· Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm he and his wife, Judy, founded several years ago have prospered. Because he is self-employed, Hector is building his own retirement fund. So far, he has accumulated a substantial sum in his investment account, mostly by following an aggressive investment posture. He does this because, as he puts it, “In this business, you never know when the bottom’s gonna fall out.” Hector has been following the stock of Rembrandt Paper Products (RPP), and after conducting extensive analysis, he feels the stock is about ready to move. Specifically, he believes that within the next 6 months, RPP could go to about $80 per share, from its current level of $57.50. The stock pays annual dividends of $2.40 per share. Hector figures he would receive two quarterly dividend payments over his 6-month investment horizon.
In studying RPP, Hector has learned that the company has 6-month call options (with $50 and $60 strike prices) listed on the CBOE. The CBOE calls are quoted at $8 for the options with $50 strike prices and at $5 for the $60 options.
a. How many alternative investment vehicles does Hector have if he wants to invest in RPP for no more than 6 months? What if he has a 2-year investment horizon?
There are three alternatives to invest in the RPP: one is that he can buy stocks for the period of less than 6 months, second alternative is that he can buy a 6 months call option with $50 strike price, 3rd alternative is that he can buy a call option with a strike price of $60/-
If he has a 2 year investment horizon then, he has only one alternative i.e. he can buy a stock and hold for the two years.
b. Using a 6-month holding period and assuming the stock does indeed rise to $80 over this time frame:
1. Find the value of both calls, given that at the end of the holding period neither contains any investment premium.
The call option with a $60 strike price that gives a right to buy 100 shares at $60 per share for a premium of $5 per share:
Price per share after 6 months = $80/-
Proceeds from option = ($80 – $60) x 100 shares = $2,000
Premium paid to purchase option ($5 x 100) = $500
Net profit from the option = $1,500/-
The call option with a strike price of $50 that gives right to buy 100 shares at $50 for a premium of $8 per share:
Price per share after 6 months = $80/-
Proceeds from option = ($80 – $50) x 100 shares = $3,000
Premium paid to purchase option ($8 x 100) =$800
Net profit from the option =$2,200/-
2. Determine the holding period return for each of the 3 investment alternatives open to Hector Francisco.
Return from buying shares:
Purchase price per share = $57.5/-
Expected dividend per share = $1.2 per share
% Return ($80 – $57.50 + $1.2)/$57.50 = 41.2%
Return from the call option of $50 strike = $2200/$800 = 275%
Return from the call option of $60 strike = $1,500/$500 = 300%
c. Which course of action would you recommend if Hector simply wants to maximize profit? Would your answer change if other factors (e.g., comparative risk exposure) were considered along with return? Explain.
I would recommend buying $60 strike call option to maximize the profit because it gives the highest return than other two alternatives.
If we consider other factors such as comparative risk exposure, percentage of portfolio being put at risk, I would make an argument for choosing a different investment vehicle. Such as if he is considering investing in a large percentage of his portfolio then, I would recommend buying the stock because if stock price fall or doesn’t move the value of stock option would fall to zero so, he would lost all amount of his investment.
Part C, Another Answer
(c) Let’s examine this question on profitability in two different ways to show the benefits of leverage with options. First, consider 100-share investments using each of the four vehicles and assuming Hector is correct about the price appreciation, and the other figures in question 2 are correct.
|Per Share||Common Stock||Warrants||$50 Call||$60 Call|
|Price in six months||80.00||38.50||30.00||20.00|
|Times 100 shares = Total profits||$2,370||$2,350||$2,200||$1,500|
Dollar profits are highest for the common stock. However, recall that HPR is highest for the $60 call and that it requires the smallest investment. Now let us assume we put the same amount into each investment, $5,750 (assuming we can purchase fractional options for illustration only).
|Totals||Common Stock||Warrants||$50 Call||$60 Call|
|Value in six months||8,000||14,758||21,563||23,000|
|Total profits||$ 2,370||$9,008||$15,813||$17,250|
With equal dollar investment, the $60 call options would have the largest profit (in both dollar and percentage terms); therefore, if Hector wants to maximize profits, he would invest in the $60 calls. However, they (along with the $50 calls) also possess the greatest risk— the total investment can be lost if the stock fails to move over the six-month life on the options.
Thus, given risk-return considerations, we may want to consider another course of action. This leads us back to the first illustration. In effect, we could consider the leverage attributes of warrants and calls and seek investment outlets which reduce our required investment but capture all or most of the capital gains potential. Of the two calls, the $50 is an “in-the-money” and the $60 is an “out-of-the-money” option; we actually have the most (profit) to gain and the least to lose with the “in-the-money” option, so it should be preferred over the $60 call. Note that if the price of the stock does not move by the expiration date, the most we will lose with the $50 call is $50 ($57.50 – $50.00 = $7.50 ´ 100 = a value at expiration of $750) versus a total loss of $500 with the “out-of-the-money” option.
The warrant has attributes similar to the $50 call, but it also has a much longer life. Thus, we can reduce risk even more by selecting the warrants rather than the $50 calls. But note that because of their higher current cost, we will also be reducing the rate of return potential. Unless current income is important, which can be obtained only through the stocks, it looks like Hector will have to decide between the $50 calls and the warrants based on his risk-return preferences