Question

QUESTION THREE . Investments and Derivatives Strategies Wamu is a 30-year aged lecturer and a father of none, He considers himself as savoir-faire Finance personality. His investment portfolio has increased to a greater extent in the few past years, although he has been fairly conservative with his investments, he now feels more confident in his investment knowledge and would like to branch out into some new areas that could bring higher returns. He has about ZMW30, 000 to invest. Attracted to the hot market for technology stocks, Wamu is interested in purchasing a tech IPO stock and identified Liquid Telecom, a company that makes complicated computer chips for wireless Internet connections, as a likely prospect. The 1-year-old company had received some favorable press when it got early-stage financing and again when its chip was accepted by a major cell phone manufacturer. Wamu also was considering an investment in 500 shares of Emperor Palace International Casino common stock, currently selling for ZMW 64 per share. After a discussion with Floro who is an economist with the Zambia Revenue Authority, Wamu believes that the long-running bull market is due to cool off and that economic activity will slow down. With the aid of Pangaea Securities his brokers, Wamu researches Emperor Palace International’s current financial situation and finds that the future success of the company may be tied to an outcome of pending court proceedings on the firm’s application to open a new floating casino on a nearby river. If the permit is granted, it seems likely that the firm’s stock will experience a rapid increase in value, regardless of economic conditions. On the other hand, if the company fails to get the permit, the falling stock price will make it a good candidate for a short sale. The following Options were open for Wamu: Option 1: Wamu can invest ZMW30, 000 in Liquid Telecom when it goes public. Option 2: He can follow closely and buy Emperor Palace International shares now at ZMW54 per share. Option 3: Wamu can Short Sell Emperor Palace shares at ZMW64 that’s with the expectation that the fortunes for the company will change to the worst. Option 4: Wait to see what happens with the casino permit and then decide whether to buy or short sell the Emperor Palace International stock. Questions a. Give an evaluation of each of the above Options and based on the scarce information given, provide a recommendation for the option you feel is the best. .

b. If Emperor Palace International’s stock price rises to ZMW70, what are the results under Options 2 and 3 what advantages and disadvantages do you attach to each result as an investment person.

c. If there is a drop in the stock price of ZMW15, what will happen under Options 2 and 3? Give an evaluation of the Advantages and disadvantages of the option outcomes.

Answer 1

Ans a.

Evaluation of Options.

Option 1

Wamu invests ZMW 30,000 in Liquid Telecom's IPO. The given information seems to give a good background about the company. The company has received enough funding from early stage investors and has also become a vendor for a big cell phone manufacturer. Therefore, there is high chance of receiving good financial returns from the IPO. Although, not all IPOs are blockbusters. The company is only 1 year old, just expected growth, the risk of investing in such an IPO is also high. Even so, it would be recommended to invest only part of ZMW 30,000 in this IPO. Overall, it is a wise option.

Option 2

Wamu can follow Emperor Palace International and buy shares at ZMW 54 per share. This would be a good strategy. But given the fact that the company has a pending case due to environmental issues, Wamu needs to keep in mind that the risk of stock price is high. In the recent times, ESG practices have become very important to investors. The chances of making profit improve if Wamu invests partly in the IPO of Liquid Telecom. Also, buying shares, even if the prices drop in the short term, may give better returns in the long run. Therefore, this is a good option.

Option 3

Wamu can Short Sell Emperor Palace shares at ZMW 64 per share with the expectation that the case will fall through and the stock prices will fall. There is no guarantee about the pending court proceedings. But, Wamu can place multiple options using a butterfly spread to ensure profit and decrease risk. Alternatively, Wamu may use half his money to short sell this stock and use the other half to invest in the IPO of Liquid Telecom. In long shares, one may keep the shares and enjoy price increases or dividends. In options, each option has a validity. Therefore, there is higher risk in this option. Overall, this option is not a wise option.

Option 4

Wamu may wait to see what happens with the court permit before buying or short selling the Emperor Palace International stock. This is not a good idea. Wamu needs to make a decision before the decision of the court. It will be too late to make a decision. Wamu may go for this option only if he is investing partly in the IPO and partly in this.

Ans b.

If stock price of Emperor Palace International rises to ZMW70, it would mean that the pending court proceedings have turned favourable. In this case, lets see how option 2 and 3 would work out:

Option 2

Wamu can follow Emperor Palace International and buy shares at ZMW 54 per share. If Wamu had bought shares at ZMW 54 per share, and prices rose to ZMW 70 per share, Wamu would make ZMW 16 per share. This means a 30% (approx) profit returns over investment. Wamu would also get good dividends in the future if he does not sell off at ZMW 70 per share. The disadvantage is opportunity cost - that Wamu would not make profits, that he would have made if he had short sold options and prices had fallen.

Option 3

Wamu can Short Sell Emperor Palace shares at ZMW 64 per share. If Wamu had short sold shares at ZMW 64 per share, and prices rose to ZMW 70 per share, Wamu would lose ZMW 6 per share in addition to the option premium. There is no advantage in this case. There would be an advantage if Wamu had used butterfly spread, the profits would have exceeded losses, leading to a net profit.

Ans c.

If there is a drop in the stock price of ZMW15, it would mean that the pending court proceedings have not turned favourable for the company.

Option 2

Wamu can follow Emperor Palace International and buy shares at ZMW 54 per share. If Wamu had bought shares at ZMW 54 per share, and prices fell to ZMW 15 per share, Wamu would lose ZMW 39 per share. But, the advantage in this case would be in the long term - even though stock prices fall, one can earn through dividends in the long term.

Option 3

Wamu can Short Sell Emperor Palace shares at ZMW 64 per share. If Wamu had short sold shares at ZMW 64 per share, and prices fell to ZMW 15 per share, Wamu would make ZMW 49 per share, the option premium would be extra. The disadvantage is that this profit is only short term. Wamu would not receive any dividends in the future.