Case Problem 15.2 Jim and Polly Pernelli Try Hedging with Stock In.docx

Case Problem 15.2 Jim and Polly Pernelli Try Hedging with
Stock Index Futures
Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like
many young couples, the Pernellis are a two-income family. Jim
and Polly are both college graduates and hold high-paying jobs.
Jim has been an avid investor in the stock market for a number
of years and over time has built up a portfolio that is currently
worth nearly $375,000. The Pernellis’ portfolio is well
diversified, although it is heavily weighted in high-quality, mid-
cap growth stocks. The Pernellis reinvest all dividends and
regularly add investment capital to their portfolio. Up to now,
they have avoided short selling and do only a modest amount of
margin trading.
Their portfolio has undergone a substantial amount of capital
appreciation in the last 18 months or so, and Jim is eager to
protect the profit they have earned. And that’s the problem: Jim
feels the market has pretty much run its course and is about to
enter a period of decline. He has studied the market and
economic news very carefully and does not believe the retreat
will cover an especially long period of time. He feels fairly
certain, however, that most, if not all, of the stocks in his
portfolio will be adversely affected by these market
conditions—although some will drop more in price than others.
Jim has been following stock index futures for some time and
believes he knows the ins and outs of these securities pretty
well. After careful deliberation, Jim and Polly decide to use
stock index futures—in particular, the S&P MidCap 400 futures
contract—as a way to protect (hedge) their portfolio of common
stocks.Questions
a. Explain why the Pernellis would want to use stock index
futures to hedge their stock portfolio and how they would go
about setting up such a hedge. Be specific.
1. What alternatives do Jim and Polly have to protect the capital
value of their portfolio?

2. What are the benefits and risks of using stock index futures
to hedge?
b. Assume that S&P MidCap 400 futures contracts are priced at
$500 × the index and are currently being quoted at 769.40. How
many contracts would the Pernellis have to buy (or sell) to set
up the hedge?
1. Say the value of the Pernelli portfolio dropped 12% over the
course of the market retreat. To what price must the stock index
futures contract move in order to cover that loss?
2. Given that a $16,875 margin deposit is required to buy or sell
a single S&P 400 futures contract, what would be the Pernellis’
return on invested capital if the price of the futures contract
changed by the amount computed in question b1?
c. Assume that the value of the Pernelli portfolio declined by
$52,000 while the price of an S&P 400 futures contract moved
from 769.40 to 691.40. (Assume that Jim and Polly short sold
one futures contract to set up the hedge.)
1. Add the profit from the hedge transaction to the new
(depreciated) value of the stock portfolio. How does this
amount compare to the $375,000 portfolio that existed just
before the market started its retreat?
2. Why did the stock index futures hedge fail to give complete
protection to the Pernelli portfolio? Is it possible to obtain
perfect (dollar-for-dollar) protection from these types of
hedges? Explain.
d. The Pernellis might decide to set up the hedge by using
futures options instead of futures contracts. Fortunately, such
options are available on the S&P MidCap 400 Index. These
futures options, like their underlying futures contracts, are also
valued/priced at $500 times the underlying S&P 400 Index.
Now, suppose a put on the S&P MidCap 400 futures contract
(with a strike price of 769) is currently quoted at 5.80, and a
comparable call is quoted at 2.35. Use the same portfolio and
futures price conditions as set out in question c to determine
how well the portfolio would be protected if these futures
options were used as the hedge vehicle. (Hint: Add the net

