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

  

Transcribed Image Text:

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. 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. 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. 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.

Answer rating: 100% (QA)

Question 1 Portfolios affected by higherthanexpected covariance Portfolio A and Portfolio B Reasons i Diversification Impact Portfolio A involves hold... View the full answer