First year trying to get a bit ahead: hedging a long position exercise

[Bov_the_builder]

Hello everyone, I am a first year student in econometrics and financial mathematics. I am reading through some books and going through some courses from the next years and I wanted to know if you all could help me with one of the assignments and to make sure that I understand what is going on here.

The assignment gives me some historical data (1 year, daily close price) and asks me to propose a portfolio of 4 stocks from a list of 20 stocks such that the portfolio that I have chosen "hedges the long position of 100 shares of CompanyA". I'm not sure of how to understand what is in quotes. My understanding is that I need to choose the 4 stocks, given the historical data, such that it reduces losses in the future (no data). I'm not sure how the information about the "long position of 100 shares of CompanyA" is supposed to be used. Did I understand this correctly?

 

[SD_]

I think it should be the stocks with max negative correlation w.r.t Stock A
or
SHORT the 4 stocks with max correlation w.r.t Stock A

 

[Bov_the_builder]

I think it should be the stocks with max negative correlation w.r.t Stock A
or
SHORT the 4 stocks with max correlation w.r.t Stock A

The idea that you're saying here is that: I expect stockA's value to increase in the future, therefore I short the stocks that are highly correlated with stockA so that if value of stockA drops, then I hedged. The first option you're proposing is to go long also on some other stock that is negatively correlated with stockA. Did I understand that right?

I guess shorting involves the cost of the premium for the option as well that should be taken into account in this problem (going long on the option also?). Depending on the price of the premium, is it then correct to assume that the optimal portfolio would be a mix between short and long depending on the price of the options premium?

 

[SD_]

Yes, defensive stocks will have low beta values and can be a part of your portfolio.
also, you can be hedged in another way for ex: long stock A and short stock B, both A and B belong to the same industry but have very different PE ratios. In this case, you have hedged your systematic exposure.

shorting involves paying a variation margin amount to the broker which also earns you interest.


- the most basic strategy would be building an efficient frontier using the risk and return characteristics only.
- the advanced one will go deep into multi-factor models and will, therefore, depend on the data that has been provided

 

[Bov_the_builder]

Thanks for the tips. I worked on it this weekend and I could come up with a few different portfolios. I'll try to dig a little more into it to see if there is a more systematic way of doing this analysis. Do you know of any multi-factor model that only uses close prices for different stocks?

 

[SD_]

I think without any additional stock-specific data such as size, value/growth, etc. there cannot be a multi-factor model. It'll be a single factor one like CAPM.