John Smith, a sophisticated investor who is both willing and able to take risk, has just noticed that GO-West Airlines has become the target of a hostile takeover. Prior to the announcement of the offer to purchase the stock for $ 72 a share, the stock had been selling for $ 59. Immidiatelly after the offer, the stock rose to $75, a premium over the offer price. Such premiums are often indicative that investors expect a higher price to be forthcomming. Such a higher price could occur if a bidding war erupts for the company or if management leads an employee or management buyout of the firm. Of course, if neither of these scenarios occurs, the price of the stock could fall back to $72 offer price. In addition, if the offer were to be withdrawn or defeated by management, the price of the stock could fall below the original stock price.

Smith has no reason to anticipate that any of these posibilities will be the final outcome, but he realizes that the price of the stock will not remain at $75. If a bidding war erupts, the price could easily exceed $100. Conversely, if takeover fails, he expects the price to decline below $55 a share, since he previously believed that the price of the stock was overvalued at $59. With such uncertainty, Smith does not want to own the stock but is intrigued with the posibility of earning a profit from a price movement that he is certain must occur.

Currently there are several three-month put and call options traded on the stock. Their strike and market prices are as follow:

Strike price Market Price of Call Market Price of Put

$50 $26.00 $0.125

55 21.50 .50

60 17.00 1.00

65 13.25 1.75

70 8 3.50

75 4.25 6.00

80 1.00 9.75

Smith decides the best strategy is to purchase both a put and a call option (to establish a stradle). Deciding on a strategy is one thing; determining the best way to execute it isquite another. For wxample, he could buy the options with the extreme strike price. Or he could buy the options with the strike price closest to the original $72 offer price.

To help determine the potential profits and losses from various positions, Smith developed profit profiles at various stock prices by filling in the following chart for each position:

Price of Stock /Intrinsic Value of the Call /Profit on the call /Intrinsic Value of the Put /Profit on the Put /Net Profit

$50

55

60

65

70

75

80

85

To limit the number of calculations, he decided to make three comparisons: (1) the purchase of two inexpensive options - buy the call with the $80 strike price and the put with the $60 strike price, (2) the purchase of the options with the $70 strike price, and (3) the purchase of the options with the price closest to the original stock price.

DO THIS:

Construct Smith's profit prifiles and answer the following questions

1. Which strategy works best if a bidding war erupts?

2. Which strategy works best if the hostile take-over is defeated?

3. Which strategy works best if the original offer price becomes the final price?

4. Which of the three positions produces the worst results and under what condition does it occur?

5. If you were Smith's financial advisor, which strategy would you advise he establish? Or would you argue that he not speculate on this takeover?