Explanation:
By investing in the stock of Jack Ville Inc. and taking a long exposure in a put option on Jack Ville Inc. stock, the portfolio manager has constructed a protective put. A protective put consists of a stock and a put option on the same stock with a strike price of X.
The payoff of the put option if the option is in the money is X-S (where S is the current price and X is the strike price).
If the option is out of the money, the payoff of the option is 0.
The payoff of the stock will be equal to the current price or the final price of stock i.e. S
Therefore, the payoff of the protective put with in-the-money put option = (X-S) + S = X. And the payoff of a fiduciary call with an out of the money option = (0) + S = S.
As mentioned in the question, the current price of the stock, S, is below X, so the option is in the money, and the payoff of the protective put is X.
Q.758 Vijay Mehta is a portfolio manager at First American Investments. He manages a portfolio that invests in a wide variety of financial instruments. Currently, a large portion of his portfolio consists of stocks and options. Recently, he purchased the stock of Jack Ville Inc. and at the same time, he also took a long exposure in a put option on the stocks of Jack Ville Inc. with the strike price of X. Suppose that, at the time of expiration, the final price of the stock, S, is below the strike price, X, then estimate the payoff of the combination of the stock and the put option.
A
The payoff of the combination of the stock and the put option is S.
B
The payoff of the combination of the stock and the put option is X.
C
The payoff of the combination of the stock and the put option is S+X.
D
The payoff of the combination of the stock and the put option is zero.
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