Question

1. As a stock portfolio manager, you have investments in many U.S. stocks and plan to hold these stocks over a long-term period. However, you are concerned that the stock market may experience a temporary decline over the next three months, and that your stock portfolio will probably decline by about the same degree as the market. You are aware that options on S&P 500 index futures are available. The following options on S&P 500 index futures are available and have an expiration date about three months from now:

                                                         

                                                Strike Price       Call Premium     Put Premium

                                                      1372                       40                       24

                                                      1428                       24                       40

The options on S&P 500 index futures are priced at $250 times the quoted premium. Currently, the S&P 500 index level is 1400. The strike price of 1372 represents a 2 percent decline from the prevailing index level, and the strike price of 1428 represents an increase of 2 percent above the prevailing index level.

1. Assume that you wanted to take an options position to hedge your entire portfolio, which is currently valued at about $700,000. How many index option contracts should you take a position in to hedge your entire portfolio?2.5 MARKS
2. Assume that you want to create a hedge so that your portfolio will lose no more than 2 percent from its present value. How could you take a position in options on index futures to achieve this goal? What is the cost to you as a result of creating this hedge? 2.5 MARKS

Answer 1

Answer:- As Per Given that,

Long Position in stocks, hedge this position is there & Fear that stock price may come down after 3 Months

Purchase put option at the strike price of 1372, in order to hedge.

If the price goes below 1372, it can sell it at the price of 1372 by paying the premium of $24.

The number of contracts required to hedge the position of $7,00,000 will be

Number of contracts - 700000/1372 = 510

So, 510 put option contract at the strike price of 1372 in order to hedge the position.

b) A long position in stocks, Hedge this position is there.

Fear that stock price may come down after 3 months & Purchase put option at the strike price of 1372 in order to hedge the position.

If the price goes below, can sell it at the price of 1372 by paying the premium of $24

The cost of hedging will be = 510*24 = 12240

Hence, Hedge this position by paying the premium of $12240