case: FRED'S QUANDARY: TO HEDGE OR NOT TO HEDGE
A little more than 10 months ago, Fred Weaver, a banker, bought 3000 shares at $4 per share. Since then, the price of the shares has risen to $7.50 per share. It is now near the end of the year, and the market is starting to weaken. Fred feels there is still plenty of play left in the shares but is afraid that the tone of the market will be detrimental to his position. His wife, Denise, is taking a course on the sharemarket and has just learned about put and call hedges. She suggests that he use puts to hedge his position. Fred is intrigued by the idea, which he discusses with his stockbroker-who advises him that the needed puts are indeed available on his share. Specifically, he can buy three-month puts, with $7.50 strike prices, at a cost of $550 each (quoted at $0.55)
QUESTIONS
1. Given the circumstances surrounding Fred's current investment position, what benefits could be derived from using the puts as a hedge device? What would be the major drawback?
2. What will Fred's minimum profit be if he buys three puts at the indicated option price? How much would he make if he didn't hedge but instead sold his shares immediately at a price of $7.50 per share?
3. Assuming Fred uses three puts to hedge his position, indicate the amount of profit he will generate if the share moves to $10 by the expiration date of the puts. What if it drops to $5 per share?
4. Should Fred use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as a hedge?