6. Suppose you are holding a $1 million portfolio and you want to protect yourse

Question

6. Suppose you are holding a $1 million portfolio and you want to protect yourself against the market downturns. You purchased 10 contracts of put options on S&P500 with a strike of 900. Suppose that the current level of SSP500 is 1,000 and each contract is worth $100,000 100 x 1,000. Suppose that after three months, the S&P500 drops to a level of 880. (a) Suppose your portfolio drops to $0.88 million in three months and you decide to close out all of your positions. What would be L: alaax? (b) Suppose your portfolio drops to $0.8 million in three months and you decide to close out all of your positions. What would be the balance? (c) What is the value of the basis risk? d) What causes the basis risk in this case?

Explanation / Answer

(a) Final value of the is $880,000

Value of put options when exercised= 10*100*(900-880)=20,000

Total value= $900,000

(b)

Final value of the is $800,000

Value of put options when exercised= 10*100*(900-800)=100,000

Total value= $900,000

(c) Basis risk= $1,000-$900= $100

(d) Basis risk can occur between the price of the asset to be hedged and the price of the asset used to hedge the asset. It can also occur because of a expiration date mismatch of the asset being hedged and the actual seeling date of the asset

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