Question

You buy $2000 worth of Stock J and simultaneously short-sell $1000 of Stock K. Over the following year, the return on Stock J is 12.6% and the return on Stock K is 19.6%. The risk-free rate in the economy is 4%. What is the percentage return on your hedge portfolio? Go out three decimal places - for example, write 7.2% as .072.

Answer 1

Sol:

Given,

Stock J bought worth $2000

Stock K short sell worth $1000

Return on stock J = 12.6%

Return on stock K = 19.6%%

Risk free rate of return = 4%

By using CAPM we calculate expected return on hedge portfolio considering Beta as 1.

Expected return on hedge portfolio = Rf + Beta x (Market premium)

Expected return on hedge portfolio = 4% + 1 x (12.6% - 4%)

Expected Return on hedge portfolio = 12.6%

Now return on hedge portfolio = $2,000 x 12.6%/$2,000 = 0.126

Alternatively if we consider opening value of portfolio as $3,000

Return on hedge portfolio = $2,000*12.6%/$3,000 = 0.084

Percentage return on hedge portfolio = $2,000 x 12.6%/$2,000 = 0.126 (If we Consider opening balance of portfolio = $2000)

Percentage return on hedge portfolio = $2,000 x 12.6%/$3,000 = 0.084 (If we Consider opening balance of portfolio = $3000)