12. The following is part of the computer output from a regression of monthly re

Question

12. The following is part of the computer output from a regression of monthly returns on Waterworks stock against the S&P 500 index. A hedge fund manager believes that Waterworks is underpriced, with an alpha of 2% over the coming month.


Beta R-square Standard Deviation
of Residuals
.75 .65 .06 (i.e., 6% monthly)

a. If he holds a $3 million portfolio of Waterworks stock, and wishes to hedge market exposure for the next month using one-month maturity S&P 500 futures contracts, how many contracts should he enter? Should he buy or sell contracts? The S&P 500 currently is at 1,000 and the contract multiplier is $250.
b. What is the standard deviation of the monthly return of the hedge portfolio?
c. Assuming that monthly returns are approximately normally distributed, what is the probability that this market-neutral strategy will lose money over the next month? Assume the risk-free rate is .5% per month.

Explanation / Answer

a)5 sell b)0.45 c)0.34

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