You own 100 shares of stock ABC，priced at $75. You want to protect against a price...

You own 100 shares of stock ABC，priced at $75. You want to protect against a price decline. You plan to hedge with an OPTION, having a Strike Price = 70 and a (per share) option price of $4.00 ( real position, the option, and overall outcomes）

a) Specify the option position, and Draw the 3 or 4 relevant “final graphs”

b) On the graphs, specify the $ outcomes if the ABC stock price is $52, 72, 92 when the option expires.

Solutions

Expert Solution

100 Stocks of ABC

Price =$75.

a) To hedge against a price decline, we should purchase a Put option on the stock of ABC.

Purchasing a put option at a strike price of $70 for $4.00 makes the effective cost of the share as $79. Remember that this is not a perfect hedge since you are protected for any fall in share price only below $70, but if the price stays between $70 - $ 75, this option does not provide any protection. So the maximum loss in this strategy is limited to $ ( 75-70) + $4 = $9.

b) 1-If the stock price goes down to $52-

Loss of Stock = $ (75-52) = $ 23.

Payoff from the put option= $( 70-52) = $ 18

So, total loss= $ (23-18) + $4( price of the option)= $9.

Likewise,

2- If the stock price becomes 72, the put option lapses and the total loss = $ (75-72) + $ 4= $7.

3- If the stock price becomes 92, the put option lapses and the total profit = $(92-75) - $ 4= $13.

The graph has been attached below.

jeff jeffy answered 2 months ago

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