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Text Book Case Problems (WK5) FIN/401 Case Problem 14.1 AC (page 588) Hector Francisco is a successful businessman in Atlanta. The boxmanufacturing firm he and his wife, Judy, founded several years ago has prospered. Because he is selfemployed, Hector is building his own retirement fund. So far, he has accumulated a substantial sum in his investment 2 TEXTBOOK CASE PROBLEMS 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 sixmonth investment horizon. In studying RPP, Hector has learned that the company has sixmonth 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. Questions a 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 twoyear investment horizon? b Using a sixmonth holding period and assuming the stock does indeed rise to $80 over this time frame: 0 Find the value of both calls, given that at the end of the holding period neither contains any investment premium. 1 Determine the holding period return for each of the three investment alternatives open to Hector Francisco. 2 c 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 AD (page 589) 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 threemonth puts, with $75 strike prices, at a cost of $550 each (quoted at $5.50). Questions b 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? c 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? d 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 3 TEXTBOOK CASE PROBLEMS drops to $50 per share? 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 AD (page 622) Case Problem 15.1 T. J.'s FastTrack Investments: Interest Rate Futures LG 5 LG 6 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 teenagerhe 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 futuresinterest 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 fiveyear 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 mostwith the biggest jump in yields. Accordingly, Vinnie recommended that T. J. short sell some fiveyear Tnote contracts. In particular, Vinnie thinks that rates on these Tnotes 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. Questions e Assume Tnote futures ($100,000/contract; 32's of 1%) are now being quoted at 103'16. 0 Determine the current underlying value of this Tnote futures contract. 1 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? (Hint: It'll be quoted at the same price as its underlying security, which in this case is assumed to be a fiveyear, 6% semiannualpay U.S. Treasury note.) f g How much profit will T. J. make if he shorts four contracts at 103'16 and then covers when fiveyear Tnote contracts are quoted at 98'00? Also, calculate the return on invested capital from this transaction. h What happens if rates go down? For example, how much will T. J. make if the yield on Tnote futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105'8? 4 TEXTBOOK CASE PROBLEMS What risks do you see in the recommended shortsale 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 AD (page 623) Excel@Investing Excel@Investing One of the unique features of futures contracts is that they have only one source of returnthe capital gains that can accrue when price movements have an upward bias. Remember that there are no current cash flows associated with this financial asset. These instruments are known for their volatility due to swings in prices and the use of leverage upon purchase. With futures trading done on margin, small amounts of capital are needed to control relatively large investment positions. Assume that you are interested in investing in commodity futuresspecifically, oats futures contracts. Refer to the contract terms of oats: \"OATS (CBOT) 5000 bu.; cents per bushel.\" Suppose you had purchased 5 December oats contracts at the settlement price of 186.75. The required amount of investor capital to be deposited with a broker at the time of the initial transaction is 5.35% of a contract's value. Create a spreadsheet to model and answer the following questions concerning the investment in futures contracts. Questions d What is the total amount of your initial margin for the five contracts? e What is the total amount of bushels of oats that you control? f What is the purchase price of the oats commodity contracts you control according to the December settlement date? g Assume that the December oats actually settled at 186.75, and you decide to sell and take your profit. What is the selling price of the oats commodity contracts? Calculate the return on invested capital earned on this transaction. (Remember that the return is based on the amount of funds actually invested in the contract rather than on the value of the contract itself.)