Question

5.   You buy the stock at a price of $43 and at the same time you buy a put option with an exercise price of $40, paying a premium of $ 2.

A. What is your total cost at the beginning for buying both the stock and the put option? Consider this as your total wealth.

B. If the stock price falls to $30 and you exercise the put, what would be your final wealth in this example?

C.   What is your maximum total loss in dollars if the stock price falls to $10 in the market?

D. What is your maximum total loss if the stock price goes down to zero?

Answer 1

Part A.) we bought the stock and paid the premium on the put option.

So, Total Cost = Stock Price + Premium on the put option = 43 + 2 = $45

Part B.) If stock Price falls to $30, we exercise the put option.

Exercise Price = $40,

Value of option = 40 - 30 = $10

Final Wealth = Current Stock Price + Value of option = 30 + 10 = $40

Part C.) If stock Price Falls to $10.

Value of Option = 40 - 10 = $30

Loss on stock = 43 - 10 = $33

Total Loss = Loss on stock - Gains from put option + Premium Paid = 33 - 30 + 2 = $5

Part D.) If stock Price Falls to $0.

Value of Option = 40 - 0 = $40

Loss on stock = 43 - 0 = $43

Total Loss = Loss on stock - Gains from put option + Premium Paid = 43 - 40 + 2 = $5