Nick Fitzgerald holds a well-diversified portfolio of high-quality, large-cap stocks. The current value of Fitzgerald's portfolio is

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Nick Fitzgerald holds a well-diversified portfolio of high-quality, large-cap stocks. The current value of Fitzgerald's portfolio is $735,000, but he is concerned that the market is heading for a big fall (perhaps as much as 20%) over the next three to six months. He doesn't want to sell all his stocks because he feels they all have good long-term potential and should perform nicely once stock prices have bottomed out. As a result, he's thinking about using index options to hedge his portfolio. Assume that the S&P 500 currently stands at 2,200 and among the many put options available on this index are two that have caught his eye:

(1) A six-month put with a strike price of 2,150 that's trading at $76, and

(2) A six-month put with a strike price of 2,075 that's quoted at $58.

a. How many S&P 500 puts would Nick have to buy to protect his $735,000 stock portfolio? How much would it cost him to buy the necessary number of puts with a $2,150 strike price? How much would it cost to buy the puts with a $2,075 strike price?

b. Now, considering the performance of both the put options and Nick's portfolio, determine how much net profit (or loss) Nick will earn from each of these put hedges if both the market (as measured by the S&P 500) and Nick's portfolio fall by 15% over the next six months. What if the market and Nick's portfolio fall by only 5%? What if they go up by 10%?

c. Do you think Nick should set up the put hedge and, if so, using which put option? Explain.

d. Finally, assume that the DJIA is currently at 17,550 and that a six-month put option on the Dow is available with a strike of 174, and is currently trading at $7.84. How many of these puts would Nick have to buy to protect his portfolio, and what would they cost? Would Nick be better off with the Dow options or the S&P 2,150 puts? Briefly explain.

Stocks
Stocks or shares are generally equity instruments that provide the largest source of raising funds in any public or private listed company's. The instruments are issued on a stock exchange from where a large number of general public who are willing...
Strike Price
In finance, the strike price of an option is the fixed price at which the owner of the option can buy, or sell, the underlying security or commodity.
Portfolio
A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly...
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Fundamentals Of Investing

ISBN: 9780134083308

13th Edition

Authors: Scott B. Smart, Lawrence J. Gitman, Michael D. Joehnk

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