SCENARIO: You are bullish on company ABC and company XYZ. Suppose you have $2 million to invest.

SCENARIO You are bullish on company ABC and company XYZ. Suppose you have $2 million to invest.

You consider four different investment strategies in the form of portfolios: Note that we assume the variances of ABC and XYZ are similar (say within 20% of each other) AND positively correlated.

Portfolio A Buy $1 million worth of ABC stock using cash.

Buy $1 million worth of XYZ stocks using cash.

Portfolio B Buy $2 million worth of ABC stock using $1 million and borrowing $1 million.

Buy $2 million worth of XYZ stock using $1 million and borrowing $1 million.

Portfolio C Buy call options on ABC stock expiring in 1 month, with strike $5 higher than ABC's stock price. The cost of all these ABC options is not more than $500,000.

Buy call options on XYZ expiring in 1 month, with strike $5 higher than XYZ's stock price.

The cost of all these XYZ options is not more than $500,000.

Portfolio D Sell put options on ABC expiring in 1 month, with strike $5 lower than ABC's stock price.

Sell put options on XYZ expiring in 1 month, with strike $5 lower than XYZs' stock price. **NOTE: **Questions 5 and 6 are **not **based on this scenario.

Question 1: Which portfolio(s) are affected by higher-than-expected covariance? Give at least 2 reasons.

Question 2: What happens to the option portfolios if the correlation between ABC and XYZ is 0?

Describe effects on return and risk.

Question 3: Excluding Portfolio D, which portfolio(s) has the potential to make more than 100%? Give at least 2 reasons.

Question 4: For proper risk management, which of the portfolios should be hedged? Give at least 2 reasons.

Question 5: What happens when you have both high volatility AND high correlation? Provide at least 2 arguments.

Question 6: Which of the portfolios have a non-linear payoff? Give at least 2 reasons.

Answer & Explanation Solved by verified expert 1.

Portfolios A and B are affected by higher-than-expected covariance because they are long positions in both stocks. Portfolio C is affected by higher-than-expected covariance because it is a long position in both stocks via call options. Portfolio D is not affected by higher-thanexpected covariance because it is a short position in both stocks via put options.

Higher-than-expected covariance means that the two stocks are more likely to move in the same direction (either up or down) than expected. This is bad news for portfolios A and B, which are long positions in both stocks. Portfolio C is also affected because it is effectively a long position in both stocks via call options. However, portfolio D is not affected because it is effectively a short position in both stocks via put options.

2.

If the correlation between ABC and XYZ is 0, then the option portfolios will not be affected. The return and risk will be the same.

If the correlation between ABC and XYZ is 0, then the option portfolios will not be affected. The return and risk will be the same. This is because the options are not dependent on each other. The price of one stock will not affect the price of the other stock.

3.

Portfolio A and Portfolio B both have the potential to make more than 100% because they are investing in both ABC and XYZ stocks. Additionally, they are both using cash to invest which means that they will not have to worry about borrowing costs.

There are a few reasons why Portfolio A and Portfolio B could potentially make more than 100%. First, they are investing in two different companies, which means that they will be able to participate in the growth of both companies. Additionally, they are using cash to invest, which means that they will not have to worry about borrowing costs. Finally, they are investing a similar amount of money in each company, which means that they will be less exposed to the risk of one company underperforming.

4.

Portfolios A and B should be hedged because they are long positions in both stocks. Portfolio C should be hedged because it is a long position in both stocks via call options. Portfolio D should not be hedged because it is a short position in both stocks via put options.

Portfolios A and B are long positions in both stocks, so they should be hedged in order to protect against downside risk. Portfolio C is a long position in both stocks via call options, so it should also be hedged. Portfolio D is a short position in both stocks via put options, so it does not need to be hedged.

Step-by-step explanation 5.

When you have both high volatility AND high correlation, you have what is known as a "volatile market." This is when prices for stocks, commodities, or other assets can change rapidly and unexpectedly. This can be caused by a number of factors, such as political unrest, economic uncertainty, or natural disasters. Volatile markets can be very dangerous for investors, as they can lose a lot of money very quickly. For this reason, it is important to be very careful when investing in a volatile market.

There are a few different ways to measure volatility. One common method is to use the standard deviation of asset prices. This measures how much prices fluctuate around the average price.

Another common method is to use the coefficient of variation, which measures the ratio of the standard deviation to the mean.

Volatile markets can be very difficult to predict. For this reason, it is important to diversify your investments. This means investing in a variety of different assets, such as stocks, bonds, and commodities. This will help to protect you from losses if one asset class starts to decline in value.

It is also important to have a well-defined investment strategy. This will help you to make decisions about when to buy and sell assets. Having a clear strategy will help you to stay calm during periods of market volatility.

Volatile markets can be very stressful for investors. It is important to remember that prices will eventually start to stabilize. If you are patient and stick to your investment strategy, you will be able to weather the storm and come out ahead in the end.

6.

There are a few portfolios that have non-linear payoffs. The first reason is that these portfolios may have derivatives that are non-linear. For example, a portfolio may have options with different strike prices. The second reason is that the portfolios may be invested in assets that have non-linear payoffs. For example, a portfolio may be invested in commodities, which often have non-linear price movements.

The non-linearity of a portfolio's payoff can be both a good and a bad thing. On the one hand, it can lead to higher potential returns if the underlying assets move in the right direction. On the other hand, it can also lead to greater losses if the underlying assets move in the wrong direction.

As such, investors need to be aware of the potential risks and rewards of investing in a portfolio with a non-linear payoff before making any decisions.