5. (Providing downside protection - Writing a covered call) Today is December 7,
ID: 2796714 • Letter: 5
Question
5. (Providing downside protection - Writing a covered call) Today is December 7, 2015. Suppose that you decide to write a covered call on 100 shares of Merck (MRK) common stock that you bought today. You plan to write one April 2016 call option with a strike price of K $52.50. You have the following information. (All prices are per share.) Merck's stock price today: $53.68 Merck does not pay dividends. Premium on this call option is $3.40 per share. This option expires mid-April. Time to expiration is approximately 4 months. · LIBOR is 0.4% per annum for this period. At expiration of the call option, the stock price is $58 per share. (a) What is your total profit or loss? ($222) (b) What is your 4-month rate of return ofthis strategy? (4.42%) (c) What is the 4-month rate of return without options? (8.05%) (d) What does the answers from (c) and (d) tell you? (Go figure) (Assume that all positions are held open until expiration.) (Assume that all positions are held open until expiration.) Do not round values at intermediate steps in your calculations c = 3.40, So = 53.68, K = 52.5, T = 4/12, r = 0.04, ST-58.Explanation / Answer
Q5
a) Total Profit will be calculated as:
(Strike Price - Spot Price of the share + Premium Received ) * No. of Shares
= ( 52.50 - 53.68 + 3.4 ) * 100 = 222 Dollars
b) 4 month return will be calculated as
Profit / { ( Spot Price - Premium Received ) * 100 }
= 222 / { (53.68 - 3.4 ) * 100 } = 4.42%
c) Rate of Return without options
= Profit / Amount of Investment
= ( 58 - 53.68 ) * 100 / ( 53.68 * 100)
= 8.05%
d) We conclude that it would have been better to not write the call option on these stocks as this leads to compromising the upside potential of the stock for a risk free return
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