You Are Evaluating a Stock That Is Currently Selling for $30

question 70

Essay

You are evaluating a stock that is currently selling for $30 per share.Over the investment period you think that the stock price might get as low as $25 or as high as $40.There is a call option available on the stock with an exercise price of $35.Answer the following questions about hedging your position in the stock.Assume that you will hold one share.
What is the hedge ratio?
How much would you borrow to purchase the stock?
What is the amount of your net investment in the stock?
Complete the table below to show the value of your stock portfolio at the end of the holding period. $$\begin{array} { | l | l | l | } \hline \text { Scenario } & \text { Low Stock Price } & \text { High Stock Price } \\\hline \text { Value of Stock at Year End } & & \\\hline \text { Repayment of Loan } & & \\\hline \text { Total } & & \\\hline\end{array}$$ How many call options will you combine with the stock to construct the perfect hedge? Will you buy the calls or sell the calls?
Show the option values in the table below. $$\begin{array} { | l | l | l | } \hline \text { Scenario } & \text { Low Stock Price } & \text { High Stock Price } \\\hline \text { Value of Call Position } & & \\\hline\end{array}$$ Show the net payoff to your portfolio in the table below. $$\begin{array} { | l | l | l | } \hline \text { Scenario } & \text { Low Stock Price } & \text { High Stock Price } \\\hline \text { Value of Stock at Year End } & & \\\hline \text { Value of Call Position } & & \\\hline \text { Total } & & \\\hline\end{array}$$ What must the price of one call option be?

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Definitions:

Annual Dividend

The total amount of dividend payments a company makes to its shareholders over a single fiscal year.

Return

The income generated on an investment over a particular period of time, expressed as a percentage of the investment's initial cost.

Call Option

A financial contract giving the buyer the right, but not the obligation, to purchase a stock, bond, commodity, or other asset at a specified price within a specific time period.

Striking Price

The fixed price at which the holder of an option can buy (in the case of a call) or sell (in the case of a put) the underlying asset.