Question

Mr. Man is the owner of a local supermarket, Fresh Market Place. Due to the difficulties the company has experienced in the past two years, its earnings have been declining in this period. As such, Mr. Man is considering buying equity interest in a listed company in the fastgrowing ecommerce industry for Fresh Market Place. While concerned about the company’s shortage of cash, Mr. Man wonders if there is a financial instrument which allows investment in the equity interest while requires little down payment. As Mr. Man’s financial advisor, you are requested to address the following:

Q1) What financial instrument would you recommend to Mr. Man? Why?

Q2) What are the main distinctions between a traditional financial instrument and a derivative financial instrument?

Q3) Describe the principles in accounting for derivatives.

Q4) Explain how to calculate the intrinsic value of a call option if the underlying stock price never increases above the strike price.

Answer 1

Q1) I would recommend that Mr. Man invest in a derivative financial instrument. This is because a derivative financial instrument requires little down payment and allows investment in an equity interest.
Q2) The main distinctions between a traditional financial instrument and a derivative financial instrument are that a traditional financial instrument requires a down payment and does not allow investment in an equity interest. A derivative financial instrument requires little down payment and allows investment in an equity interest.
Q3) The principles in accounting for derivatives are that a derivative financial instrument is valued at its intrinsic value, and that the intrinsic value is the difference between the underlying stock price and the strike price.
Q4) The intrinsic value of a call option is the difference between the underlying stock price and the strike price. If the underlying stock price never increases above the strike price, the intrinsic value of the call option is zero.