1. A portfolio manager is considering using index put options or index futures contracts to hedge his equity portfolio. What statements are correct about the two vehicles?
I. An index futures hedge will give the portfolio manager very close protection. If the beta is taken into consideration it is hoped that every dollar lost in the portfolio would be gained by the futures contracts. For a portfolio hedge using index puts, if the beta and delta are used to determine the number of put option contracts, it can also provide very close protection.
II. There is no up-front cost to entering a futures contract, although a performance bond (initial margin) must be posted. Additional margin may be called for if the futures position moves adversely.
III. There is a cost to purchasing put option contracts; however, once the premium is paid, there are no further margin obligations (with long option positions).
IV. As long as the futures hedge is in place, there is no possibility for windfall gains. Unlike hedging with futures, put options do provide the possibility for windfall gains.
a) I, II
b) III, IV
c) I, III
d) I, II, III, IV
Chapter 3: The Institutional Investor
1. With this type of pension plan, pension liabilities (pension benefits promised to retirees) resemble those of insurers in that they are guaranteed by the sponsor. If plan investments perform poorly and do not equal the pension liability, the plan sponsor is liable for the shortfall.
a) DB plan
b) DC plan
c) DB and DC plans
1. d) I, II, III, IV
Statement I is correct. However delta is not discussed in the PMT text book.
For Statement I, delta represents how much the option should change in price for a $1.00 change in the stock price. For example, if the stock price falls $1.00, and the put option is expected to rise by $0.50, the delta is –0.50. If the stock price falls $1.00 and the put option price rises to $0.50, twice the amount of puts should be purchased, relative to the stock owned, to properly protect the downside risk.
Statement II is correct.
Statement III is correct.
Statement IV is correct. If puts are used to hedge a long position, and the stock rises, the investor will profit by the increase in the stock price. If the investor sells futures to hedge a long stock position, if the stock goes up, there will be losses on the short futures, which offset the profit on the stock.
2. a) DB Plan
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