimizing the impact of broader market fluctuations.

In a broader context, just as office 365 resellers must understand the intricacies of market dynamics and customer needs to offer tailored solutions, Chang’s strategy illustrates a similar level of expertise in navigating and exploiting market inefficiencies. Should the valuations of PEP and KO revert to historical norms over the next three months, Chang’s strategy should effectively capitalize on this mean reversion, leading to potential profits. This well-considered pairs trading strategy not only reflects a deep understanding of market inefficiencies but also aligns with a disciplined investment approach to navigating volatile market conditions.