In April 2016 a U.S. investor holds a well diversified stock portfolio with a market value of $20 million. 80% of the portfolio has been constructed to match the performance of the S&P 500 index. The other 20% of the portfolio is held in ten international shares favoured by the investor. Due to uncertainty surrounding global macro-economic factors the investor is worried about the potential for a significant drop in equity prices over the following six month period. The investor has learned that the options market may be a suitable way for him to hedge his underlying risk.
On April 1 2016 the S&P 500 index stands at a value of 1700.
The following S&P 500 index options are available:
June 2016 expiration 1650
September 2016 expiration 1700
December 2016 expiration 1800
Assume all S&P 500 index options have a $500 multiplier.
A) -As a financial analyst recommend a suitable hedging strategy for the above investor. Can the investor hedge 100 per cent of his portfolio using the above options?
B) -Calculate the payoff to such a strategy in the event that the S&P 500 declines by 20% over the next six month period and his holding of the other ten shares falls by 10%