Xiaoran Gao
Member
Hi,
I'm struggling on this question:
"A building society issues a one-year bond that entitles the holder to the return on a weighted-average share index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to the end of the year.
Explain how the building society can use a combination of call and put options to prevent making a loss on these bonds."
I completely understand that the building society should purchase a put option with a strike price of xS_t, since if the share price goes down below xS_t, the society can exercise the option to prevent loss. Also the society should sell something to cover the premium of this put option.
But why should the society sell a call option with a strike price of 1.3S_t?
Thanks!
I'm struggling on this question:
"A building society issues a one-year bond that entitles the holder to the return on a weighted-average share index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to the end of the year.
Explain how the building society can use a combination of call and put options to prevent making a loss on these bonds."
I completely understand that the building society should purchase a put option with a strike price of xS_t, since if the share price goes down below xS_t, the society can exercise the option to prevent loss. Also the society should sell something to cover the premium of this put option.
But why should the society sell a call option with a strike price of 1.3S_t?
Thanks!