Donna Donie, CFA, has a client who believes the common stock price of TRT Materials (currently $58 per share) could move substantially in either direction in reaction to an expected court decision involving the company. The client currently owns no TRT shares, but asks Donie for advice about implementing a strangle strategy to capitalize on the possible stock price movement. A strangle is a portfolio of a put and a call with different exercise prices but the same expiration date. Donie gathers the following TRT option price data:
a. Recommend whether Donie should choose a long strangle strategy or a short strangle strategy to achieve the client’s objective.
b. Calculate, at expiration for the appropriate strangle strategy in part ( a ), the:
i. Maximum possible loss per share.
ii. Maximum possible gain per share.
iii. Break-even stock price(s).
a. Long Strangle strategy
b. (i) $9 (ii) Unlimited (iii)$46 and $69
alue at expiration = Value of call + Value of put + Value of stock
= $0 + ($35 – $30) + $30 = $35
Given 5,000 shares, the total net proceeds will be:
(Final Value – Original Investment) × # of shares
Unlike others, since a long strangle strategy consists of buying and selling a put and a call with same expiration date and underlying assets but at a different exercise price, this should be the best strategy.
(i) The maximum possible loss per share = total cost of two options = $5 +$4 = $9
(ii) The maximum possible gain is unlimited due to the possibility of a substantial movement in either direction.
(iii) If the stock price finishes $9 below the put exercise price, the break even = $55- $9 = $46
If the stock price finishes $9 above the put exercise price, the break even = $60 + $9 = $69
You are attempting to value a call option with an exercise price of $100 and one year to expiration. The underlying stock pays no dividends, its current price is $100, and you believe it has a 50% chance of increasing to $120 and a 50% chance of decreasing to $80.
The risk-free rate of interest is 10%. Calculate the call option’s value using the two-state stock price model.
The multiplier for a futures contract on a certain stock market index is $250. The maturity of the contract is one year, the current level of the index is 1,000, and the risk-free interest rate is .2% per month. The dividend yield on the index is .1% per month.
Suppose that after one month, the stock index is at 1,020.
a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that the parity condition always holds exactly.
b. Find the holding-period return if the initial margin on the contract is $10,000.
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