Question 4 (20 marks) Eason, a portfolio manager, has just purchased a stock at $1,300 per share which he believes to have promising prospect. To protect against losses, Eason plans to purchase an at-the-money European put option on the stock for $70, with exercise price $1,300, and three-month time to expiration. Alternatively, as Eason feels that he may be spending too much on this put, he could also buy a three-month put with strike price of $1,270 which costs only $55.

a. Analyze the two hedging strategies by drawing the profit diagrams for the stock-plus-put positions for various values of the stock in three months. (14 marks)

b. When does the strategy with cheaper put do better? When does it do worse? (4 marks)

c. Why are the prices of the puts different? (2 marks)