Hello there, on page 16 of the course notes, there is a core reading text that says 'An example of when a derivative contract might be used is when a provider is concerned about the impact of a fall in the value of its equity portfolio. It could enter into a contract to protect its equity portfolio falling below a certain level. Potentially, the cost of this 'downside protection' could be partially met by the sale of some 'upside' potential via a second derivative contract.' What does 'the cost of this downside protection refer to? There is an example question that follows, but I don't quite understand how selling the upside using a second derivative contract relates to the downside protection. Thank you in advance!
Cost of downside protection = Cost of long put. Sale of upside potential = Income from short call. The strike price of put option will be chosen so that maximum loss is limited. The strike price of call option will be chosen so that maximum profit is limited and some or all of premium of long puts is recovered. Why would fund manager limit maximum profit? This is because put options require upfront premium payment. He may not have cash to bear this cost. Also, if the objective of fund is to match liabilities rather than profit maximization, then limiting returns beyond liability requirements is acceptable.
