Hector Francisco is a successful businessman in Atlanta. The box-manufacturing f
ID: 2655401 • Letter: H
Question
Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm he and his wife, Judy, founded several years ago has 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 bottoms 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.
Questions
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?
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.
2. Determine the holding period return for each of the 3 investment alternatives open to Hector Francisco.
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.
Explanation / Answer
Answer:a If Hector wants to invest in RPP for six months, he could use any of the vehicles mentioned: purchase the common stock; purchase warrants; purchase the $50 call; or purchase the $60 call. For a two-year investment horizon, he could use only two of these vehicles: the common stock and the warrants (the expiration dates on the calls are not long enough to enable Hector to invest for the full two years of this investment horizon).
(b) (1) Assuming that Hector’s expectations are correct, the stock will be priced at $80 at the end of the holding period; therefore, the value of the warrant will be:
($80 – $45) * 1 = $35
If it trades at a premium of 10 percent, its market price will be:
$35 *1.10 = $38.50
(2) Value of the first call ($50 exercise price):
V = ($80 – $50) * 100 = $3,000
Value of second call ($70 exercise price):
V = ($80 – $60) * 100 = $2,000
(3)HPR(stock investment)=[(0.50*2.40)+(80-57.50)]/$57.50
=41.22%
*Dividends will be received for only 6 months, or 2 quarters.
HPR(Warrants)=$38.50-$15/$15
=156.67%
*Recall that $38.50 is the market price of the warrant at the end of the
investment horizon (see b(1) above).
HPR(call with $50 exercise price)=($3000-$800)/$800=275%
HPR(call with $60 exercise price)=($2000-$500)/$500=300%
(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.
Investment Vehicles
Per Share
Common Stock
Warrants
$50 Call
$60 Call
Investment
$57.50
$15.00
$8.00
$5.00
Dividends
1.20
0
0
0
Price in six months
80.00
38.50
30.00
20.00
Capital gain
22.50
23.50
22.00
15.00
Profits
23.70
23.50
22.00
15.00
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).
Investment Vehicles
Totals
Common Stock
Warrants
$50 Call
$60 Call
Investment
$5,750
$5,750
$5,750
$5,750
Dividends
120
0
0
0
Value in six months
8,000
14,758
21,563
23,000
Capital gain
22,250
9,008
15,813
17,250
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
Investment Vehicles
Per Share
Common Stock
Warrants
$50 Call
$60 Call
Investment
$57.50
$15.00
$8.00
$5.00
Dividends
1.20
0
0
0
Price in six months
80.00
38.50
30.00
20.00
Capital gain
22.50
23.50
22.00
15.00
Profits
23.70
23.50
22.00
15.00
Times 100 shares = Total profits
$2,370
$2,350
$2,200
$1,500
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