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You are forming an investment strategy
You are forming an investment strategy.
You think there is a great upward potential in the stock market and would like to invest in the stocks. However, you are not able to afford substantial stock market losses and so are concerned on the risk of a market collapse, which you think is not impossible.
Choice 1: Your financial advisor suggests a protective put position: buy both shares in a stock index fund (currently $900 per share) and put options on those shares with 3-month expiration and exercise price of $780.
Choice 2: Your friend suggests you instead buy a 3-month call option on the index fund with exercise price $840 and buy 3-month T-Bill with face value $840.
(1). Compare these two choices in the following tables.
Choice 1:
|
If S<780 |
If 780<=S<=840 |
If S>840 |
|
|
Payoff: |
|||
|
Stock |
S |
S |
S |
|
Put |
|||
|
Total |
|||
Choice 2:
|
If S<780 |
If 780<=S<=840 |
If S>840 |
|
|
Payoff: |
|||
|
T-Bill |
840 |
840 |
840 |
|
Call |
|||
|
Total |
|||
(2). Use the above information; please represent the payoffs of each strategy in one diagram with the stock price as the X-axis and payoff as the Y-axis.
Expert Solution
Step 1: For the put, the pay off begins only below 780, hence, below 780, the pay off is 780 - S and else 0;
Hence the table is:
| Choice 1 | S<780 | 780<=S<=840 | S>840 |
| Stock | S | S | S |
| Put | 780-S | 0 | 0 |
| Total | 780 | S | S |
Step 2: For the call option, the pay off will start only after 840, hence, pay-off after 840 is S-840 else 0;
| Choice 1 | S<780 | 780<=S<=840 | S>840 |
| T Bill | 840 | 840 | 840 |
| Call | 0 | 0 | S-840 |
| Total | 840 | 840 | S |
The net diagram will be like a call option with the strike price at 780 and 840 respectively for the individual cases.
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