Not long ago, Vanessa Woods sold her company for several million dollars. 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-mount futures contracts on the Dow Jones Industrial Average which hare currently trading at 11,960.
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 $4,875, how much money would she need to set up this hedge?
d) Assume that over the next six months, stock prices do fall, and the value of Vanessa's portfolio drops to $3.3 million. If DJIA futures contracts are trading at 10,400, how much will she make (or lose) on the future 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?