Question #101

of 111 A stock is priced at 38 and the periodic risk-free rate of interest is 6%. What is the value of a two-period European put option with a strike price of 35 on a share of stock using a binomial model with an up factor of 1.15, a down factor of 0.87 and a risk-neutral up probability of 68%? A) $0.57. B) $0.64. C) $2.58. Mark Washington, CFA, is an analyst with BIC, a Bermuda-based investment company that does business primarily in the U.S. and Canada. BIC has approximately $200 million of assets under management, the bulk of which is invested in U.S. equities. BIC has outperformed its target benchmark for eight of the past ten years, and has consistently been in the top quartile of performance when compared with its peer investment companies. Washington is a part of the Liability Management group that is responsible for hedging the equity portfolios under management. The Liability Management group has been authorized to use calls or puts on the underlying equities in the portfolio when appropriate, in order to minimize their exposure to market volatility. They also may utilize an options strategy in order to generate additional returns. One year ago, BIC analysts predicted that the U.S. equity market would most likely experience a slight downturn due to inflationary pressures. The analysts forecast a decrease in equity values of between 3 to 5% over the upcoming year and one-half. Based upon that prediction, the Liability Management group was instructed to utilize calls and puts to construct a delta-neutral portfolio. Washington immediately established option positions that he believed would hedge the underlying portfolio against the impending market decline. As predicted, the U.S. equity markets did indeed experience a downturn of approximately 4% over a twelve-month period. However, portfolio performance for BIC during those twelve months was disappointing. The performance of the BIC portfolio lagged that of its peer group by nearly 10%. Upper management believes that a major factor in the portfolio's underperformance was the option strategy utilized by Washington and the Liability Management group. Management has decided that the Liability Management group did not properly execute a delta-neutral strategy. Washington and his group have been told to review their options strategy to determine why the hedged portfolio did not perform as expected. Washington has decided to undertake a review of the most basic option concepts, and explore such elementary topics as option valuation, an option's delta, and the expected performance of options under varying scenarios. He is going to examine all facets of a delta- neutral portfolio: how to construct one, how to determine the expected results, and when to use one. Management has given Washington and his group one week to immerse themselves in options theory, review the basic concepts, and then to present their findings as to why the portfolio did not perform as expected.