Case 059Portfolio construction and sizingWarm up
Vetrin Partners starts a quarter with Rs 100 crore long and Rs 100 crore short on Rs 100 crore of capital. Longs rise 20% and shorts rise 30%. What are the new gross and net exposures, and what must the PM do to get back to target?
1The situation
Vetrin Partners runs a market-neutral equity book with a target of 100% of capital long and 100% short: 200% gross, zero net. At the start of the quarter it has Rs 100 crore of capital, Rs 100 crore of longs and Rs 100 crore of shorts.
In a sharp rally, the longs rise 20% and the stocks it is short rise 30%. Ignore financing costs and borrow fees.
2Your task
What are capital, gross and net exposure after the move, and what trades bring the book back to its target?
Quick check
After the move, what is Vetrin's net exposure as a share of its capital?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Capital falls to Rs 90 crore, gross rises to 278% and net drifts to 11.1% short. Longs made Rs 20 crore and shorts lost Rs 30 crore. To get back to 100% long and 100% short of the new Rs 90 crore, the PM sells Rs 30 crore of longs and buys back Rs 40 crore of shorts: Rs 70 crore of trading that shrinks the whole book, not just evens it.
Step 1What happened to the capital and the positions?
Mark each side to market, then settle the P&L into capital. Longs rose from 100 to 120, a Rs 20 crore gain; shorts rose from 100 to 130, a Rs 30 crore loss, so capital falls to Rs 90 crore. A short that rises is a loss, and the position grows as it does: you now owe Rs 130 crore of stock. A household that borrowed a neighbour's gold to sell, planning to buy it back cheaper, owes more gold in rupee terms every time gold goes up, while its own savings shrink.
| Rs crore | Start | After the move | Target | Trade |
|---|---|---|---|---|
| Longs | 100 | 120 | 90 | sell 30 |
| Shorts | 100 | 130 | 90 | cover 40 |
| Capital | 100 | 90 | 90 | |
| Gross, % of capital | 200% | 278% | 200% | |
| Net, % of capital | 0% | -11.1% | 0% |
Step 2Why is this resizing and not just rebalancing?
Because both targets are set against capital, and capital shrank. Evening up the two sides at 120 each would fix net but leave gross at 267% of a smaller capital base, more leverage than the mandate allows. The book has to shrink to Rs 90 crore a side. That means selling Rs 30 crore of longs and covering Rs 40 crore of shorts, Rs 70 crore of trades, most of it buying back the shorts that just hurt.
Step 3What is uncomfortable about the trade, and what do PMs do about it?
Covering shorts into a rally feels like buying at the top, and selling longs that are working feels like cutting winners. But leaving the drift alone means the book is 11% net short with 278% gross, a bet on the market falling that nobody decided to make. Most platforms set bands, for example net within plus or minus 5% of capital and gross within 20 points of target, and trade back inside them within a day. A PM who believes the shorts are now more overvalued can argue to keep some of the size, but should say that is a new decision, not a leftover from the move.
Where candidates lose it
The usual error is dividing by the old capital: net of 10 on 100 is 10%, but the book no longer has 100. Exposures are always measured against today's capital, which fell by the P&L.
The second is fixing net by trimming only the shorts to 120. That returns net to zero but leaves gross at about 267%, well above the mandate.
What the interviewer asks next
- What if longs rose 30% and shorts 20% instead? Walk through the same steps.
- Which shorts would you cover first, the biggest losers or the smallest, and why?
- How does beta change the definition of neutral here?
Company names and figures are illustrative.