Question

You just bought 200 shares of Charlie Company stock for $70, and you want to use 3 month call options with a strike price of $75 to hedge your position. You believe that the stock will be worth either $65 or $85 in three months. How many calls must you sell to create a risk-free portfolio?

a. 2

b. 4

c. 0.5

d. 0.25

e. None of the above

2. The expected rate of return on the portfolio that you created should equal the risk-free rate.

a. true

b. false

Answer 1

You must sell 2 call options to create a risk-free portfolio (assuming that the stock does not go below $65).

Each option contract is for 100 shares of the underlying stock and since you are long 200 shares, to eliminate the downside risk of up to $5 you must sell 2 call options.

The expected rate of return on the portfolio that you created should equal the risk-free rate.

False.

The expected rate of return on the portfolio can be greater than the risk-free rate depending on the call option premium collected.

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