The stock price of KLM is currently at $30 per share. Assume that over 3 months, it can either go up by 20% or down by 20% and that interest rates are at 6% p.a. A friend of yours owns 5,000 shares of KLM that is held in trust and which he cannot sell for another six months. As he is looking to put a down payment on a home he wants to buy in six months, he wants to protect the value of his holding from falling below $120,000 and has come to you for advice. It seems that a financial institution is willing to provide him with the required insurance for an up-front one-time premium payment of $4,500.
What should he do?
To calculate the worth of insurance provided by the financial institution, consider a six-month European put option with a strike price of $24. The risk-free rate is 6%. First, calculate the risk-neutral probability of a 20% rise in the first quarter.
S0 = 30 X = 24 u ...
The solution discusses a question regarding stock insurance, to see if it is worth a one-time premium payment.