profit from the hedge to the new depreciated value of the stock
portfolio.) What are the advantages and disadvantages of using
futures options, rather than the stock index futures contract
itself, to hedge a stock portfolio?
Case -2
Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like
many young couples, the Pernellis are a 2-income family. Jim
and Polly are both college graduates and hold high-paying jobs.
Jim has been an avid investor in the stock market for a number
of years and over time has built up a portfolio that is currently
worth nearly $375,000. The Pernellis’ portfolio is well
diversified, although it is heavily weighted in high-quality, mid-
cap growth stocks. The Pernellis reinvest all dividends and
regularly add investment capital to their portfolio. Up to now,
they have avoided short selling and do only a modest amount of
margin trading.
Their portfolio has undergone a substantial amount of capital
appreciation in the last 18 months or so, and Jim is eager to
protect the profit they have earned. And that’s the problem: Jim
feels the market has pretty much run its course and is about to
enter a period of decline. He has studied the market and
economic news very carefully and does not believe the retreat
will cover an especially long period of time. He feels fairly
certain, however, that most, if not all, of the stocks in his
portfolio will be adversely affected by these market
conditions—though some will drop more in price than others.
Jim has been following stock-index futures for some time and
believes he knows the ins and outs of these securities pretty
well. After careful deliberation, Jim and Polly decide to use
stock-index futures—in particular, the S&P MidCap 400 futures
contract—as a way to protect (hedge) their portfolio of common
stocks.
Questions

a. Explain why the Pernellis would want to use stock-index
futures to hedge their stock portfolio, and how they would go
about setting up such a hedge. Be specific.
Pernellis thinks that the market will fall in the future and his
portfolio would fall accordingly. Thus, he wants to eliminate
the portfolio risks by using the stock index future contract.
Pernellis may set this strategy by short selling of the stock
index future contract. For short selling Pernellis would required
the number of future contract for short selling equal to his value
of portfolio divide by current price of future contract x the lot
size.
1. What alternatives do Jim and Polly have to protect the capital
value of their portfolio?
They have other alternatives rather than stock index future
contract such as:
They can buy a stock put option and they can write call option
of the stock, they can buy index put and write the call option of
stock index.
2. What are the benefits and risks of using stock-index futures
as hedging vehicles?
The benefit is that they can reduce or eliminate the risk of
portfolio and the risks is that they may requires more amount
after buying or selling the stock Index future contract due to
shortfall.
b. Assume that S&P MidCap 400 futures contracts are currently
being quoted at 769.40. How many contracts would the Pernellis
have to buy (or sell) to set up the hedge?
No. of contracts required to hedge the portfolio =

$375,000/(769.40 x 100) = 4.87
Or 5 contracts are required to buy or sell to set up the hedge.
1. Say the value of the Pernelli portfolio dropped 12% over the
course of the market retreat. To what price must the stock-index
futures contract move in order to cover that loss?
The portfolio value dropped = 12% of $375,000 = $45,000
No. of stock Index future contract should be shorted = 5
The stock index future must move to 90 pts [45,000/ (5 x 100)]
in order to cover that loss.
1. Given that a $16,875 margin deposit is required to buy or sell
a single S&P 400 futures contract, what would be the Pernellis’
return on invested capital if the price of the futures contract
changed by the amount computed in part b1, above?
Margin deposit required = $16,875/-
Future contract changed by = 90
Gain from future contract = $90 x 100 = $9,000
Return of capital invested in future contract = $9,000/$16,875 x
100 = 53.33%
c. Assume that the value of the Pernelli portfolio declined by
$52,000, while the price of an S&P 400 futures contract moved
from 769.40 to 691.40. (Assume that Jim and Polly short sold
one futures contract to set up the hedge.)
Value of portfolio declined by = $52,000
Future contract moved by = $78 [769.40 – 691.40]
Gain from short selling of future contract = 78 x 100 = $7,800/-

1. Add the profit from the hedge transaction to the new
(depreciated) value of the stock portfolio. How does this
amount compare to the $375,000 portfolio that existed just
before the market started its retreat?
Depreciated value of portfolio = $375,000 - $52,000 =
$323,000/-
Profit from the short selling of future contract = $7,800
Value of hedged portfolio = $323,000 + $7,800 = $330,800/-
Loss from portfolio or declined value of portfolio = $375,000 -
$330,800 =$44,200/-
2. Why did the stock-index futures hedge fail to give complete
protection to the Pernelli portfolio? Is it possible to obtain
perfect (dollar-for-dollar) protection from these types of
hedges? Explain.
The stock index hedge future fails to give complete protection
to the Pernelli portfolio because Pernelli didn’t use right hedge
ratio. There are 5 number of stock index future required to
hedge the portfolio:
No. of stock index future contract required = Value of portfolio
(375,000)/ (100*500) = 5 contract (approximately)
But Pernelli used only one stock index future.
It may not possible to obtain perfect (dollar to dollar) protection
from these types of hedges. Pernilli could get maximum
protection by using the right hedging ratio that is by short
selling of 5 stock index future contracts then:
Gain from the short selling of stock index future = $70 x 100 x
5 = $35,000/-
Declined value of portfolio = $52,000, she could get protection
of $35,000 against her portfolio loss.
d. What if, instead of hedging with futures contracts, the
Pernellis decide to set up the hedge by using futures options?
Fortunately, such options are available on the S&P MidCap 400

