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Financial Engineering - Covered Call Strategy
 

Financial Engineering - Covered Call Strategy

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Determine IBM stock to be the best suitable for the covered call strategy. Justified our choice by considering the following factors: (i) the short duration of the strategy, (ii) current market ...

Determine IBM stock to be the best suitable for the covered call strategy. Justified our choice by considering the following factors: (i) the short duration of the strategy, (ii) current market conditions, (iii) relative valuation of IBM, (iv) relative risk of IBM, (v) volatility of your IBM's stock returns, (vi) bid-ask spread and liquidity of the stock and the option, etc.
Graphed the expected pay of for the covered call strategy for various choices
of X, assuming the stock price does not change, changes +/- 5% from the price on February 21.
The position will be liquidated on March 11 (i.e., we will buy back the call
and sell the stock) following its implementation. This is a suggested investment for an
endowment fund so carefully consider the levels of risk involved.

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  • High risk aversionMildly bullish, don’t expect incredible gains, where the upside potential is denied by option, but minor gains in stock,
  • High risk aversionMildly bullish, don’t expect incredible gains, where the upside potential is denied by option, but minor gains in stock,
  • Offering cap, unlike SAP and Oracle, Cisco (can Because of size, not as nimble as small companies  buys and integrates into IBMP/E 13.8 industry avg. 18Berkshire Hathaway : almost 7% stake (IBM) 17% (BH)Liquidity: 3.9 million stock (1.2B outstanding) 25 contracts (2000+ open int)
  • Consistently positive return over competitiors
  • Higher EBITDA multiple than average
  • Thank you, Ashish, for the introduction. We are going to cover three topics today – First, The Risk Management Process followed in JapanSecond, The Aftermath of the Sendai EarthquakeAnd Last, we will talk about the Lessons Learnt
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Financial Engineering - Covered Call Strategy Financial Engineering - Covered Call Strategy Presentation Transcript

