Case Problem 14.1 The Franciscos’ Investment Options
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.
- 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?
- Using a six-month holding period and assuming the stock does indeed rise to $80 over this time frame:
- Find the value of both calls, given that at the end of the holding period neither contains any investment premium
- 4. Determine the holding period return for each of the three investment alternatives open to Hector Francisco.
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
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?
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?
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?
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?
Case Problem 15.1 T. J.’s Fast-Track Investments: Interest Rate Futures
T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teenager—he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he’s young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.
Recently, T. J. has started playing with financial futures—interest rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn’t go wrong with interest rate futures) and soon set up a trading account with Vinnie’s firm, Banano’s of Portland.
The other day, Vinnie called T. J. and suggested he get into five-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most—with the biggest jump in yields. Accordingly, Vinnie recommended that T. J. short sell some five-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short four contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.
a. Assume T-note futures ($100,000/contract; 32’s of 1%) are now being quoted at 103’16.
1. Determine the current underlying value of this T-note futures contract.
2. What would this futures contract be quoted at if Vinnie is right and the yield does go up by one percentage point, to 6.5%, on the date of expiration? ( It’ll be quoted at the same price as its underlying security, which in this case is assumed to be a five-year, 6% semiannual-pay U.S. Treasury note.)
b. How much profit will T. J. make if he shorts four contracts at 103’16 and then covers when five-year T-note contracts are quoted at 98’00? Also, calculate the return on invested capital from this transaction.
c. What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105’8?
d. What risks do you see in the recommended short-sale transaction? What is your assessment of T. J.’s new interest in financial futures? How do you think it compares to his established commodities investment program?
Case Problem 15.2 Jim and Polly Pernelli Try Hedging with Stock Index Futures
Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a two-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis’ portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading.
Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that’s the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditions—although some will drop more in price than others.
Jim has been following stock index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock index futures—in particular, the S&P MidCap 400 futures contract—as a way to protect (hedge) their portfolio of common stocks.
a. Explain why the Pernellis would want to use stock index futures to hedge their stock portfolio and how they would go about setting up such a hedge. Be specific.
1. What alternatives do Jim and Polly have to protect the capital value of their portfolio?
2. What are the benefits and risks of using stock index futures to hedge?
b. Assume that S&P MidCap 400 futures contracts are priced at $500 × the index and are currently being quoted at 769.40. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?
1. Say the value of the Pernelli portfolio dropped 12% over the course of the market retreat. To what price must the stock index futures contract move in order to cover that loss?
2. Given that a $16,875 margin deposit is required to buy or sell a single S&P 400 futures contract, what would be the Pernellis’ return on invested capital if the price of the futures contract changed by the amount computed in question ?
c). Assume that the value of the Pernelli portfolio declined by $52,000 while the price of an S&P 400 futures contract moved from 769.40 to 691.40. (Assume that Jim and Polly short sold one futures contract to set up the hedge.)
1. Add the profit from the hedge transaction to the new (depreciated) value of the stock portfolio. How does this amount compare to the $375,000 portfolio that existed just before the market started its retreat?
2. Why did the stock index futures hedge fail to give complete protection to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.
d) The Pernellis might decide to set up the hedge by using futures options instead of futures contracts. Fortunately, such options are available on the S&P Midcap 400 Index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying S&P 400 Index. Now, suppose a put on the S&P Midcap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and a comparable call is quoted at 2.35. Use the same portfolio and futures price conditions as set out in question to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. ( Add the net profit from the hedge to the new depreciated value of the stock portfolio.) What are the advantages and disadvantages of using futures options, rather than the stock index futures contract itself, to hedge a stock portfolio?