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FIN 401 Lecture Notes - Lecture 3: Trading Strategy, Cengage Learning, Call Option

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School
Ryerson University
Department
Finance
Course
FIN 401
Professor
Thomas Barbiero

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Document Summary

1. (basic notation and terminology) the average of the bid and ask discounts is 8. 22. Yield = (100/98. 4473) (365/68) 1 = 0. 0876. Note that even though the t-bill matured in 67 days, we must use 68 days since that is the option"s time to expiration. (minimum value of a call) this would create an arbitrage opportunity. The call would be purchased and immediately exercised. For example, suppose s0 = 44, x = 40, and the call price is . Then an investor would buy the call and immediately exercise it. This would cost for the call and for the stock. Then the stock would be immediately sold for , netting a risk-free profit of . In other words, the investor could obtain a stock for . Since everyone would do this, it would drive the price of the call up to at least .

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Related Questions

A call option gives the holder (Points : 4) the obligation to buy something the right to sell something the right to buy something the obligation to sell something none of the above Question 2. 2. A call option priced at $2 with a stock price of $30 and an exercise price of $35 allows the holder to buy the stock at (Points : 4) $2 $32 $33 $45 $35 Question 3. 3. A put option in which the stock price is $60 and the exercise price is $65 is said to be (Points : 4) in-the-money out-of-the-money at-the-money exercisable none of the above Question 4. 4. Organized options markets are different from over-the-counter options markets for all of the following reasons except (Points : 4) exercise terms physical trading floor regulation standardized contracts credit risk Question 5. 5. The advantages of the over-the-counter options market include all of the following except (Points : 4) customized contracts privately executed freedom from government regulation lower prices none of the above Question 6. 6. The option price is also referred to as the (Points : 4) strike spread premium fee none of the above Question 7. 7. An investor who exercises a call option on an index must (Points : 4) accept the cash difference between the index and the exercise price purchase all of the stocks in the index in their appropriate proportions from the writer immediately buy a put option to offset the call option immediately write another call option to offset none of the above Question 8. 8. What amount must a call writer pay if a cash-settled index call is exercised? (Points : 4) difference between the index level and the exercise price exercise price difference between the exercise price and the index level index level none of the above Question 9. 9. You are the purchaser of a call option with $5 premium and $145 exercise price. You bought this option when the stock price was $120. If the stock price now is $155, what is the net cash flow to you if you exercise? (Points : 4) $10 $5 $30 $35 Question 10. 10. You are the purchaser of a put option where the premium is $4 and exercise price is $52. You bought this option when the stock price was $52. If the stock price is $42 right now, what is your net cash flow? (Points : 4) negative $14 negative $6 $6 $4 Question 11. 11. You wrote a call option with premium of $5 and exercise price of $55. You sold this when the stock price was $45. If the stock price now is $65, what is your net cash flow? (Points : 4) negative $5 $25 $20 $5 negative $10 Question 12. 12. You wrote a put option with a premium of $3 and exercise price of $22. You sold this option when the stock price was $25. If the stock price is $22 now, what is your net cash flow? (Points : 4) $6 $3 negative $3 $0 negative $6 Question 13. 13. The maximum gain of the writer of a put option with a premium of $3 and an exercise price of $120 is: (Points : 4) $120 $117 $3 $123 unlimited Question 14. 14. The maximum gain of the purchaser of a put option with a premium of $3 and exercise price of $120 would be: (Points : 4) unlimited $120 $117 $3 $123 Question 15. 15. The maximum gain of the writer of a call option with a premium of $3 and an exercise price of $120 would be (Points : 4) unlimited $3 $117 $120 $123 Question 16. 16. The maximum gain of the purchaser of a call option with a premium of $3 and an exercise price of $120 would be (Points : 4) unlimited $120 $117 $123 $3 Question 17. 17. You have the following information: Put: X=$40, Premium=$4 Call: X=$50, Premium=$6 You bought the stock at $45 Scenarios: S=20, S=45, S=90 Given above information, please calculate the net payouts for a protective put strategy for each different scenario. (Points : 4) -$9, -$4, $41 $25, $0, $0 -$5, $-9, $0 $16, -$4, $45 Question 18. 18. You have the following information: Put: X=$40, Premium=$4 Call: X=$50, Premium=$6 You bought the stock at $45 Scenarios: S=20, S=45, S=90 Given above information, please calculate the net payouts for a covered call strategy for each different scenario. (Points : 4) $6, $6, $11 $6, $0, $51 -$19, $6, $11 -$19, $6, $51 -$6, -$6,$45 Question 19. 19. You have the following information: Put: X=$40, Premium=$4 Call: X=$50, Premium=$6 You bought the stock at $45 Scenarios: S=20, S=45, S=90 Given above information, please calculate the net payouts for a collar strategy for each different scenario. (Points : 4) -$3, $2, $7 -$9, $6, $11 $16, $2, $52 -$4, $0, $6 Question 20. 20. You have the following information: S=65, X=60, T=1, r=0, C=7, P=4 Evaluating the situation from a Put-Call Parity framework, what steps would you take to implement an arbitrage strategy? (Points : 4) Sell Call, Buy Put, Short Stock, Invest remainder Sell Call, Buy Put, Buy Stock, Borrow remainder Buy Call, Sell Put, Buy Stock, Borrow remainder Buy Call, Sell Put, Short Stock, Invest remainder Buy Call, Sell Put, Short Stock, Borrow remainder Question 21. 21. Given the information and the solution you found for Question #20, what is the arbitrage amount? (Points : 4) If S>X, then $6 and if SX, the arbitrage will be $4 If S>X, then $3 and if SX, then $2 and if SX, the arbitrage will be $2 Question 22. 22. You have the following information: S=26, X=20, T=2, r=3.4%, C=15, P=6 Evaluating the situation from a Put-Call Parity framework, what steps would you take to implement an arbitrage strategy? (Points : 4) Sell Call, Buy Put, Buy Stock, Borrow remainder Sell Call, Buy Put, Short Stock, Invest reaminder Buy Call, Sell Put, Buy Stock, Borrow remainder Buy Call, Sell Put, Buy Stock, Invest remainder Buy Call, Sell Put, Short Stock, Invest remainder Question 23. 23. Using the information and the solution from Question #22, what would be the final arbitrage amount? (approximately) (Points : 4) If S>X or SX then $9, if SX or SX then $3, if SX or S

