QUESTION 1: (6 points, 2 points each section) You own 100 shares of Don't Worry Be Happy Inc. each. You expect that the share price will increase in the long run. You are, however, worried that their share price will fall SUBSTANTIALLY in the short-term. To protect against this possibility, you can use call and put options on Don't Worry Be Happy Inc. Both options are European options and have the same expiration date. The current share price of Don't Worry Be Happy Inc. is $45, and the firm will not pay dividends during the life of the options. Each option is on 100 shares of Don't Worry Be Happy Inc. The exercise price of the put options is $40 and its premium is $4 per share. The exercise price of the call options is $50 and its premium is $4 per share. IMPORTANT: THE EXERCISE PRICES ARE NOT EQUAL TO THE CURRENT STOCK PRICE. a) Design a hedging strategy against SUBSTANTIAL price declines using either put options or call options. Calculate the initial investment and the maximum profits and losses (relative to the current stock price). You are concerned about the high cost of the insurance provided by the strategy above, as well as by the amount of the maximum loss. Design a hedging strategy that will cost less money today and will have a lower maximum loss, using the options above. Calculate the initial investment and the maximum profits and losses (relative to the current stock price). c) Compare the two strategies above. When will the two strategies have the same profits or losses? Which strategy is better? EXPLAIN. QUESTION 1: (6 points, 2 points each section) You own 100 shares of Don't Worry Be Happy Inc. each. You expect that the share price will increase in the long run. You are, however, worried that their share price will fall SUBSTANTIALLY in the short-term. To protect against this possibility, you can use call and put options on Don't Worry Be Happy Inc. Both options are European options and have the same expiration date. The current share price of Don't Worry Be Happy Inc. is $45, and the firm will not pay dividends during the life of the options. Each option is on 100 shares of Don't Worry Be Happy Inc. The exercise price of the put options is $40 and its premium is $4 per share. The exercise price of the call options is $50 and its premium is $4 per share. IMPORTANT: THE EXERCISE PRICES ARE NOT EQUAL TO THE CURRENT STOCK PRICE. a) Design a hedging strategy against SUBSTANTIAL price declines using either put options or call options. Calculate the initial investment and the maximum profits and losses (relative to the current stock price). You are concerned about the high cost of the insurance provided by the strategy above, as well as by the amount of the maximum loss. Design a hedging strategy that will cost less money today and will have a lower maximum loss, using the options above. Calculate the initial investment and the maximum profits and losses (relative to the current stock price). c) Compare the two strategies above. When will the two strategies have the same profits or losses? Which strategy is better? EXPLAIN
