Asked by Jonnel Young on May 06, 2024
Verified
You would like to hold a protective put position on the stock of Avalon Corporation to lock in a guaranteed minimum value of $50 at year-end. Avalon currently sells for $50. Over the next year, the stock price will increase by 10% or decrease by 10%. The T-bill rate is 5%. Unfortunately, no put options are traded on Avalon Co.
What would have been the cost of a protective put portfolio?
A) $48.81
B) $51.19
C) $52.38
D) $53.38
Protective Put
An investment strategy that involves buying a put option on a stock one owns, providing downside protection in case the stock's price decreases.
T-bill Rate
The yield or interest rate paid to investors of U.S. Treasury bills, short-term debt instruments issued by the U.S. government.
Stock Price
The current market price at which a share of a company's stock can be bought or sold.
- Gain an understanding of protective puts and the process for their replication utilizing stocks and T-bills.
Verified Answer
MM
Matthew McNellisMay 07, 2024
Final Answer :
B
Explanation :
The hedge ratio is −0.5. A portfolio comprising one share and two puts would provide a guaranteed payoff of 55, with present value of 55/1.05 = 52.38. Therefore,
S + 2P = 52.38
50 + 2P = 52.38
P = 1.19
The protective put strategy = 1 share + 1 put = 50 + 1.19 = 51.19
S + 2P = 52.38
50 + 2P = 52.38
P = 1.19
The protective put strategy = 1 share + 1 put = 50 + 1.19 = 51.19
Learning Objectives
- Gain an understanding of protective puts and the process for their replication utilizing stocks and T-bills.