Index. These futures options, like their underlying futures
contracts, are also valued/priced at $500 times the underlying
S&P 400 Index. Now, suppose a put on the S&P MidCap 400
futures contract (with a strike price of 769) is currently quoted
at 5.80, and a comparable call is quoted at 2.35. Use the same
portfolio and futures price conditions as set out in part c to
determine how well the portfolio would be protected if these
futures options were used as the hedge vehicle. (Hint: Add the
net profit from the hedge to the new depreciated value of the
stock portfolio.) What are the advantages and disadvantages of
using futures options, rather than the stock-index futures
contract itself, to hedge a stock portfolio?
Value of portfolio = $375,000
Strike price = 769
Value of stock index future contract put option = $5.80
Value of stock Index future contract call option = $2.35/-
Multiplier = 500 times
No. of contracts needed to fully protection of this portfolio =
$375,000/(769 x 500) =1 contract (approximately)
Cost of put option = $5.80 x 1 x 500 = $2,900
Premium received in selling a call option = $2.35 x 500 = $1175
Net premium paid = $2,900 - $1175 = $1,725/-
The stock Index future moves 70 pts down:
The proceeds from put option = 2 x $5.80 x 500 = $5,800/-
Option premium paid (put) = $2,900
Net proceeds from the both options = $2,900 + 1175 = $4,075/-
Value of hedged portfolio = $375,000 - $52,000 + $4,075 =
$327,075/-
Advantages & disadvantages of using future stock index option
rather than using a stock index future:
1) Stock index future option contract requires less investment
amount rather than the future contract.
2) Stock Index future option contract may not eliminate whole
risk of the portfolio because the premium of options reduced

rapidly through the time passes and if the movement of index
option is slow or doesn’t move anymore the price of buying a
option would be zero but selling a option would be beneficial.
3) The stock index future contract may reduce almost loss of the
portfolio.
4) The stock index future contract requires higher margin than
the option contract and sometimes needs more amount of money
due to shortfall.
Conclusion:
We have seen through the above cases and an example from the
real world that the hedging is a most important strategy in
today’s world. The investors should manage the risk and reward
ratio. Investing in the equity is risky because it has a risk of
market fall due to weak economic conditions of the country and
world. Currently, Investors are worry to invest in the equity,
Stock prices of banking and reality sector companies have fallen
almost 50% and other stocks have fallen to almost 20%.
Investors are not looking to invest in the equity funds they are
withdrawing the investment amount from the equity and
investing in the other alternatives such as they are investing in
the debt funds rather than investing in the equity funds.
Overall conclusion is that an investor should not invest in a one
fund only. Investor should invest in a multiple assets such as
Equity plus debts plus cash etc.
Asset allocation is the most important part and decision in the
portfolio management. Thus investors should distribute their
allocation vary carefully to the various funds.
Investor must choose one of the hedging strategies for the
equity portfolio to reducing the risk and for safeguarding
against the decline.