I need the answers to the mini case on Chapter 9. The textbook solutions doesnt have anything posted yet. I need questions C-1,D-3,E 1-2, F,G,H,L, and O.

Textbook: Corporate Finance by Michael Ehrhardt and Eugene Brigham

Mini Case – Chapter 9,

During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis ’ s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:(1) The firm ’ s tax rate is 40%.(2) The current price of Harry Davis ’ s 12% coupon, semiannual payment, non callable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.(3) The current price of the firm ’ s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.(4) Harry Davis ’ s common stock is currently selling at $50 per share. Its last dividend(D 0 ) was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Harry Davis ’ s beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%. For the own-bond-yield-plus- judgmental-risk-premium approach, the firm uses a 3.2% risk premium.(5) Harry Davis ’ s target capital structure is 30% long-term debt, 10% preferred stock ,and 60% common equity. To help you structure the task, Leigh Jones has asked you to answer the following questions.

Question 3 5 pts

Part C) What is the cost of preferred stock?

Question 4 5 pts

Part D) Using CAPM, what is the cost of equity?

Question 5 5 pts

Part E) Using DCF, what is the cost of equity?

Question 6 5 pts

Part E) If you had used ROE to calculate the growth rate in place of the given growth rate, what would the ROE-based growth rate be? (Note: ROE (return on equity) is the amount of profits earned per year on the shareholders' equity. If no dividends were paid out and the company was earning an ROE of 10%, then the entire 10% would be reinvested in the company each year. Consequently, we would expect the equity to grow at 10% per year. If, however, we paid out 70% of our earnings to our shareholders, we would only have 30% of those profits left to grow with. Consequently, we would expect the equity to grow by 3% per year (10% ROE x 30% retained.)

Question 7 5 pts

Part F) Using the bond premium method, what is the cost of equity?

Question 8 5 pts

Part G) What is your best estimate of cost of equity?

Just use an unweighted average of the three different cost of equity numbers you have computed.

Question 9 5 pts

Part H) What is the WACC?

Question 10 5 pts

Part L) What is the division cost of equity?

Question 11 5 pts

Part L) What should be the Division WACC? (Note: The book states that the Cost of Debt is 12%. This is confusing because the book usually uses the term "Cost of Debt" as the After-Tax Cost of Debt. It this problem, the book is using 12% as the Interest Rate or Pre-Tax Cost of Debt. The WACC calculation uses the After-Tax Cost of Debt.)

*Make certain that you are using the after-tax cost of debt based on 12% interest rate.

Question 12 5 pts

Part O) What is the estimated cost of equity?

Question 13 5 pts

Part O) Assuming that the bond sells for 100, what is the cost of debt?

*Recognize that "the bond sells at 100" means that the bond sells at 100% of face value. Also, make sure that you are inputting the cost of debt and not the interest rate.