A bank has just written European put options on 10.000 shares of a stock on which no exchange-traded options exist. A group of employees discusses how to best hedge this position. All of them agree that "do nothing and hope for the best" is not an acceptable strategy.

a. Employee A suggests to sell short 10.000 shares of the stock. He argues that this would reduce the bank's risk, as the bank then has the possibility to get rid of the (low-priced) stocks, which it will receive from the put if the stock price at maturity turns out to be below the put's strike. Point out the flaw in this argument. 2

b. Employee B suggests a "stop-loss strategy", where the bank always sells short 10.000 shares once the stock price drops below the strike, and buys back the 10.000 shares when the stock price rises above the strike. Point out three problems faced by the bank when trying to implement this strategy! 3

c. Employee C suggests a "delta-hedging strategy", where the bank always tries to hold 10.000*P shares (P is the delta of the put option). Point out two problems faced by the bank when trying to implement this strategy! 2

d. Employee D argues that this delta-hedging strategy is a "buy high, sell low"-strategy, which is bound to lose money. How does the expected loss of the strategy relate to the put price?

Answer rating: 100% (QA)

a The flaw in Employee As argument is that selling short 10000 shares of the stock creates unlimited ... View the full answer