References:
· Sushant, Portfolio management, ‘’Tips for diversifying your
portfolio’’, retrieved through;
http://www.portfoliomanagement.in/tips-for-diversifying-your-
portfolio.html
· Hedged your portfolio using stock index future (2002),
published by Chicago Mercantile Exchange (pp-1, pp23).
· ‘’The Case for Hedge funds’’, Tremont Advisors Inc. & Tass
Research, 3rd edition, Feb 2003 (pp 9)
· Absolute Returns: The Risks and Opportunities of Hedge Fund
Investing,” byAlexander M. Ineichen, published by John Wiley
& Sons, 2002, Page 36.
· “Dealing with Myths of Hedge Fund Investment,” Thomas
Schneeweis, The Journal of
Alternative Investments, Winter 1998.
Assignment 3: Cultural Activity Report
Visit a museum or art gallery before the end of Week 9. If you
are unable to get to a museum or gallery within your area, then
a "create your own museum" assignment can be completed in its
place (see Option 2 details below). The museum or gallery
should have content that fits our course well. Here is some
information about the museum visit in person:
· It makes sense to approach a museum the way a seasoned
traveler approaches visiting a city for the first time. Find out
what is available to see. In the museum, find out what sort of
exhibitions are currently housed in the museum and start with
the exhibits that interest you.
· If there is a traveling exhibition, it's always a good idea to see
it while you have the chance. Then, if you have time, you can
look at other things.
· The quality of your experience is not measured by the amount
of time you spend in the galleries or the number of works of art

that you see.
· The most rewarding experiences can come from finding
ten (10) works of art by five (5) different artists who intrigue
you and then considering those works in leisurely
contemplation. Most museums have benches where you can sit
and study a particular piece.
Option 1: Visiting a Museum
Write a two to three (2-3) page report (500-750 words) that
describes your experience.
1.
a. Clearly identify the event location, date attended, the
attendees, and your initial reaction upon arriving at the museum
or gallery.
b. Provide specific information and a description of at least ten
(10) pieces by a minimum of five (5) different artists.
c. Provide a summary of the pieces and describe your overall
reaction after viewing them.
d. Use the class text as a reference (additional sources are fine,
but not necessary unless required by your content). Your report
should include connections you make between things observed
in your activity and things learned in the course and text.
Option 2: Create and Curate Your Own Art Museum
For this paper, you will select and curate ten (10) works of art
to include in your own Art Museum. Use the text
and online sources to help you find these works of art. This
assignment is an alternative option for visiting a museum or art
gallery.
After researching, answer the following questions by writing a
two to three (2-3) page report, (750-800 words) that describes
your experience.
1. Select ten (10) works of art from at least five (5) artists from
different time periods discussed in the text, 18th century to
modern times.

2. Provide a brief description of each piece and a picture if
possible, explaining why you chose each piece.
3. Describe where and how you would display each piece,
whether individually or grouped together.
4. Describe the museum attendees, the admission charges, the
advertising programs, and your role as museum founder and
curator. Give your museum a name and a location.
Case Problem 15.1 T. J.’s Fast-Track Investments: Interest Rate
Futures
T. J. Patrick is a young, successful industrial designer in
Portland, Oregon, who enjoys the excitement of commodities
speculation. T. J. has been dabbling in commodities since he
was a teenager—he was introduced to this market by his dad,
who is a grain buyer for one of the leading food processors. T.
J. recognizes the enormous risks involved in commodities
speculating but feels that because he’s young, he can afford to
take a few chances. As a principal in a thriving industrial design
firm, T. J. earns more than $150,000 a year. He follows a well-
disciplined investment program and annually adds $15,000 to
$20,000 to his portfolio.
Recently, T. J. has started playing with financial futures—
interest rate futures, to be exact. He admits he is no expert in
interest rates, but he likes the price action these investments
offer. This all started several months ago, when T. J. met Vinnie
Banano, a broker who specializes in financial futures, at a party.
T. J. liked what Vinnie had to say (mostly how you couldn’t go
wrong with interest rate futures) and soon set up a trading
account with Vinnie’s firm, Banano’s of Portland.
The other day, Vinnie called T. J. and suggested he get into
five-year Treasury note futures. He reasoned that with the Fed
pushing up interest rates so aggressively, the short to
intermediate sectors of the term structure would probably
respond the most—with the biggest jump in yields. Accordingly,
Vinnie recommended that T. J. short sell some five-year T-note
contracts. In particular, Vinnie thinks that rates on these T-

