"Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a 2-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading. Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And thats the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditionsalthough some will drop more in price than others. Jim has been following stock-index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock- index futuresin particular, the S&P MidCap 400 futures contractas a way to protect (hedge) their portfolio of common stocks C 1. Profit from the hedge transaction (gain from short selling of future contract) = 100*change in S&P 400 future contract = 100*(769.40 691.40) = 7800 Depreciated Value Portfolio 375000 52000 = 323000 Value of hedged portfolio Depreciated value +profit from hedge transaction = 323000 + 7800 = 330000 Portfolio will be reduced by 44200 (375000 330000) C2. The stock index futures failed because Pernelli did not choose the right hedge ratio, and the portfolio did not behave exactly like the S &P 400 Medcap Index; perfect protection is nearly impossible the only way to obtain a guaranteed hedge is to build a portfolio of stocks exactly like those in the S&P 400 Midcap Index Question The Pernellis might decide to set up the hedge by using futures options instead of futures contracts. Fortunately, such options are available on the S&P MidCap 400 index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying price of the underlying S&P 400 Index. Now, suppose a put on the S&P MidCap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and as a comparable call is quioted at 2.35. Use the same portfolio and futures price conditions as set in question c to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. (HINT add the net profit from the hedge to the new depreciated value of the stock portfolio) What are the advantages and disadvantages of using futures options, rather than the stock index futures contract itself, to hedge a stock portfolio?