Question

is the appropriate hurdle rate for this project? Explain. Question 4 [10+4 14 marks Sid Neigh owns 2,000 shares in Arepo Ltd, which is a company listed on the ASX. The current price of Arepo's shares is $9.00 per share. There are also put and call options traded on Arepo shares with each option contract covering 100 shares. Sid sells 20 one-month call options with an exercise price of $10.00 per share and buys 20 one-month put options with an exercise price of $8.00 per share. He intends to sell his shares in one month's time. a) Complete the following table. Show your calculations for the first two and the last two rows. Total payoff Total payoff from the 20 Price per Total value of shares in one month's time share in one from the 20 Total cash flow in one put contracts bought month's call contracts sold month's time time $6.00 $7.00 $8.00 $9.00 $10.00 $11.00 $12.00 Describe the effect(s) of Sid's option strategy on the returns he would otherwise have made. Is Sid likely to be a highly risk averse or less risk averse investor? Explain. b)

Answer 1

Answer:

a)

Price per Share in one month's time	Total Value of Shares in One Month's Time	Total Payoff from the 20 call contracts sold	Total Payoff from the 20 Put Contracts sold	Total cash flow in one month's time
$ 6.00	$ 12,000	- $ 120	$ 160	$ 12,040
$ 7.00	$ 14,000	- $ 140	$ 160	$ 14, 020
$ 8.00	$ 16,000	-$ 160	$ 180	$ 16,020
$ 9.00	$ 18,000	- $ 180	$ 180	$ 18,000
$ 10.00	$ 20,000	- $ 200	$ 200	$ 20,000
$ 11.00	$ 22,000	- $ 200	$ 220	$ 22,020
$ 12.00	$ 24,000	- $ 200	$ 240	$ 24,020

Calculations :

1. when price is $ 6.00 :

Price per Share in one month's time	Total Value of Shares in One Month's Time	Total Payoff from the 20 call contracts sold	Total Payoff from the 20 Put Contracts sold	Total cash flow in one month's time
$ 6.00	= 2000 shares X $ 6.00 = $ 12,000	Do not exercise the option as right to buy is at $ 10.00 per option and one months price is $ 6.00 per option , therefore buy stocks at $ 6.00 = 20 x $ 6.00 = $120	Exercise the option as right to sell at $ 8.00 and one months price is $ 6.00 = $ 8.00 x 20 = $ 160	= $ 12000 - $ 120 + $ 160 = $ 12,040

2.when price is $ 7.00 :

Price per Share in one month's time	Total Value of Shares in One Month's Time	Total Payoff from the 20 call contracts sold	Total Payoff from the 20 Put Contracts sold	Total cash flow in one month's time
$ 7.00	= 2000 SHARES X $ 7.00 = $ 14,000	Do not exercise the option as right to buy is at $ 10.00 and one months price is $ 7.00. Therefore buy at one months spot price = 20 x $ 7.00 = $ 140	Exercise the option as right to sell is at $ 8.00 and one months price is $ 7.00. Therefore buy at one months spot price = 20 x $ 8.00 = $ 160	=$ 14,000 -$ 140 + $ 160 = $ 14,020

3.when price is $ 11.00 :

Price per Share in one month's time	Total Value of Shares in One Month's Time	Total Payoff from the 20 call contracts sold	Total Payoff from the 20 Put Contracts sold	Total cash flow in one month's time
$ 11.00	= 2000 SHARES X $ 11.00 = $ 22,000	Exercise the option as the right to buy is $ 10.00 and one month spot price is $ 11.00 = 20 x $ 10.00 = $ 200	Do not Exercise the option as right to sell at $ 8.00 and one month spot price is $ 11 therefore sell at spot price = 20 x $ 11.00 = $ 220.00	= $ 22,000 -$ 200 + $ 220 = $ 22,020

4.when price is $ 12.00 :

Price per Share in one month's time	Total Value of Shares in One Month's Time	Total Payoff from the 20 call contracts sold	Total Payoff from the 20 Put Contracts sold	Total cash flow in one month's time
$ 12.00	= 2,000 SHARES X $ 12.00 = $ 24,000	Exercise the option as right to buy is at $ 10.00 and one months price is $ 12.00. Therefore buy as per call option = 20 x $ 10.00 = $ 200	Do not exercise the option as right to sell is at $ 9.00 and one months price is $ 12.00. Therefore sell at one months spot price = 20 x $ 12.00 = $ 240	= $ 24,000- $ 200 + $ 240 = $ 24,040

b) Effects of Sid's strategy :

1. No loss bearing

2. call and put options equalize the loss effect

Sid is likely to be less risk averse investor.

Reasons:

1. the call and put options he entered would equalize the loss against gain and there would be no loss bearing

2. The call and put options would be priced near to the price of stock he holds ( his holding price ). So he wants to cover short term risk