The portfolio manager of a hedge fund believes that stock A is undervalued and stock B is

Question:

The portfolio manager of a hedge fund believes that stock A is undervalued and stock B is overvalued. Currently their prices are $30 and $30, respectively. The portfolio manager of the fund buys 100 shares of A and sells 100 shares of B short.

a) Why does the portfolio manager establish these two positions?

b) What is the initial cash outflow from the two positions?

c) What are the net profits and losses on the positions if, after a period of time, the prices of each stock are

Price of A Price of B

$25 ...................................... $25

27.50 ................................. 27.50

30 ....................................... 30

32.50 ................................ 32.50

35 ..................................... 35

d) What are the net profits and losses on the positions if, after a period of time, the prices of each stock are

Price of A Price of B

$25 ..................................... $35

27.50 ................................. 32.50

30 ..................................... 30

32.50 ............................... 27.50

35 .................................... 25

e) What are the net profits and losses on the positions if, after a period of time, the prices of each stock are

Price of A Price of B

$25 .............................. $20

27.50 .......................... 25

30 .............................. 30

32.50 ........................ 35

35 ............................ 40

f) What are the net profits and losses on the positions if, after a period of time, the prices of each stock are

Price of A Price of B

$25 ............................... $27.50

27.50 ............................ 28.25

30 ................................ 30

32.50 .......................... 31.25

35 .............................. 32.50

g) For the portfolio manager’s expectation to be fulfilled, the prices of the stocks have to follow which of the above four patterns? What are the implications if the other patterns of stock prices occur?

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