Solution: Building a Protected Stock Payoff

Exercise: Building a Protected Stock Payoff

Solution

The terminal payoff is $S_T+(95-S_T)^+=\max(S_T,95)$.

For $S_T=80$, the stock is worth $80$ and the put pays $15$, so total payoff is $95$. For $S_T=95$, total payoff is $95$. For $S_T=120$, the put expires worthless and the stock is worth $120$.

Takeaways

• A protective put creates a floor.
• The upside remains open.
• The omitted premium is the cost of buying that floor.