A collar is a strategy in which the holder of a position in a stock/index buys a put option with a strike price lower than the current stock/index price and sells a call option with a strike price higher than the current stock/index price. The call premium is intended to reduce the cost of the put premium. The call strike price is often set to make the call premium completely offset the put premium.

Integrated Wealth Asset Management (IWAM) is a small investment management company with $50 million of assets under management. Its performance is measured at the end of the calendar year. Through nine months this year, IWAM has earned outstanding returns for its clients, with its overall portfolio up about 21 percent. IWAM is, however, concerned about the fourth quarter. IWAM management has worked hard for this performance year to date and would not want to see it evaporate.

A partner has learned of the collar strategy, which would enable the company to purchase insurance against downside losses, in the form of puts, by selling off some of its upside gains, in the form of calls. IWAM has never used options before but believes that it understands the risks and rewards. It is not authorized, however, to use options for any of its client accounts. The partners decide to experiment with the collar strategy using $500,000 from the company's discretion account. The partners know that the collar is a conservative strategy and will not jeopardize the discretion account.

The partners approach Pacific Regional Bank (PRB) with a request to purchase a collar covering $500,000 of the portfolio. PRB knows that this is a small derivatives transaction, which it would ordinarily not do, but it knows that if IWAM is satisfied with this strategy, it will likely do larger transactions later. The bank knows that it can do the transaction and hedge the risk in the stock index options market. It also believes that it can buy and sell the options at slightly better prices than it would give IWAM, thereby covering its costs and generating a small profit.

PRB asks IWAM about the amount of downside risk it is willing to bear. IWAM feels it can tolerate a loss of about 6 percent in the fourth quarter so that its overall annual return would be about 15 percent. The S&P 500 is currently at 1,250. The S&P 500 dividend yield is 1.5 percent, the estimated volatility is 0.2, and the risk-free rate is 4 percent. Since the S&P 500 is at 1,250 and the transaction covers a $500,000 portfolio, there will be 400 individual options required to cover the $500,000 portfolio

PRB is concerned about one point. What if IWAM's portfolio does not perform identically to the S&P 500? It discusses this with IWAM, which says that its portfolio sensitivity to the S&P 500 is about 101 percent. In technical terms, the beta is 1.01. IWAM is satisfied that

this is a close enough match to the S&P 500. PRB is not so sure but believes that the risk is worth taking. So the collar is executed.

During the final three months of the year, the market surprisingly continues to perform well. The portfolio rises 7.5 percent to $537,500. The S&P 500, however, outperforms the portfolio, increasing at a 10 percent rate to 1,375.

Q1. Design the Collar Strategy using S&P index as the underlining asset, state and calculate the Call and Put Option positions (long or short) and levels (strike prices) that PRB should take based on IWAM's situation?

Q2. What would be the Maximum Possible overall net return (in %) for the portfolio combined with the Collar Strategy that PRB implemented?

Q3. What was the Actual overall net return (in %) for the portfolio combined with the Collar Strategy that PRB implemented?

Q4. Has the portfolio combined with the Collar Strategy that PRB implemented actually earned the maximum possible overall net return which you calculated in Q2 and Q3? What happened and Why? Do you believe that IWAM would be satisfied with the performance of its portfolio combined with this Collar Strategy implemented by PRB?

Q5.show all the steps used in Derivagem.

It is an INDIVIDUAL case.

Answer all questions based on your analysis and calculation. Show your steps of

calculation. Explain clearly your justifications.

Detailed instruction and requirement on the case will also be given and discussed in

class.