notes should go up by a full point (moving from about 5.5% to
around 6.5%) and that T. J. should short four contracts. This
would be a $5,400 investment because each contract requires an
initial margin deposit of $1,350.Questions
a. Assume T-note futures ($100,000/contract; 32’s of 1%) are
now being quoted at 103’16.
1. Determine the current underlying value of this T-note futures
contract.
2. What would this futures contract be quoted at if Vinnie is
right and the yield does go up by one percentage point, to 6.5%,
on the date of expiration? (Hint: It’ll be quoted at the same
price as its underlying security, which in this case is assumed to
be a five-year, 6% semiannual-pay U.S. Treasury note.)
b. How much profit will T. J. make if he shorts four contracts at
103’16 and then covers when five-year T-note contracts are
quoted at 98’00? Also, calculate the return on invested capital
from this transaction.
c. What happens if rates go down? For example, how much will
T. J. make if the yield on T-note futures goes down by just 3/4
of 1%, in which case these contracts would be trading at 105’8?
d. What risks do you see in the recommended short-sale
transaction? What is your assessment of T. J.’s new interest in
financial futures? How do you think it compares to his
established commodities investment program?
(a) (1) The current underlying value is 103% & 16/32% or
103.5% of the face value. With a face value of $100,000, the T-
notes are being priced at $103,500.
(2) The new quote would be computed using the following
inputs:
10N, 3.25I/Y, $3,000 PMT, $100,000 FV
Compute PV = $91,889
Hence, the quote would be 91-28.
(b) (1.035 – 0.98) $100,000 ´ 4 = $5,500 ´ 4 = $22,000 gain
$22,000/$4,000 = 550%
According to the Table 16.2, the initial margin is $3,000 per

contract, which would reduce the rate of return on invested
capital to 183% ($22,000/$12,000).
(c) (1.035 – 1.0525)$100,000 ´ 4 = –$1,750 ´ 4 = –$7,000 loss
–$7,000/$4,000 = –175%
It is possible to loss more than 100 percent, if T.J. Patrick
continues to make maintenance margin deposits, as the rising
value of the T-note exhausts his deposit. Also note that
according to the
Table 16.2, the initial margin is $3,000 per contract, which
would reduce the rate of return on invested capital to –58.3%.
(d)
T.J has made a profit on the futures contract market. If TJ was
to invest more in the furtures contract market based on his
annual savings ( $15000 to $20000), he could have a good
return on his investment. Since TJ is young, he can take the risk
associated with the futures contract market.
Case Problem 14.2 Luke’s Quandary: To Hedge or Not to Hedge
A little more than 10 months ago, Luke Weaver, a mortgage
banker in Phoenix, bought 300 shares of stock at $40 per share.
Since then, the price of the stock has risen to $75 per share. It is
now near the end of the year, and the market is starting to
weaken. Luke feels there is still plenty of play left in the stock
but is afraid the tone of the market will be detrimental to his
position. His wife, Denise, is taking an adult education course
on the stock market and has just learned about put and call
hedges. She suggests that he use puts to hedge his position.
Luke is intrigued by the idea, which he discusses with his
broker, who advises him that the needed puts are indeed
available on his stock. Specifically, he can buy three-month
puts, with $75 strike prices, at a cost of $550 each (quoted at
$5.50).Questions
a. Given the circumstances surrounding Luke’s current
investment position, what benefits could be derived from using
the puts as a hedge device? What would be the major drawback?

b. What will Luke’s minimum profit be if he buys three puts at
the indicated option price? How much would he make if he did
not hedge but instead sold his stock immediately at a price of
$75 per share?
c. Assuming Luke uses three puts to hedge his position, indicate
the amount of profit he will generate if the stock moves to $100
by the expiration date of the puts. What if the stock drops to
$50 per share?
d. Should Luke use the puts as a hedge? Explain. Under what
conditions would you urge him not to use the puts as a hedge?
A. If Luke buys the 3 puts, he will ensure that his profit does
not do below (75 - 40 - 5.5) = 24.5 per share. That is, if the
stock price were to crash, he will still make a profit of $24.5
per share or total $7350. The drawback is that if its a bull
market and the stock price doesn't fall anytime in the 3 months,
he would lose the premium paid on the 3 puts = 3*550 = $1,650
B.The minimum profit will be 300*(75-40-5.5) = $7,350
If Luke sells all the shares, he would make 300*(75 - 40)
= $10,500
C. If stock price is $100:
total gain = gains from stock sale and gains from put
gains from stock sale = 300 *(100-40) = $18,000
gains from put : the put will expire without it being executed =
-3*550 = -1,650
Total Gains = 18000 - 1650 = $16,350
If Stock price is $50:
total gain = gains from stock sale and gains from put
gains from stock sale = 300 *(50-40) = $3,000
gains from put : 300*(75-25-5.5) = $13,350
Total Gains = 3000 + 13350 = $16,350

