Market Neutral Strategy Involves Both Buying And Shorting Stock. Discuss

Question 1 (maximum of 200 words for the answer)

A market neutral strategy involves both buying and shorting stock.  In this strategy, the investor purchases shares of stock in companies she or he likes, but combines this investment with short positions in stock of other companies in the same industry.

 

Explain the difference between systematic and unsystematic risk.

Which type of risk is being reduced by the market neutral strategy?  What is the beta of a portfolio which follows this strategy likely to be?

Which type of risk is the investor still exposed to with a market neutral strategy?  Under what circumstances would the investor earn abnormal returns?

 

Question 2 (maximum of 200 words for the answer)

Comment on the validity of the following statement, including as much detail, examples etc. as you need:

 

“Buying a Call option on a stock is less risky than buying the stock itself, because your maximum loss is restricted to the premium paid for the option.”

 

Question 3 (maximum of 300 words for the answer)

After some research you identify a small, publicly traded company in the technology sector that you are interested in investing in.  Discuss the relative risks and rewards of the following ways of investing in the company (do not just describe the legal differences, focus on strengths and weaknesses as they relate to risk and return):

 

a)  buying shares of the company’s stock

b)  buying regular fixed coupon bonds issued by the company

c)  buying a Call option on the company’s stock

d)  buying convertible bonds issued by the company

 

Question 4

You decide to set up a straddle trade on a stock.  This is a trading strategy that involves buying both a Call option and a Put option on the same stock. The following summarizes the details of the trade at the time you execute it:

 

Stock Price = $29 per share

Call option:  strike price of $30 per share, premium of $2.31 per share

Put option:  strike price of $30 per share, premium of $3.11 per share

 

You implement the straddle trade at this point in time and then maintain the trade until the expiry of the options.  When the options expire the price of the stock is $28 per share.

 

What is your holding period return on the straddle trade (show all workings carefully)?

 

Question 5 (maximum of 150 words for the answer)

The following chart shows the cumulative abnormal returns (CARs) for firms announcing a Seasoned Equity Offering (SEO).

a) What form of the efficient market hypothesis is this testing?

b) Is the evidence present in favor of or contrary to market efficiency?  Explain why.

c)  What accounts for the shape of the graph prior to the announcement of the SEO (i.e. from t=-25 to t=0)?