FM212 MT Class Assignments Hand in Problem Set 2: Minicase IShares MSCI Emerging Markets

Your uncle has decided to invest £100,000 over the next month. He is very keen on the IShares MSCI Emerging Markets (EEM) but is unsure about the best strategy. His broker recommended he buys a protective put on the stock index, but your uncle has never traded options before and is not much of a risk taker. He wants you to devise a plan for him to capitalize if markets do well but still be protected if the index loses value. You realize that a protective put will protect him from downside risk, but you think a straddle plus investment in the underlying stock may offer similar downside protection, while increasing the upside potential. You decide to show him three strategies 1) unhedged, 2) protective put and 3) straddle plus investment in the underlying stock and the resulting profits and returns he could face from each. The current price for EEM shares is $39.5 and one-month at-the-money options on EEM shares are trading at $1.35 (Call) and $0.84 (Put). Assume that you can buy less than a unit of each option contract and share. Using this data, create a table with the payoffs, profits and returns of the following investments portfolios, using the at-the-money options: 1. Buy EEM shares 2. Buy EEM shares and puts (# shares= # puts) 3. Buy EEM shares, puts and calls (# shares= # puts= # calls) In each case make sure you invest 100% of the $100,000, no more and no less. Note that this implies that number of EEM shares bought will be decreasing from portfolios 1 to 3. Show your results for a limited number of possible stock prices at maturity (one month), for example: 31.5; 33.5; 35.5; 37.5; 39.5; 41.5; 43.5; 45.5; 47.5. The current risk free rate is zero at all maturities.

How would you explain the pros and cons of the 3 strategies to your uncle? In addition, draw the profit diagram for each portfolio. Can you also comment on the different intercepts and slopes?