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A large mutual fund holds 100,000 shares of Alphabet (Google) common stock, which is currently trading...

A large mutual fund holds 100,000 shares of Alphabet (Google) common stock, which is currently trading at $1,202/share with a beta of 1.15. The CME Group E Mini Dow futures contract trades at $5 times the index, which for the June contract is at 25,542.

  1. The fund managers are worried about the volatility of the tech stocks in their portfolio, so they want to hedge. Construct a hedge position (short or long) on the basis of this fear.
  2. In June, their fears are realized. Alphabet has underperformed the market, closing at $1175 while the index is at 26,056. Calculate the performance of the hedge by computing the change in the portfolio position and the change in the futures position. Was it successful? Explain.

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Expert Solution

Here,

A large mutual fund holds 100,000 shares of Alphabet (Google) common stock.

Current Market Price of Alphabet (Google) = $ 1,202/share

Beta = 1.15 Times

CME Group E Mini Dow Futures $ 5 times the index trades at 25,542.

a. The fund managers are worried about the volatility of the tech stocks in their portfolio, so they want to hedge.

Here, Mutual fund holds 100,000 shares of Alphabet (Google) so to hedge this fund manager will have to take the opposite position in the future contracts. So, fund managers will Short the CME Group E Mini Dow $5 times the index Future Contract.

Total number of future contracts to be shorted = 100,000 shares*$ 1,202*1.15 / (25,542 * $5)

= 1083 Contracts(approx.)

b. In June, their fears are realized. Alphabet has underperformed the market, closing at $1175 while the index is at 26,056. Calculate the performance of the hedge by computing the change in the portfolio position and the change in the futures position. Was it successful? Explain.

- Calculation of the change in portfolio value = 100,000 shares ($1,202 - $1,175) = $ 2,700,000.

So, the value of the portfolio is reduced by $ 2,700,000 due to a decrease in the value per share of the Alphabet (Google) by $ 27.

- Calculation of change in the future position = 1083 Contracts * $5 * (26,056-25,542) = $ 2,783,310.

So, there is a loss of $ 2,738,310 in the future position taken to hedge volatility of tech stocks in the CME Group E mini Dow $5 times index.

So, from the above calculation, it is clear that the hedge was unsuccessful as it reduced the value of the portfolio by $ 2,700,000 and also there is a loss of $ 2,738,310 in the future position taken to hedge volatility of tech stocks in the CME Group E mini Dow $5 times index as the hedge did not cover the loss on tech stock but also added it's loss.   


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