Week 5 Problems
FIN/402
Case Problem 14.1 A-C (page 588)
The first alternative is for Hector to invest in RPP shares directly and hold for the 6 months. Hector could also invest in RPP with purchase a six-month call options with a $50 strike price and quoted $8 premium. Lastly He has the choice of investing in RPP with a six-month call option of %40 strike price and $5 premium. If the investment horizon is 2 years, the only choice would be to invest without options and hold for that amount of time.
First call option $3000 Second call option is $2000
The holding period returns are 41.2%, 275%, and 300% respectively.
The $50 call option is the best option for Hector. It requires the least amount of capital and the return is in the money. It generates more capital with lesser risk than the $60 call option.
Case Problem 14.2 A-D (page 589)
With a put option, Luke can hedge his portfolio to keep the profits that he has already earned in his stock even if the price were to drop. The put is not obligatory so he does not have to fulfill the contract if the value of the stock rises at contract expiration. However, if the prices do continue to rise closer to the expiration his premium will be worthless and will be out the money.
Hedged Profit= $7350
Regular Profit= $10,500
Strike price of the option = $75
Price per option with 100 shares = $550
Price of three options with 300 shares = $550*3 = $1650
If stock price moves to $100
Proceeds from exercised of the option = 0
Gain from stock sale = $300*(100-40) = $18000
Profit will be = $18000- $1650 = $16350
If stock price moves to $50
Gain from stock sale = $300*(50-40) = $3000
Proceeds from exercised of the option = $25*300 = $7500
Profit will be = $3000 + $7500- $1650 = $8850
I have a conservative perspective and feel like Luke should add puts to his in portfolio to hedge potential losses. He would benefit from protecting his gains since the stock price is expected to fall.
Case Problem 15.1 A-D (page 622)
T-notes futures = $103,500
Quoted price = 91-28
$22,000 gain/ 407.4% margin
The yield would be –129.629%. If T.J. Patrick continues to make maintenance margin deposits, as the rising value of the T-note exhausts his deposit he would actually lose more.
If the T-note price goes down, he can earn a return as well as the interest then T.J. will earn a return. If the price rises with the interest rate, then there would be a loss. The margin in the trade reduces the potential return or increases the loss.
Case Problem 15.2 A-D (page 623)
A hedge in stock index future could prevent the Pernelli’s from loses in their portfolio from a bearish market. Be setting up a short selling S&P 400 Midcap futures, they can help prevent large losses.
The alternatives are short selling, buying puts or using stock index options.
Stock index futures are easier to set up and the investment costs are low compared with the other choices. If the market does not perform as expected, the Pernelli’s run the risk of experiencing a loss.
Value of the S&P 400 Midcap futures contract = 569.40 * $500 = $284,700
479.4
266%
The net would be $362,000 which is less than the what the portfolio started at.
The hedge failed to fully protect the investment. However, there was some recovery of profits that helped to lessen the loss of the investment. If the hedge was set up exactly like its counter (S&P 400 Midcap Index) then the Pernelli’s would not have experienced a loss at all.
This hedge would be set up with puts. Accordingly, the put would cost:
5.80 $500 = $2,900
It would have a value at the end of the investment period of:
Value of put = (Strike Price – Market Price) * $500
= (769 – 691.4) $500
= $38,800
Value of portfolio($375,000 – $52,000) = $323,000
+ Profit from put hedge($38,800 – $2,900)= $35,900
$258,900
The regular hedge was not as effective as the futures hedge in this case. The amount that would have been hedged did not offer the same protection although the investment fee was less. This still offered the Pernelli’s a way to capital in the downturn of the market.
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