Question

Suppose you have $40,000 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 strike price of $50 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 $55 per share? What about $46 per share? (A negative value should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Answer 1

From the Above calculation of the pay off table with the following details:

Premium Paid=$2.5

Intrinsic Value=Spot price-Strike price

Profit and loss=Intrinsic value+premium paid

So, According to the calculations,

The profit from call option if the underlying share is trading at $55 is $2.5 per Call Option.

With an amount of $40000 to invest, the investor can buy 16000 calls.

=$40000/2.5

=16000 calls

If the shares trade at $55 the profit shall be

=$2.5 per call*16000 calls

=$40000 of Profit

The amount invested and realised profit are same, leading to $00 of gains.

What if the share trades at $46? According to the payoff table, if the share is trading at $46, then the loss shall be -$2.5.

NOTE: In call option the loss is always limited to the amount of premium paid.

Therefore if an investor invested $40000 in call option by buying 16000 calls, the loss shall be

=-25*16000

=-$40000.

Annualised returns:

Formula:

=((Investment+Gain)/Investment)^(365/180)-1

=((40000+00)/40000)^(365/180)-1

=00

So, if the prices reaches $55, the gains on investment are zero as the investment amount is equal to realiised profit.

What if the price reaches $46?

=((Investment+Gains OR loss/Investment)^(365/185)-1

=((40000+-40000/40000)^(365/180)-1

=-1

So, if the price of the share reaches $46 then the annualised return shall be -1 or 100% of our capital as we loose $40000 of capital invested in the market.