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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:

 

                                                                        Exercise price

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%

 
Guest Mar 8, 2018

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