Explain and illustrate your answers to these questions in no more than 2,500 words. This limit includes tables and captions but excludes footnotes, endnotes, tables of figures and references. Answers that exceed this limit will result in a loss of marks. Full details of penalties for late submission, exceeding the word limit and other information can be found at the end of this assignment.

Question 1:

Using daily data on the share price of Whitbread plc (share price in GB pounds, source https://uk.finance.yahoo.com), the daily logged return has been calculated for the year 6 June 2013 to 5 June 2014, where the return is calculated as

u_i = ln(S_i/S_i-1)

Using the methods described on p. 295 in Hull, the estimated volatility per annum is calculated as 21% (or 0.21). The Whitbread closing stock price on 6 June 2014 is £43.50. The 12 month sterling interbank lending rate for 6 June 2014 is 0.96% (or 0.0096) (source: www.bankofengland.co.uk).

1(a) Suppose you have a long position in the stock on 6 June 2014. How would you hedge against price declines for a one-year period, using puts, calls, and combinations of options?

1(b) Suppose you have a short position in the stock on 6 June 2014 (for example, you are obliged to purchase the stock in one year). How would you hedge against price increases for a one-year period, using puts, calls, and combinations of options?

Question 2:

On 5 June 2015 the closing price of Whitbread stock is £49.77. Calculate the payoffs for the strategies you chose in Q1a combined with the long position in the stock, and the strategies you chose in Q1b combined with the short position in the stock.

Comment on your results.

Your assignment must be properly referenced.