Response to the following problem:
C.F. Wong holds a well-diversified portfolio of high-quality, large-cap shares. The current value of Wong's portfolio is $475 000, but he is concerned that the market is heading for a big fall (perhaps as much as 10%) over the next three to six months. He doesn't want to sell all his shares because he feels they all have good long-term potential and should perform nicely once share prices have bottomed out. As a result, he decides to look into the possibility of using index options to hedge his portfolio. Assume that the ASX 200 currently stands at 2910 points and among the many put options available on this index are two that have caught his eye:
(1) a six month put with a strike price of 2890 that is trading at 26, and
(2) a six-month put with a 2830 strike price that is quoted at 12.
a. How many ASX 200 puts would Wong have to buy to protect his $475 000 share portfolio? How much would it cost him to buy the necessary number of 2890 puts? How much would it cost to buy the 2830 puts?
b. Now, considering the performance of both the put options and the Wong portfolio, determine how much net profit (or loss) Wong will earn from each of these put hedges if both the market (as measured by the ASX 200) and the Wong portfolio fall by 10% over the next six months? What if the market and the Wong portfolio fall by only 5%? What if they go up by 10%?
c. Do you think Wong should set up the put hedge and, if so, using which put option? Explain.