Question

5. Briefly define the following option strategies (2 marks each =8 marks)

5.1. Protective put

5.2. Covered call

5.3. Straddle

5.4. Spread

6. The manager of a large portfolio includes $100 million worth of long-term bonds paying an average coupon rate of 7%. The manager believes that interest rates are about to rise. Explain n how he can address his concerns using interest rates swaps. In your answer, include a clear definition of an interest rate swap (5)

Answer 1

5.

5.1 Protective put : In this strategy the investor holds a stock and sells a put option. This put option protects against a fall in the stock prices. A premium is paid to buy the put option. This strategy protects against the downside prices.

5.2 Covered call : In this strategy, the holder of a stock sells a call option. Although he limits his upside potential for gains he earns an amount of premium by selling a call option. He generates an income stream by selling call options.

5.3 Straddle : In this strategy, an individual buys and sells both call and put options simultaneously at the same strike price for the same underlying asset at the same date of expiration.

5.4 Spread : A spread is an option strategy where the buyer or the seller sells an equal number of options at the class or on the same underlying security but at different strike prices.

6. If a manager believes that the interest rate are going to rise, they will enter into a swap , where they will pay a fixed rate and receive floating payments. In this way, they can lock in a fixed payment and receive higher floating payments and thus reduce their uncertainty of paying higher coupon rates due to the rising interest rates in the economy. In this way, the portfolio manager will be able to pay a fixed coupon rate instead of higher coupon payments and protect himself from higher interest rates.

Swaps exchanges fixed for floating , floating for fixed or fixed for fixed payments.