Determining values: Convertible bond Craig\'s Cake Company has an outstanding is

Question

Determining values: Convertible bond Craig's Cake Company has an outstanding issue of 15-year convertible bonds with a $1,000 par value. These bonds are convertible into 80 shares of common stock. They have a 13% annual coupon interest rate, whereas the interest rate on straight bonds of similar risk is 16%. Calculate the straight bond value of this bond. Calculate the conversion (or stock) value of the bond when the market price is $9, $12, $13, $15, and $20 per share of common stock. For each of thc common stock prices given in part b, at what price would you expect the bond to sell? Why? Make a graph of the straight value and conversion value of the bond for each common stock price given. Plot the per-share common stock prices on the x axis and the bond values on the y axis. Use this graph to indicate the minimum market value of the bond associated with each common stock price.

Explanation / Answer

a. Profit = (100 x 70) - (100 x 62) = $8000

b. Profit on option = 100 x (70 - 60) - 600 = $400

c. To breakeven, the stock price should rise higher to justify the cost incurred in purchasing the option

Increase in Stock price = 600 / 100 = $6 per share.

d. An option buyer stands to make a profit if the underlying asset – let’s say a stock, to keep it simple – rises above the strike price (for a call) or falls below the strike price (for a put) before expiration of the option contract. Conversely, an option writer stands to make a profit if the underlying stock stays below the strike price (if a call option has been written), or stays above thestrike price (if a put option has been written) before expiration. The exact amount of profit depends on (a) the difference between the stock price and the option strike price at expiration or when the option position is closed, and (b) the amount of premium paid (by the option buyer) or collected (by the option writer).

Here’s a simple test to evaluate your risk tolerance in order to determine whether you are better off being an option buyer or an option writer. Let’s say you can buy or write 10 call option contracts, with the price of each call at $0.50. Each contract typically has 100 shares as the underlying asset, so 10 contracts would cost $500 ($0.50 x 100 x 10 contracts).

If you buy 10 call option contracts, you pay $500 and that is the maximum loss that you can incur. However, your potential profit is theoretically limitless. So what’s the catch? The probability of the trade being profitable is not very high. While this probability depends on implied volatility of the call option and the period of time remaining to expiration, let’s call it 25%.

On the other hand, if you write 10 call option contracts, your maximum profit is the amount of the premium income, or $500, while your loss is theoretically unlimited. However, the odds of the option trade being profitable are very much in your favor, at 75%.

So would you risk $500, knowing that you have a 75% chance of losing your investment and a 25% chance of making a big score? Or would you prefer to make a maximum of $500, knowing that you have a 75% chance of keeping the entire amount or part of it, but have a 25% chance of the trade being a losing one? The answer to that question will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.

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