  • FINANCIAL ENGINEERING & Derivative PRODUCTSCOVERED CALL strategy
  • INTRODUCTIONEntity: Endowment FundGoal: Short Term Return Minimal RiskSeeking: Mildly Bullish Stock High Trading Volume Low Asset VolatilityInvestment: International Business Machines
  • COVERED CALL STRATEGYCovered Call Strategy ◦ Stock Price: $199.31 ◦ Strike Price: $210.00 ◦ Call Price (Ask): $3.35 ◦ Maturity Date: July 20, 2012
  • Selection CriterionOffering Capabilities (Business Diversification) ◦ hardware, software and servicesNew Services Growth ◦ $3.5B in acquisitions last yearLower Volatility / Stable EarningsLow P/E (Relative to Industry)High Institutional OwnershipHigh Liquidity (Stocks and Options)
  • S&P: IBM
  • Stock Price5 Year3 Months
  • Valuation12-month target price of $227 reflects a target multiple of 13.6X, whichis at the high end of the five-year historical range for IBM, applied to our2013 EPS estimateWe view the stocks valuation as attractive, given IBM‘s economies ofscale and relatively steady earnings performance
  • Identified Stocks Current Call Price BA Premium Shares Call Premium Stock Strick Volatility ∆ β θ Price (in theory) /Stock Price we buy Get (In Theory)Caterpillar Inc 95.60 100 2.08 20.30% 0.3449 1.86 -0.0200 0.05% 1,046 $ 2,180Deer & Company 90.37 95 2.12 18.76% 0.3434 1.38 -0.0149 0.07% 1,106 $ 2,345General Motors 27.68 30 0.93 28.13% 0.3412 1.69 -0.0068 0.07% 3,612 $ 3,3683M 104.18 105 3.03 12.68% 0.4800 1.06 -0.0113 0.10% 959 $ 2,903Intel 21.08 23 0.18 18.61% 0.1818 1.01 -0.0029 0.05% 4,743 $ 861Harley-Davidson 52.40 55 1.72 27.08% 0.3827 1.63 -0.0152 0.06% 1,908 $ 3,286IBM 200.32 210 3.66 14.31% 0.3213 0.62 -0.0221 0.07% 499 $ 1,827** Rf = 0.1%** Fund = $100,000** All numbers come from CBOE
  • Returns
  • Beta
  • RELATIVE VALUATION
  • VOLATILITY
  • KEY STATISTICS FACTOR STATISTICStock: Outstanding Shares 1.12BStock: Average Trading Volume 3.9MStock: Volatility 17.19 (Ind Avg: 29.33)Stock: Bid-Ask Spread (3 M) $0.06Option: Current Trading Volume 25 ContractsOption: Bid-Ask Spread $0.11
  • EXPECTED PAYOFF Expected Stock Price Strike Stock Price Call Price Call Price TotalStock Gain/Loss @Feb20 Price @Mar11 (Short@Feb20) (Long@Mar11) Gain/Loss per Share 209.28 9.47 5.74 2,875.23IBM 199.31 205 199.31 5.24 4.46 0.78 391.37 189.34 1.63 (6.35) (3,180.21) 209.28 6.85 6.46 3,238.25IBM 199.31 210 199.31 3.35 2.93 0.42 208.30 189.34 0.95 (7.57) (3,792.13) 209.28 4.78 7.38 3,699.54IBM 199.31 215 199.31 2.20 1.85 0.35 174.10 189.34 0.53 (8.30) (4,158.09) 209.28 3.21 8.15 4,081.23IBM 199.31 220 199.31 1.39 1.12 0.27 136.51 189.34 0.28 (8.86) (4,437.87) 209.28 2.08 8.74 4,377.96IBM 199.31 225 199.31 0.85 0.65 0.20 100.87 189.34 0.15 (9.26) (4,639.34) Parameters  Risk free rate = 0.1%  Volatility = 14.36%  Days between Mar 11 to Jul 20 = 131  Days between Feb 20 to Mar 11 = 19
  • Graph: Profit/loss to stock Price50.0040.0030.0020.0010.00 - 151 161 171 181 191 201 211 221 231 241(10.00)(20.00)(30.00)(40.00)(50.00) X = 210 Gain/Loss X = 215 Gain/Loss X = 220 Gain/Loss Stock Gain/Loss
  • Graph: Profit/loss to stock Price60.0040.00 20220.00 - 151 161 171 181 191 201 211 221 231 241(20.00)(40.00)(60.00) X = 210 Gain/Loss Stock Gain/Loss
  • GreeksFund 100000 Call Price Expected Stock Price Stock Price Call Price Total Stock @Feb20 Strike @Mar11 Expiration (Short@Feb20) (Long@Mar1 Gain/Loss Gain/Loss 1) per Share Delta 209.28 9.47 5.74 2,875.23 Delta Theta position IBM 199.31 205 199.31 20-Jul 5.24 4.46 0.78 391.37 0.3893 0.6107 -0.0252 189.34 1.63 (6.35) (3,180.21) Delta 209.28 6.85 6.46 3,238.25 Delta Theta position IBM 199.31 210 199.31 20-Jul 3.35 2.93 0.42 208.30 0.2869 0.7131 -0.01224 189.34 0.95 (7.57) (3,792.13) Delta 209.28 4.78 7.38 3,699.54 Delta Theta position IBM 199.31 215 199.31 20-Jul 2.20 1.85 0.35 174.10 0.2014 0.7986 -0.0184 189.34 0.53 (8.30) (4,158.09) Delta 209.28 3.21 8.15 4,081.23 Delta Theta position IBM 199.31 220 199.31 20-Jul 1.39 1.12 0.27 136.51 0.1346 0.8654 -0.0142 189.34 0.28 (8.86) (4,437.87) Delta 209.28 2.08 8.74 4,377.96 Delta Theta position IBM 199.31 225 199.31 20-Jul 0.85 0.65 0.20 100.87 0.0866 0.9134 -0.0104 189.34 0.15 (9.26) (4,639.34)Delta Position of Covered Call + Delta call =1 Strike Delta Delta Increase Decrease Increase Price X Option
  • Q&A Thank You