On July 1^st, 2022, through your firms detailed fundamental analysis and projections of Amazons dual main businesses, you believe the price of AMZN will increase 10% by October 21st given no change in market performance over the holding period.

Through similar fundamental analysis, your firm also believes Tesla is undervalued by 5%. You believe that the Tesla AI Day on September 30th will be a catalyst for other investors to realize this undervaluation and that TSLA will be trading at the valuation implied by your model by October 21 given no change in market performance. Your firm also realizes that they have no particular expertise in timing the market but expects the market to fall by 6% between July 1st and October 21st. To realize returns specifically from your firms proprietary stock picking ability, you decide to hedge the market risk of both stocks by trading E-Mini S&P 500 December 2022 futures contracts, i.e., futures contract on the S&P 500 that settle in December 2022.

You will enter a position of 10,000 shares in AMZN and TSLA on July 1st and exit on October 21st.

Instructions

(Use Yahoo Finance to collect the required financial data.)

Construct a hedge position that will eliminate the systematic risk exposure to AMZN and TSLA. To do this, satisfy the following:

Part I: Establish the position1

1. Identify and calculate the values that you need to know as of 7/1/2022:

a. AMZN and TSLA stock prices

b. Price of E-Mini S&P 500 December 2022 futures contract (ESZ22)

c. Market beta with respect to the S&P 500 of both stocks. You will need to calculate these using daily data over the five years prior to 7/1/2022 (i.e., daily data from 6/30/2017 to 6/30/2022).

2. Formulation of the plan:

a. What is the systematic expected return of both stocks over your holding period?

b. What is the total expected return of both stocks over your holding period if the predictions about the market, AMZN, and TSLA are accurate? What would each stocks CAPM alpha be if the predictions are accurate? What would the dollar value of the alphas be given the size of the positions?

c. What position will you take in the December futures contract on July 1st to hedge market risk during your holding period? How many contracts are required (round to the nearest whole number) and will you be long or short the futures? Make sure to account for the contract unit/multiplier.

Part II: Performance Measurement over holding period (i.e., as of 10/21/2022)

1. The basics:

a. Identify and calculate the realized values of the stocks and futures contract positions, separately, as of October 21st.

b. Calculate the profit or loss from the two stock and futures contract positions separately.

c. What was the overall profit or loss of the combined hedged position?

d. What was the realized return of the combined hedged position?

2. Without hedging.

a. What would have been the realized return if you had not hedged the market risk using futures?

b. How does the realized return of the combined hedged position compare with what the anticipated return should have been without accounting for the market risk - explain?

Part III: Reflection

a. What are the assumptions necessary for this hedging strategy to work?

b. Do the hedged return change if you calculated the market beta of AMZN and TSLA based on the prior two years instead of prior five years? If they do change, what are some possible reasons for this? What are the tradeoffs between using a longer time period versus a shorter but more recent time period?

c. What major risks are present that is not accounted for by this hedge strategy?

d. What other strategies are available that might achieve the same ends?