A portfolio manager in charge of a portfolio worth $10 million is concerned that the market might decline rapidly during the next six months and would like to use options on an index to provide protection against the portfolio falling below $9.5 million. The index is currently standing at 500 and each contract is on 100 times the index. What should the strike price of options on the index be the portfolio has a beta of 1?

Question

Quizplus · Accepted Answer

Since the portfolio has a beta of 1, it is expected to have the same level of volatility as the market. To protect the portfolio against a market decline from 500 to 475 points, the strike price of the options should be set to 475. This would provide an intrinsic value of (500-475) * 100 = $25,000 per contract, which would compensate for the potential loss in the portfolio's value. Setting the strike price too low (e.g. 425 or 450) would provide more protection but at a higher cost, while setting it higher (e.g. 500) would not provide enough protection against the expected decline. Therefore, the best choice is C) 475.

A Portfolio Manager in Charge of a Portfolio Worth $10