You hold 20,000 shares in ABC plc which are currently priced at 500p. ABC has de
ID: 2618780 • Letter: Y
Question
You hold 20,000 shares in ABC plc which are currently priced at 500p. ABC has developed a revolutionary flying machine. If trials prove successful the share price will rise significantly. If the government bans the use of the machine, following a trial failure, the share price will collapse. Required:
(a) Explain and illustrate how you could use the traded options market to hedge your position.
Further information
Current time: 30 January.
Traded option quotes on ABC plc on 30 January:
(b) What is meant by intrinsic value, time value, in-the-money, at-the-money and out-of-the-money?
Use the above table to illustrate.
Explanation / Answer
a) One who is holding 20,000 shares which are currently priced at 500p will have a total value invetsted in ABC = 20000*500 = 10,000,000 p. The risk to the investor is downside whihc is when hte share price callapses in future. In order to hedge this downside risk, investor in ABC can choose to buy Options which will act as a hedge for any loss in share price fall. The way this strategy can be implemented is to buy Put option on ABC stock adn the price of Put option will increase with the fall in share price of ABC adn max loss whch an investor will incur in long position of Put optios is the loss of premium paid to buy the options. The profit in Put options position will be offset by the loss in value of shares position and hence will be a complete hedge to ABC share holding position.
b) Intrinsic value - Market price of an option minus the strike price - representing the profit to the option holder is the option is exercised by the holder
Time Value - Option premium minus Intrinsic value. The time value of option decreased with the passage of time or in other words, towards the maturity of option, the time value decreases.
In-the-money - When the price of option underlying stock is less than the strike price of Option
At-the-money - When the price of option underlying stock is equal to strike price of Option and hence zero intrinsic value.
Out-of-the-money - When the price of option underlying stock is greater than the strike price of Option
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