Question

4. Kostas owns some stocks of Greek financial companies. He wants to hedge the position since the Greek economy is going through a deep recession.

a.Would buying a put option on a broad market index on the Athens Stock Exchange (ATHEX) be a good strategy to hedge his position?

b.What would happen if the recession continued and the market went further downward?

c. What would happen if the economy rebounded but the financial sector did not recover from the crisis?

Answer 1

In given question we can infer the mention of deep recession that is an indicative of plummating price levels in the market, crashing of some sort of stock markets, deflation etc.

Hence Kostas must have informed himself of looming slowdown therefore he tries to hedge downside risk as he owns portfolio of stocks of Greek financial companies.

Payoff for Put Option =Max((K-S(T),0)

Ans A)

When we buy a put option we buy right to sell the option but not the obligation that is for an instance if we buy put option of Strike price K and can be exercised at maturity. If Stock price at the time T is less than K then owner of put option can exercise the put or if stock price at time T is higher than K then he lets the put option unexercised.

In deep recession scenario when stock prices are probably going to fall buying a put option would hedge Kostas from downside risk and though he makes losses on portfolio but will gain on put option position hence losses are minimized.

Ans B)

Even if recession continued and market went down under further it is still believed to be profitable to have long put option (Long means we have bought and Short means we have sold)
hence we will make profit on put option untll it reaches the lower bound of price equals to zero.

Ans C)

IF Financial sector cant recover then there is possibility of expensive put option in near future hence no additional advantage of hedging with put option hence he should sell off the portfolio at the earliest