Question

You are currently managing a stock portfolio worth $55 million and you are concerned that over the next four months equity values will be flat and may even fall. Consequently you are considering two different strategies for hedging against possible stock declines:
(1) buying a protective put, and
(2) selling a covered call (i.e., selling a call option based on the same underlying stock position you hold).

An over-the-counter derivative dealer has expressed interest in your business and has quoted the following bid and offer prices (in millions) for at-the-money call and put optins that expire in four months and match the characteristics of your portfolio:
Bid Ask
Call $2.553 $2.573
Put 1.297 1.317

(a) For each of the following expiration date values for the unhedged equity position, calculate the terminal values (net of initial expense) for a protective put strategy.
35 40 45 50 55 60 65 70 75

(b) For each of these same expiration date stock values, calculate the terminal net profit values for a covered call strategy.

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Answer (a):
In protective put strategy, put options are purchased on the equity portion so that if there is decline in the stock prices, the losses can be compensated by gains in options market.
Current value of equity position = $55 million
Since the put option is at the money, strike price of the option = $55 million
Premium paid to buy the put option = $1.317 million...

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