You are managing a hedge fund. Today, you find that the stock of Microsoft is undervalued. So, you would want to buy Microsoft stocks. But you know that buying the stocks only will make you exposed to risk even if the stock is actually undervalued. So, you would sell short the S&P 500 index. How would you decide how much of the index you would sell short? Even if all the assumptions and the necessary estimates are correct, you are still exposed to some risk. What is the remaining risk in the above strategy?
How to determine the amount of selling:
Remaining risk: