Nico Yong Is Considering the Purchase of 100 Shares of Cisco

question 51

Essay

Nico Yong is considering the purchase of 100 shares of Cisco Systems stock at $22 per share. Because the economy is picking up, Nico believes the demand for Oracle's router systems will increase substantially causing the price of Cisco's shares to increase to $30 per share. As an alternative, Nico is considering the purchase of a call option for 100 shares of Cisco at with an exercise price of $25. This 180 day option will cost Nico $200. Assume no brokerage costs or dividends.
(a) What will Nico's profit be on the stock transaction if he decides to buy the stock and its price does increase to $30 per share and he sells?
(b) How much will Nico earn on the option transaction if he purchases the option and the underlying stock price rises to $30?
(c) How much must the stock price rise for Nico to break even on the option transaction?
(d) Based on parts (a) and (b) above, what should Nico do? Explain.

---

Definitions:

Consumer Surplus

The difference between the maximum price a consumer is (or consumers are) willing to pay for an additional unit of a product and its market price; the triangular area below the demand curve and above the market price.

Willing To Pay

The maximum amount an individual is prepared to spend to purchase a good or service or to avoid something undesirable.

Moral Hazard

A situation in economics where one party is willing to take risks because the costs that could result will not be borne by that party.

Behavior Alteration

The modification or change in individual or group behaviors, often initiated by interventions or environmental modifications.