Question

2. A money manager invested in iShares Russell 2000 Index ETF Fund (Ticker: IWM). The current value of her portfolio is $1 million. Today, she decided to use option contracts to hedge the stock portfolio against a decline in market value in next 3 months.

a. What type of option (call or put) contract she should choose to hedge her portfolio?

b. Should she take a long or short (buy or sell) position?

c. How many option contracts will be needed to hedge the portfolio?

d. If she wants to protect your portfolio value from dropping more than 8%. Which option contract will you choose? What is the max and min gain/loss from this strategy?

Answer 1

Investment = $1 Million

Price = 1000000/ 2000 indiex fund= 500

Ans a)To Hedge Portfolio

Money Manager have to SELL CALL option so can it will hedge its position out of Certainity of Price Decrease

This strategy is also known as Covered Call.

If Price Increase then then it will payout for call writing premium and price Decrease then Call write option gain would Settle the Loss.

Ans b) She should Take SHORT Position in call to not getting Lose because of time decay.

Ans c) To hedge She can take 2 position

1. BUY PUT OPTION

2. SHORT CALL OPTION

Ans d) The Maximum risk she can bear = 8%

In that Scenario , 500*8% =$ 40

She can buy Put option near strike price which will be of 40 $

where the Maximum loss would be $40 which equivalent to premium = 2000*40 = $80000

Maximum gain if price decrease and call option convert to in the money so comparing the lodd in stock it will be at Break even