Alan just bought 100 shares of Global, Inc. (GLO) at $45 per share and as protection he also bought a three-month put with a $45 strike price at a cost of $400

Question

One of two scenarios is expected to occur in the next three months: (a) GLO stock declines to $33; and (b) GLO stock rises to $61. Calculate the profit or loss under each scenario and explain how the hedge has provided protection for Alan's position in GLO. Ignore transaction costs.
What will be an ideal response?

Answer 1

Answer: Cost of GLO = ($45)(100) = $4,500
Cost of put = $400
In three months:
(a) GLO at $33
Total loss = {($45 - $45)(100)} - $400 = $-400
(b) GLO at $61
Total gain = {($61 - $45)(100)} - $400 = $1,200
At a cost of $400, Alan minimized his loss under scenario (a) to $400, which is less than the $1,200 he would have lost holding GLO stock only. For this downside protection, Alan gave up $400 and reduced his profit in scenario (2) to $1,200 rather than the $1,600 he would have earned by holding only the GLO stock. The hedge reduced his risk by lowering his potential return.