Question

Suppose you have $25,000 to invest. You’re considering Miller-Moore Equine Enterprises (MMEE), which is currently selling for $50 per share. You also notice that a call option with a $50 strike price and six months to maturity is available. The premium is $2.5. MMEE pays no dividends. What is your annualized return from these two investments if, in six months, MMEE is selling for $56 per share? What about $46 per share?

Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.

	Annualized Return Stock Option $56 per share % % $46 per share % %

Answer 1

If I buy the stock, your $25,000 will purchase 500 shares.

$25,000 divided by $50/share equals 500 shares.

A call contract costs a premium of $2.5 * 100 shares = $250, so when you take $25,000 invested and divide it by $250 you can buy 100 contracts.

In six months, if MMEE is selling for $56, your stock will be worth 500 shares * $56 = $28,000,

Your dollar gain will be $ 3000 ($28000 - $25000), your return for six month period is $3000/$25000 = 12%

To annualize your return, we need to compute effective annual return, recognizing that there are two six month period in a year.

1 + EAR = 1.12² = 1.2544

EAR = 0.2544 or 25.44%

Your annualized return on the stock is 25.44%

If MMEE is selling for $ 46 per share, your loss on the stock investment is 8% of which annualizes as

1 +EAR = 0.92² = .8464

EAR = -.15636 or -15.36%

At the price $56, your call options are worth $56-50 = $6 each, but you now control 10,000 Share (100 Contracts), so your options are worth 10,000 * 6 = $60000 total.

you invested $25,000 so your dollar return is $60000 - 25000 = 35000 and your percentage return is $35000/ 25000 = 140%, compared to 12% on the stock investment. this annualized to

1 + EAR = 2.4² = 5.76

EAR = 4.76 or 476 %

However, if MMEE is selling for $ 46 when your options mature, then you lose everything ($25000 investment) and your return is -100%