Posted: March 23rd, 2017

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

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 bottom will 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 six 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 six-month investment horizon.

 

In studying RPP, Hector has learned that the company has six-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.

  1. How many alternative investments does Hector have if he wants to invest in RPP for no more than six months? What if he has a two-year investment horizon?
    1. Using a six-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.  
    3. 4.  Determine the holding period return for each of the three investment alternatives open to Hector Francisco.
    4.  

    5. 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

    Case Problem 14.2 Luke’s Quandary: To Hedge or Not to Hedge

    A little more than 10 months ago, Luke Weaver, a mortgage banker in Phoenix, bought 300 shares of stock at $40 per share. Since then, the price of the stock has risen to $75 per share. It is now near the end of the year, and the market is starting to weaken. Luke feels there is still plenty of play left in the stock but is afraid the tone of the market will be detrimental to his position. His wife, Denise, is taking an adult education course on the stock market and has just learned about put and call hedges. She suggests that he use puts to hedge his position. Luke is intrigued by the idea, which he discusses with his broker, who advises him that the needed puts are indeed available on his stock. Specifically, he can buy three-month puts, with $75 strike prices, at a cost of $550 each (quoted at $5.50  c.  Assuming Luke uses three puts to hedge his position, indicate the amount of profit he will generate if the stock moves to $100 by the expiration date of the puts. What if the stock drops to $50 per share? 

  2. d.  Should Luke use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as a hedge?
  3. b.       What will Luke’s minimum profit be if he buys three puts at the indicated option price? How much would he make if he did not hedge but instead sold his stock immediately at a price of $75 per share?
  4. a.      Given the circumstances surrounding Luke’s current investment position, what benefits could be derived from using the puts as a hedge device? What would be the major drawback?
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