Shonna\'s existing investment portfolio is made up of 45% equities, 45% bonds an
ID: 2797529 • Letter: S
Question
Shonna's existing investment portfolio is made up of 45% equities, 45% bonds and 10% money market. Her intended investment position is 1,000 shares of stock A and expects the performance of stock A to move sideways in the next six months and would like to improve her return over this period Given the following assumptions: o o o o Stock A current price 6 months put(95%) option pricing 6 months call (105% option pricing Tenor of structured product SGD 10.00 8% 7% 6 months (assume 12m/year) (a) What structured note will be suitable given her market view, explain briefly your reasons) (6 marks) tb) At the maturity of the note, Stock A was SGD 10.75, Given your answer in (a) what is the payoff for Shonna? Please show all calculations (4 marks) From your answer in (a) - name 2 key components and 2 key risks of such a structured product (c) (8 marks)Explanation / Answer
(a) Since Shonna has a balanced investment portfolio and expects stock A to move sideways in the next 6 months, in order to improve her return over this period, she can consider investing in a structured note that gives her a long position on the stock with a long strangle option strategy. A long stock long strangle would imply she buys 1000 shares of stock A, buys an out-of-the-money call option on 1000 shares and buys out-of-the-money put option on 1000 shares for 6 months. This strategy would ensure that if stock A goes slightly up in 6 months, the long position on the stock + the net payoff on call option will make more money than what is lost on the premium for the put option. If stock A goes slightly down in 6 months, the loss on the stock position + call option premium would be compensated by the net payoff on the put option position.
(b) The payoff for Shonna would be as follows:
Cost of purchasing 1000 shares of stock A @ SGD 10 is 1000*10= SGD 10000
Cost of purchasing 6 months call option (105% option pricing) @ 7% for 1000 shares is 1000*(0.7/2)= SGD 350
Cost of purchasing 6 months put option (95% option pricing) @ 8% for 1000 shares is 1000*(0.8/2)= SGD 400
Total cost of structured note = 10000+350+400= SGD 10750
At maturity after 6 months, stock A was SGD 10.75.
Value of stock position is 1000*10.75= SGD 10750
Value of call option is (10.75-10.5)*1000= SGD 250
Since put option has expired out-of-the-money, value of put option is 0
So net profit on the structured note is (10750+250+0)-10750= SGD 250
(c) Key components of structured product:
1. Long position on underlying stock
2. Long position on out-of-the-money call option and out-of-the-money put option (long strangle)
Key risks of structured product:
1. If price of put option is much higher than price of call option then net payoff may loss making even if stock A moves up.
2. If stock A moves down and price of call option is much higher than put option then net position would be loss making.
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