E
Edwin
Member
Hi, I am not convinced that the strategy shown in the solution does "limit the downside risk on the portfolio" or "sacrifice some of the upside".
Let's first point out that the initial downside risk is falling bond prices....
On their own a put will limit (put a floor) downside risk and a short call will sacrifice (cap) some upside. However, this is not the case for the net effect, as shown in the diagram in the Mock solution, under bullish markets losses will be incurred when the value of the index rises above S(2) - one may argue that this is what sacrificing some upside is, BUT if prices rise significantly you can lose the whole portfolio, in other words you are short volatility. Also this strategy does not limit the risk of falling bond prices, it eliminates it completely - as bond prices keep falling, you keep more profit.
The correct strategy is a Bull call spread/Bull put spread and a position in the underlying index. This can be made to have a zero cost;-
FTSE100+P(K1)-C(K2) = 0, the strike prices adjust to ensure a zero cost overall. See APRIL 1999 Q5 - 109/CT8 exam. Also see my graph (attached);-
Assumption;- the words ''an option strategy" does not restrict investing in the underlying.
For part (iii) can someone explain to me why the effectiveness of an Options hedge is equal to the correlation squared? Since for a futures hedge it is the square of the hedge ratio.
Let's first point out that the initial downside risk is falling bond prices....
On their own a put will limit (put a floor) downside risk and a short call will sacrifice (cap) some upside. However, this is not the case for the net effect, as shown in the diagram in the Mock solution, under bullish markets losses will be incurred when the value of the index rises above S(2) - one may argue that this is what sacrificing some upside is, BUT if prices rise significantly you can lose the whole portfolio, in other words you are short volatility. Also this strategy does not limit the risk of falling bond prices, it eliminates it completely - as bond prices keep falling, you keep more profit.
The correct strategy is a Bull call spread/Bull put spread and a position in the underlying index. This can be made to have a zero cost;-
FTSE100+P(K1)-C(K2) = 0, the strike prices adjust to ensure a zero cost overall. See APRIL 1999 Q5 - 109/CT8 exam. Also see my graph (attached);-
Assumption;- the words ''an option strategy" does not restrict investing in the underlying.
For part (iii) can someone explain to me why the effectiveness of an Options hedge is equal to the correlation squared? Since for a futures hedge it is the square of the hedge ratio.
Last edited by a moderator:
The key is that the person owns the portfolio AND has the option strategy. As you say, the option strategy gives unlimited loss if teh underlying rises, but if you own the portfolio as well, you get equal and opposit gains. It cannot wipe out the portfolio. In fact if you att the profits and losses from the portfolio to the same diagram, you end up with a bull spread as you mentioned.