Question

QUESTION 26

1. Barry believes that due to COVID-19 the price of a listed pharmaceutical company BigPharma Ltd is expected to rise in the next few months. Barry does not currently have the cash flow required to buy the share but finds a call option with an expiry of 2 months, an exercise price of $80 and a premium of $4.50. The current share price of BigPharma Ltd is $70.00.

   (a) In order for Barry to benefit from the expected rise in the BigPharma Ltd share price, should he buy or sell the call option? What will be the initial cash flow from this position?

   (b) Explain when Barry would exercise the option.

   (c) Calculate the breakeven point of the option, and the profit/loss to Barry if at expiry of the option, BigPharma's share price was $90.

   (d) Is there a way Barry could have profited from an expected price increase using put options? If so, explain how. Describe any additional risks that would have been involved.

Answer 1

Solution 1) Since the share price is expected to rise, thus, Barry would be benefitted by buying the call option. This will give him the right to buy the share at $80. So, if the share price increases and is more than $80, then, Bary would be benefitted as he can buy the shares at lower prices than the future spot prices.

Initial cash flow = -$4.50

So, Barry will pay $4.50 as a premium at the time of buying the option. This will be the only cash flow at the time of initiation.

Solution 2) Barry would exercise the option when the share prices will be more than the strike price, i.e., $80.

For example, after 2 months, let's the share price increases to $85, then, Barry would be benefitted by exercising the call option and buy the stock at $80 and then sell it for $85 in the spot market.

Thus, the call option will be exercised when the share price is greater than the strike price.

Solution 3) Breakeven point means there is no profit or loss.

Profit/loss from the call option = Share price at expiry - Strike Price - Premium paid

For breakeven, profit = 0

Thus, Share price - Strike Price - Premium paid = 0

Share price = Strike Price + Premium paid

Breakeven Share price = 80 + 4.5 = $84.5

Case) Share price at the expiry = $90

Profit = Share price at expiry - Strike Price - Premium paid

Profit = 90 - 80 - 4.5 = $5.5

Solution 4) In case the stock prices are expected to increase, Barry can also be benefitted by using the 'Short Put' options. When the share price is expected to increase, Barry can earn profits by gathering premium by selling the put options. When the share prices increase then the put option is not exercised and thus, as a seller, he will benefit by collecting the premiums.

Risks involved are that if the share price does not increase as expected then it would lead to the exercise of the put option by the buyer and thus, it would lead to losses.

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