A fund manager manager is concerned about the performance of the market over the next three months and plans to use three-month put options on a well-diversified index, with a strike price of 1950, to hedge its risk. Additional information is as follows:

The portfolio is worth $50 million with a beta of 0.80. The current level of the index is 2,000, one contract is on 100 times the index. The risk-free rate is 4% per annum. The dividend yield on the index is 2% per annum.

a) How many put option contracts should the fund manager purchase? A: 200

b) Calculate the effect of your strategy on the fund managers returns if the level of the market in three months is 1,700, 1,800, 1,900, 2,000, 2,100 and 2,200. A: Use the spreadsheet from class to trace out these hedge positions, answering the following questions for each outcome. You should also practice at least one of these rows by hand!

What is the cash flow associated with options position? What is the percent return on the market index (including dividends)? What is the predicted return on the equity portfolio, as forecasted by the CAPM? What is the cash flow on the equity portfolio? What is the cash flow on the hedged equity portfolio (i.e., CF on options position plus CF on equity portfolio)?