You are holding call options on a stock. The stock’s beta is 0.76, and you are concerned that the stock market is about to fall. The stock is currently selling for $16 and you hold 1 million options on the stock (i.e., you hold 10,000 contracts for 100 shares each). The option delta is 0.80. How much of the market-index portfolio must you buy or sell to hedge your market exposure?

ANSWER:

1) You have to sell some amount of the market index portfolio, to be on the profiting and secured side.

2) The amount of market index

portfolio to sell is $9,728,000

Explanation:

Since the stock market is about to fall. That means the market index will increase.

Let's assume the stock market index will increase by 1%. That means the 1million share option of the stock will increase by;

Beta% × Delta × price unit of stock × Share option on stock.

Therefore;

0.76% × 0.8 × $16 × 1,000,000 = $97,280

Since each option has 100 shares. Therefore the amount of market index portfolio to sell will be;

$97,280 × 100 = $97,280 × 100 = $9,728,009.

For the shareholder to hedge it's market exposure, $9,728,000 of the market index portfolio must be sold. Since 1% change in the index would cause the portfolio value to change by $97,280

Inventory   20,500    debit

    A/P                      20,500 credit

Inventory   12,075    debit

    A/P                      12,075 credit

Inventory   8,000    debit

    A/P                     8,000 credit

Explanation:

We will debit our inventory for the amount of merchandise we purchased and any other cost needed to get it ready for sale in our stock.

In the case of the second purchase as the terms are shipping point the goods are ours from the moment their are loaded into the ship thus, we should pay the freights. This will be a necessary cost to get the inventory so we activate through inventory instead of declaring an expense.