Ken Webster manages a $ 100 million equity portfolio benchmarked to the S& P 500 index. Over the past two years, the S& P 500 Index has appreciated 60 percent. Webster believes the market is overvalued when measured by several traditional fundamental/ economic indicators. He is concerned about maintaining the excellent gains the portfolio has experienced in the past two years but recognizes that the S& P 500 Index could still move above its current 668 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 665 (just out of the money).
€¢ The put can be financed by selling two 675 calls (further out of the money) for every put purchased.
€¢ Because the combined delta of the two calls is less than 1 ( i. e., 2 3 .36 5 .72), the options will not lose more than the underlying portfolio will gain if the market advances.

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 percent to 701.00
ii. Remained at 668 (no change)
iii. Declined by approximately 5 percent to 635.00 (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

Options to Create the Collar Characteristics Option price Option implied volatility Option's delta Contracts needed for collar 675 Call $4.30 11.00% .36 602 665 Put $8.05 14.00% -044 301