Question

QUESTION 1

1. a) Suppose you own 10,000 shares that are worth £50 each.

   1. i) Evaluate how put options can be used to provide you with insurance against a decline in the value of your holding over the next four months.

   2. ii) Construct a payoff diagram to illustrate your answe

Answer 1

Put option is a contract that gives an investor the right,but not the obligation, to sell shares of an underlying security at a contarct price(Strike Price) at a certain time in future.

i)Suppose you buy a put option on given shares that is currently trading at £50 each.You buy a put option with strike price of £50 per share for a premium of £3 on 10,000 shares,set to expire in 4 month.In this strategy,the maximum amount you can loose is Contract price i.e £30,000.If the share price falls to  £35 per share by the time of expiration date,you will be £15(i.e 50-35) in the money on your put option.

Payoff=£15*10000 shares-£30,000

=£120,000.00

Thus,you have save a loss of £150,000 through put option.