Here goes the Q A market neutral hedge fund has established a net long equity position, and worries about a decrease in stock market value. Which of the following would provide the best protection? A) A short sale of stock. B) An in-the-money put. C) An at-the-money put
Pretty easy - ‘A’ because, the decrease in the stock market vaule will be directly correlated to the gain on the short position. Put would be effective too, but LONG Put would need a premium payment upfront so the payoff would be adjusted accordingly.
A? his would create a counter position though
I remember one reading which said that that the delta neutral hedge is effective for small movements in the stock. Based on the estimates, assuming we have taken appropriate positions Long stock and short call. What impact does the positions have if there is a large slide down in the price movement. To make it work effective do we need to constantly rebalance or would it entail a loss
C. He just needs to spend a small premium to protect against the downside.
For large movements in the stock, the effectiveness of the hedge as calculated by the gamma, is low. So you will need to continuously rebalance the portfolio to maintain the hedge per say or take a loss.
Dreary Wrote: ------------------------------------------------------- > He just needs to spend a small premium to protect > against the downside. But no premium at all to protect against the downside with a short-position.
But, he does not want to sacrifice the upside.
He is worried about a decrease in stock market value, not concerned about the upside at all. Intrepreting that would be reading ‘beyond’ the question I guess. Let’s hear the official answer.
Swap: U r right Here is the Answer The correct answer was A) A short sale of stock. If the stock market decreases, the put increases in value in sync with the option delta. This change in value may not fully protect the fund’s position. In contrast, the short stock position does not require a premium to be paid and can better protect the fund’s position if the stock market declines
I beg to differ. 1) Shorting the same stocks in your portfolio would be like selling your portfolio, which is not typically done. 2) Shorting some other stocks has its own risk, and it would be worse than the delta problem mentioned in the answer. 3) There is a premium to be paid for shorting, depending on the borrow rate.
I agree with you Dreary Just a rubbish question
it would be better worded if the question stated “and was worried about a (large/ small) decrease in the stock market value” the implications of which would justify either a short stock position for a large (relative) movement or a delta hedge for a small (relative) movement. I agree with newsuper agreeing with Dreary… this question is stupid.
A is definitely the better answer here. If you want to hedge, you short the stock (box the position), you are 100% hedged no cost to you. You buy a put, you’re paying a premium (theta) most likely and while you are getting protection, you are getting your protection at a price. nowhere here did it say the guy wanted to still take advantage of the upside- just said what is the best protection. and dreary- 1) Shorting the same stocks in your portfolio would be like selling your portfolio, which is not typically done. this is done all of the time. 3) There is a premium to be paid for shorting, depending on the borrow rate. what if we’re in a 3% or whatever % interest rate environment, you aren’t levering up to box the stock, and you’re actually getting paid a premium for the short sale proceeds? a hedge fund could term up their easy to borrows at fed, a bank right now would pay over fed to lend you easy to borrow names b/c they need the cash, the prime broker would make the spread off of the bank paying you over fed, you pay the HF fed on the borrow, they box up the stock, have zero market risk, and get paid on that short better than cash is paying in their portfolio. whammy. boxed positions happen all of the time in the real world.
banni, this question is more complicated to answer than it appears from the question, but I agree, if you look at it as protection against downside only, then yes, you could achieve that with shorting only. Also, that’s a good point about probability of borrowing due to current credit conditions. However, be careful here as shorting against the box has long been dead since the IRS deemed it an actual sale, which took away the tax advantage, so you don’t really do it for tax purposes anymore. Also, you need to factor in the lost dividends due to the short position (you have to pay the original holder their due dividends from your own dividends, so it cancels out).
divi side- your long gets paid the div, you pay the div out of the short side. the boxed guy doesn’t lose out. if it’s a qualified divi such that the acct you’re borrowing the stock from gets a cash in leiu payment and not a qualified divi, sux for the long holder with the margin debit- not the HF borrowing their stock. boxed positions aren’t just for tax treatment, which you are correct died many yrs ago. riskless arbitrage if you can on a hard to borrow get paid more on the long than you’re getting charged on the short (you’d go long at one prime, short at another- hard to pull off if in the long term), giddy up. or like i said above- let’s say right now you don’t really want to put on any big bets in your account. say you’re a $100mm fund. let’s say i’m paying you fed open less 25 bps for cash right now. so you could sit in cash and earn 0. you could do something like buy treasuries or a money market fund, sure. or maybe you say box up an easy to borrow stock- MSFT, buy 100mm worth. for $100mm maybe you wouldn’t get a sweetheart rate, but there are banks needing cash right now to the point where maybe they’d pay you fed + 25 bps or something like that to give them cash and take MSFT off of their hands. so what if you could get paid fed + 10 bps on the short? now you’re boxed up on MSFT for $100mm, zero debit balance, earning 35 bps on your short sale proceeds (assuming fed at 25 bps), and most brokers will let you lever off of a boxed position and hold you to something like a 5% requirement. if you saw something attractive in the market and wanted to close the box, it’s as easy as saying collapse the box. again, not done everyday and certainly won’t work for a little guy investor, but just saying… boxed positions still happen and more frequently than you might think. or if you want to get even trickier, start doing the long side with a swap on something foreign to arb dividend/tax rates, etc… that loophole will eventually get closed out by regulation, but yeah, boxed stocks happen. dead they are not.
All of this real, practical industry (and not simplied CFAI) discourse is making my mind blow up. I’ll return to my imaginary world of frictionless markets 
Great arb opportunity, interesting stuff, but what happens if you had to buy to cover for some reason and you didn’t have the cash? You deliver your own stock?
if you had the $100mm long, $100mm short on a $100mm portfolio, reg T margin (we’ll keep it easy here) will hold you to 50% reqs on both sides. so you on the box are held to $50mm reqs on the long, $50mm reqs on the short. you’re essentially at 50% equity b/c you have $200mm on (100 long/100 short), but you have no margin debit b/c you only bought $100mm worth and you had the $100mm to begin with. your “surplus” would be zero here- you’re right at the edge of a margin call. so what if you buy back the long? assuming px didn’t change at all, now you’re just short $100mm of the MSFT- your requirement on that is $50mm, so you’d be short $100mm of stock on your $100mm portfolio with “reg T surplus” of $50mm, cash of $100mm, short sale proceeds of $100mm, but your broker would only let you wire out $50mm. since 50% req- you go and buy $100mm now of whatever other stock, you take your surplus back down to zero (the $100mm x reg T 50% = the 50mm surplus used), you use up the cash. You’re golden. Had you boxed it up, got held to let’s say 5% margin on the box, use up that other 95% by doing other trades and then you don’t collapse but rather close out only half of that trade- you have entered the wild world of a margin call. time to wire in some $$. as for the stock borrow- if you weren’t in a margin debit to begin with, you weren’t collateralizing your short with your own long so the broker would take your buy cover and be able to deliver out the long b/c they are borrowing that stock from XYZ bank (not your long position).
5% margin requirement on stocks is wild, I’ll try that one day soon. Back to L2 scheduled programming.