Financial Management of Risks 447have to be paid for up front, and then receive a subsequent positive payoff de-
pending on what happens to the underlying stock. Short calls and short puts re-
ceive all of their cash inf lows up front and then become potential liabilities.
A Protective Put Strategy
A put option can be thought of as price insurance for someone who owns the
underlying asset. For example, suppose you are a pension fund manager, and
you hold hundreds of shares of Microsoft stock. You hold the stock because you
believe the stock will rise in value. You worry, however, that the stock price
can fall, and losses will be so great that the fund will be unable to meet the
needs of the retirees. An effective hedging strategy would be to buy Microsoft
put options. You would choose the strike price to be at a level that would guar-
antee the solvency of the fund. If Microsoft stock falls below the strike price of
the put options, the put options will pay off the difference between the new
lower market price and the strike price. If Microsoft stock rises, the put op-
tions would expire out of the money. The insurance would not pay off, but you
would reap the high return of the rising stock. This strategy is known as buy-
ing a protective put. It is essentially portfolio insurance. The strategy allows
for the upside appreciation of the portfolio, yet sets a f loor below which the
value of the portfolio cannot fall.
A protective put strategy can also be implemented by a producer who
faces the risk of his product’s price falling. For example, a cattle rancher can
buy put options on cattle, thereby fixing the lowest price at which he will be
able to sell his herd.
Swaps
The third category of derivative we will examine is swaps. A swap is an agree-
ment between two parties to exchange cash f lows over a period of time. The
EXHIBIT 13.4 Payoff diagram for a written put option position.
–110–70
–90–50–30–1010300 10203040506070 80 90100 110120 130Payoff (dollars)Terminal stock price (Strike price = $100)