Not long ago, Vanessa Woods sold her company for several million dollars (after taxes). She took some of that money and put it into the stock market. Today, Vanessa's portfolio of blue-chip stocks is worth $3.8 million. Vanessa wants to keep her portfolio intact, but she's concerned about a developing weakness in the market for blue chips. She decides, therefore, to hedge her position with six-month futures contracts on the E-mini Dow Jones Industrial Average, which are currently trading at 11,963.

a. Why would she choose to hedge her portfolio with the DJIA rather than the S&P 500?

b. Given that Vanessa wants to cover the full $3.8 million in her portfolio, describe how she would go about setting up this hedge.

c. If each contract required a margin deposit of $4,930,

how much money would she need to set up this hedge?

d. Assume that over the next 6 months stock prices do fall, and the value of Vanessa's portfolio drops to $3.3 million. If E-mini DJIA futures contracts are trading at 10,843, how much will she make (or lose) on the futures hedge? Is it enough to offset the loss in her portfolio? That is, what is her net profit or loss on the hedge?

e. Will she now get her margin deposit back, or is that a "sunk cost"gone forever?

a. Why would she choose to hedge her portfolio with the DJIA rather than the S&P 500?(Select the best answer below.)

A. Since Vanessa's portfolio consists of large-cap stocks, the Dow Jones Industrial Average Index would track her stock portfolio better than the S&P 500, which would be an appropriate hedge for a portfolio of blue-chip stocks.

B.Since Vanessa's portfolio consists of blue-chip stocksstocks of major, well-established companies, the Dow Jones Industrial Average Index would track her stock portfolio better than the S&P 500, which would be an appropriate hedge for a portfolio of large-cap stocks.

Part 2

b. Given that Vanessa wants to cover the full $3.8 million in her portfolio, describe how she would go about setting up this hedge.(Select the best answer below.)

A.Vanessa is concerned about a developing weakness in the market for blue chips so she should short-sell DJIA futures contracts. If the value of the portfolio drops, she would offset the loss on the portfolio by a gain on the futures contracts. One DJIA futures contract is worth $119,630. To cover the full $3,800,000 in her portfolio, she would short-sell 32 contracts ($3,800,000/$119,630).

B.Vanessa is concerned about a developing weakness in the market for blue chips so she should buy DJIA futures contracts. If the value of the portfolio drops, she would offset the loss on the portfolio by a gain on the futures contracts. One DJIA futures contract is worth $119,630. To cover the full $3,800,000 in her portfolio, she would short-sell 32 contracts ($3,800,000/$119,630).

C.Vanessa is concerned about a developing weakness in the market for blue chips so she should short-sell DJIA futures contracts. If the value of the portfolio drops, she would offset the loss on the portfolio by a gain on the futures contracts. One DJIA futures contract is worth $11,963.To cover the full $3,800,000 in her portfolio, she would short-sell 320 contracts ($3,800,000/$11,963).

Part 3

c. If each contract required a margin deposit of 4,930, to set up this hedge she would need

$. enter your response here.

(Round to the nearest dollar.)

Part 4

d. The amount she will make (or lose) on the futures hedge is

$ enter your response here.

(Round to the nearest dollar. Enter as a positive number for a gain and a negative number for a loss.)

Part 5

Her net profit (or loss) on the hedge is

$. enter your response here.

(Round to the nearest dollar. Enter as a positive number for a gain and a negative number for a loss.)

Part 6

e. Will she now get her margin deposit back, or is that a "sunk cost"gone forever?(Select the best answer below.)

A. Vanessa will not get her margin deposit back. The margin deposit is a sunk cost (like an option premium, not a refundable security deposit.

B. Vanessa will get her margin deposit back. Although the purchase of a futures contract does involve a margin deposit, it is a refundable security deposit, not a sunk cost (like an option premium).