Reference no: EM131105235

A long-time client, an insurance salesperson, has noticed the increased acquisition activity involving commercial banks. Your client wishes to capitalize on the potential gains associated with this increased acquisition activity in the banking industry by creating speculative positions using options. Your client realizes that bank cash flows are sensitive to changes in interest rates, and he/she believes that the Federal Reserve is about to increase short-term interest rates. Realizing that an increase in the short-term interest rates will lead to a decrease in the stock prices of commercial banks, your client wants the value of his/her portfolio of options to be unaffected by changes in short-term interest rates. Explain how the investor can use option contracts to protect his/her portfolio against changes in value due to changes in the risk-free rate, and to capitalize on the expected price changes in bank stocks.