Question

4. A manager would like to protect a $1,000,000 portfolio from any decline below $800,000 in the next three months before transaction costs and premiums. The risk free rate is 4%. The beta of the portfolio is 2. The stock index is at 250. Three-month puts on the index are available with Exercise Price: 220 225 230, and 235 Premium: $1 What is the best strategy (lowest cost the manager could use to achieve his/her goal if the future index level is expected to be: 215 220 225 or 230? Justify your answer.

Answer 1

Best strategy for the manager: The manager should square off his position when the index reaches below the index level of 225, if he is a conservative investor.If investor is aggressive in nature then he need to execute put options up to the extent of $2,00,000

Future index levels 215 220 225 230

Difference in index from current levels 35 30 25 20

Decrease in % from current levels 14% 12% 10% 8%

Beta factor 2 2 2 2

Decrease in portfolio value % 28% 24% 20% 16%

Value of portfolio ($ million) 0.72 0.76 0.80 0.84