Question

1. How can financial institutions with stock portfolios use stock options when they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more stock?
2. Explain how and why the option premiums may change in response to a surprise announcement that the Fed will increase interest rates even if stock prices are not affected?
3. Assume you are looking at a call option on Bristol Cities Inc. with an exercise price of $104. Current stock price today is $102 and the option has a premium of $3. What will be the profit or loss earned by the speculator at prices of $101, $104 and $112 just before time of expiry? Assume the option will not be exercised until maturity.

Answer 1

1- The Call Option gives us the right to Buy the stock at the Strike price at the expiration date, irrespective of the stock price at the expiration date. If we expect the stock price to rise substantially and we dont have enough funds to purchase stock, then we can buy a Call Option which will allow us to purchase the stock at the strike price and sell it off at the market price on expiration date.

Example:

Price today = 100

Strike Price of Call Option = 100

Premium for Purchase the Call Option = 10

So the total cost of purchasing the option is 10.

Now assume that the price at expiration is at 150. The call option gives us the right to buy the stock at 100 giving us a profit of 50. However we paid 10 to purchase the call option so our ultimate profit is 50 - 10 = 40. giving us a return of 400% on our investment. And our investment amount was 1/10th of the total value.

2- If the interest rate increases then the value of Options will call. The normal calculation of Option prices is based on Black Scholes model which incorporates a certain interest rate to calculate the possible Present Value of Future payoffs. So if the interest rates decreases we have a higher denominator which makes the present value lower thus causing the Option price to go down irrespective of the share prices movement.

3- Price paid to Purchase the Option = 3$

Strike Price = 104$ (Which means the Call option will be exercised if the price goes above 104$ and will expire worthless if it remains at or under 104$)

Payoff = Price at Expiration - Strike Price - Premium Paid

Case -1 - Price is 101$

In this case the call option wont be exercised and will expire worthless giving a loss of the premium paid i.e. 3$

Case 2 - Price is 104$

In this case also the call option wont be exercised and will expire worthless giving a loss of the premium paid i.e. 3$

Case 3 - Price is 112$

In this case the Call Option will be exercised and the Payoff will be as follows:

Payoff = 112 - 104 - 3 = 5$

So the Speculator will make a profit of 5$.