You are attempting to formulate an investment strategy. On the one hand, you think there is great upward potential in the stock market and would like to participate in the upward move if it materializes. However, you are not able to afford substantial stock market losses and so cannot run the risk of a stock market collapse, which you recognize is also possible. Your investment adviser suggests a protective put position: Buy shares in a market index stock fund and put options on those shares with three-months until expiration and exercise price of $1,040. The stock index is currently at $1,200. However, your uncle suggests you instead buy a three-month call option on the index fund with exercise price $1,120 and buy three-month T-bills with face value $1,120.

a. On the same graph (given on the next page), draw the payoffs to each of these strategies as a function of the stock fund value in three months. (2+2 Points) Hints: Think of the options as being on one share of the stock index fund, with the current price of each share of the index equal to $1,200. In this question you are asked to find the pay-off for the below strategies. You may want to use the table below to do that.

(i) Strategy Buy [Stock + Put]: Buy shares in a market index stock fund and put options on those shares with three-months until expiration and exercise price of $1,040.

(ii) Strategy Buy [Call + T-bills]: Buy a three-month call option on the index fund with exercise price $1,120 and buy three-month T-bills with face value $1,120).

b. Given your answer in part a which strategy must require a greater cost to establish? (2 Point) Hint: In this part you want to compare the final payoffs from the two strategies to answer this question?

c. Suppose the cost in the market of the securities are as follows. Stock fund: $1200 T-bill (face value $1120): $1080 Call (Exercise price $1120): $160 Put (Exercise price $1040): $8 Below fill the table of profits realized for each portfolio for the following values of the stock price (ST) in three months: ST = $0, $1,040, $1,120, $1,200, and $1,280. Graph the profits to each portfolio as a function of ST on a single graph. (3+3 Points) Hint: For the profit you first need to find the initial cost of each strategy using the data for the market prices above. For example, strategy with stock and put costs $1208.

d. Which strategy will have a higher beta? How do you reach your conclusion? (1+2 Points)