A
portfolio hedge is purchased in the form of a spread.
1) The call is an
option on ABC Corp. with a $3 premium and a $55 exercise.
2) The put is an option
on ABC Corp. with a $1 premium and a $45 exercise.
What is the value of the hedge with a 20% probability
of ABC E(v) at $40, a 60% E(v) at $50 (current price),
and a 20% E(v) at $60?
First, calculate the net gains/losses under each probability.
At
50, the value is: cost of the spread ($1 x 100 share
put) + ($3 x 100 share call). So 100 + 300 = $400
cost (or 400) of the spread.
1) The $50 per share level has no gain or loss with
a cost of 400, so at $50 per share the profit/loss
is $400.
2) At $60 per share, the put is worth zero since the price of the stock is more than the put's exercise price (45). The call is worth 6055 or $500 for 100 shares with a cost of 400, or a net of $100, so at $60 per share the profit/loss is $100.
3) At $40 per share, the call won't be exercised because the ABC stock price is under the exercise price of the call ($55). The put is worth 4540, or $500 with a cost of 400, so at $40 per share the profit/loss is $100.
Finally, sum the probabilities:
.6
* 400 = 240
.2 * 100 = 20
.2 * 100 = 20
The value of the hedge turned out to be $200. What would it be if there were a 40% chance of stability (no gain or loss) and a 40% chance the put would be exercised at an actual of 30? Knowing how these sensitivities work, and the direction ups and downs take the end result, is key to quick responses on many of the CFA questions!
RELATED FAQS

12b1 fees in mutual funds, are known as “assetbased distribution charges,” ...
The correct answer is b. To initiate 12b1 fee charges in a mutual fund, there must be a majority vote by the full board ... 
The ShurGro variable annuity uses an AIR of 3% for those contract holders who are ...
The correct answer is b. Any time the actual growth rate of the separate account exceeds the account’s AIR, the payment will ... 
Sometimes investment banking firms allocate shares of hot issues to the personal ...
The correct answer is a) Spinning is the act of selling hot issues to the personal accounts of corporate officers which in ... 
Donald has been putting aside money for his retirement into a Roth IRA for six years. Although ...
The correct answer is A) In a Roth IRA, there is no required distribution date as there is in a traditional IRA.
 No results found.