Ken Webster manages a $200 million equity portfolio benchmarked to the S&P 500 Index...

Ken Webster manages a $200 million equity portfolio benchmarked to the S&P 500 Index. Webster believes the market is overvalued when measured by several traditional fundamental/economic indicators. He is therefore concerned about potential losses but recognizes that the S&P 500 Index could nevertheless move above its current 883 level. Webster is considering the following option collar strategy:

• Protection for the portfolio can be attained by purchasing an S&P 500 Index put with a strike price of 880 (just out of the money).

• The put can be financed by selling two 900 calls (further out-of-the-money) for every put purchased.

• Because the combined delta of the two calls (see following table) is less than 1 (that is, 2 × .36 = .72) the options will not lose more than the underlying portfolio will gain if the market advances.

The information in the following table describes the two options used to create the collar.

a. Describe the potential returns of the combined portfolio (the underlying portfolio plus the option collar) if after 30 days the S&P 500 Index has:

i. risen approximately 5% to 927.

ii. remained at 883 (no change).

iii. declined by approximately 5% to 841.

(No calculations are necessary.)

b. Discuss the effect on the hedge ratio (delta) of each option as the S&P 500 approaches the level for each of the potential outcomes listed in part ( a ).

c. Evaluate the pricing of each of the following in relation to the volatility data provided:

i. the put

ii. the call