Chapter 2 Securities Markets and Transactions 15
Solutions to Problems
14.5 A call option purchased for $600 with a $60 strike price can later be sold (or exercised) when the
underlying stock has a $75 price; given this, it will generate the following:
= –
= – ´ –
= – =
– ´ –
=
= =
= ´ =
Profit Value at expiration Purchase price
[($75 $60) 100] $600
$1,500 $600 $900
[($75 $60) 100] $600
HPR $600
$900 150%
$600
Annualized rate of return 150% (12/6) 300%
14.6 Price of put option + Price of stock = Price of call option + Price of risk-free bond
14.7 Price of put option + Price of stock = Price of call option + Price of risk-free bond
Because the risk-free rate is assumed to be 0%, the price ofthe bond is just $80.
14.8 Price of put option + Price of stock = Price of call option + Price of risk-free bond
Because the risk-free rate is assumed to be 0%, the price of the bond is just $87.50.
The market price calculated using the 87.50 strike price is fairly close to the answer calculated in
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
14.9 Cost of ETF puts 100 $1.20 $120
14.10 You would lose the cost of the puts, which would expire worthless
14.11 To buy this S&P 100 put, Dorothy will have to pay 100 times the quoted price:
Now if the S&P Index drops to 850 by the put expiration date, the option will be worth:
where 905 strike price on the option.
Thus, the profit from this investment would be
The holding period return would be
On the other hand, if the S&P Index rose to 925 by the expiration date, the put option would be
14.12 Protecting profits with a put hedge:
a. Stock price drops to $60 three months later
Value of the put: $75 $60 $15
Profit:
With the stock trading at $75, Myles has already made a profit of $15,900. His intent is to protect
b. Stock price rises to $90 in threemonths:
Value of the put:$0
Profit:
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
If the stock price goes up to $90, Myles would make additional capital gains on the stock. Net of
c. The major advantage of a put hedge is that it allows investors to enjoy the upward profit potential
d. In-the-money options are more expensive, and as a hedging device, they are riskier than
at-the-money options (those with strike prices exactly equal to the current market price of the
Even though out-of-the-money options are inexpensive, using those options to create a put hedge
Profit:
Myles’s profit dropped from $15,900 to $12,300, for a net loss of $3,600 on the put hedge. This
loss is due to $3,000 of unprotected capital gains and the $600 cost of the put.
Fitzgerald can buy either three or four contracts.We will assume three.
b. SCENARIO I: Market drops by 15%
Hedging using the six-month put with a strike price of2,150
©2017 Pearson Education, Inc.
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
SCENARIO II: Market drops by 5%
Hedging using the six-month put with a strike price of 2,150
Hedging using the six-month put with a strike price of 2,075
Hedging using the six-month put with a strike price of 1,450
SCENARIO III: Market goes up 10%
Hedging using the six-month put with a strike price of 2,150
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 19
Hedging using the six-month put with a strike price of $2,075
c. As can be seen from the above analysis, Fitzgerald would be better off when the market declines
41.880
apprx. 42 put options
SCENARIO I: Market drops by 15%
Hedging using the DJIA put with a strike price of 108
Fitzgerald would be better off with the DJIA put option (strike price 174) rather than the S&P
©2017 Pearson Education, Inc.