D. Yes, Luke should use the puts to hedge. As seen above, the
puts protect the portfolio in case the stock price falls. It caps
the potential downside while allowing Luke to hold onto the
stock for potential gains if the stock price goes up. The only
situtation when puts are not suitable is when its a strong bull
market and downside is limited. However, given the volatility
of markets, such situation is unpredictable.
Case -1
· Hector Francisco is a successful businessman in Atlanta. The
box-manufacturing firm he and his wife, Judy, founded several
years ago have prospered. Because he is self-employed, Hector
is building his own retirement fund. So far, he has accumulated
a substantial sum in his investment account, mostly by
following an aggressive investment posture. He does this
because, as he puts it, “In this business, you never know when
the bottom’s gonna fall out.” Hector has been following the
stock of Rembrandt Paper Products (RPP), and after conducting
extensive analysis, he feels the stock is about ready to move.
Specifically, he believes that within the next 6 months, RPP
could go to about $80 per share, from its current level of
$57.50. The stock pays annual dividends of $2.40 per share.
Hector figures he would receive two quarterly dividend
payments over his 6-month investment horizon.
In studying RPP, Hector has learned that the company has 6-
month call options (with $50 and $60 strike prices) listed on the
CBOE. The CBOE calls are quoted at $8 for the options with
$50 strike prices and at $5 for the $60 options.
Questions
a. How many alternative investment vehicles does Hector have
if he wants to invest in RPP for no more than 6 months? What if
he has a 2-year investment horizon?

There are three alternatives to invest in the RPP: one is that he
can buy stocks for the period of less than 6 months, second
alternative is that he can buy a 6 months call option with $50
strike price, 3rd alternative is that he can buy a call option with
a strike price of $60/-
If he has a 2 year investment horizon then, he has only one
alternative i.e. he can buy a stock and hold for the two years.
b. Using a 6-month holding period and assuming the stock does
indeed rise to $80 over this time frame:
1. Find the value of both calls, given that at the end of the
holding period neither contains any investment premium.
The call option with a $60 strike price that gives a right to buy
100 shares at $60 per share for a premium of $5 per share:
Price per share after 6 months = $80/-
Proceeds from option = ($80 - $60) x 100 shares = $2,000
Premium paid to purchase option ($5 x 100) = $500
Net profit from the option = $1,500/-
The call option with a strike price of $50 that gives right to buy
100 shares at $50 for a premium of $8 per share:
Price per share after 6 months = $80/-
Proceeds from option = ($80 - $50) x 100 shares = $3,000
Premium paid to purchase option ($8 x 100) =$800
Net profit from the option =$2,200/-
2. Determine the holding period return for each of the 3
investment alternatives open to Hector Francisco.
Return from buying shares:
Purchase price per share = $57.5/-
Expected dividend per share = $1.2 per share

% Return ($80 - $57.50 + $1.2)/$57.50 = 41.2%
Return from the call option of $50 strike = $2200/$800
= 275%
Return from the call option of $60 strike = $1,500/$500 = 300%
c. Which course of action would you recommend if Hector
simply wants to maximize profit? Would your answer change if
other factors (e.g., comparative risk exposure) were considered
along with return? Explain.
I would recommend buying $60 strike call option to maximize
the profit because it gives the highest return than other two
alternatives.
If we consider other factors such as comparative risk exposure,
percentage of portfolio being put at risk, I would make an
argument for choosing a different investment vehicle. Such as if
he is considering investing in a large percentage of his portfolio
then, I would recommend buying the stock because if stock
price fall or doesn’t move the value of stock option would fall
to zero so, he would lost all amount of his investment.
Part C, Another Answer
(c) Let’s examine this question on profitability in two different
ways to show the benefits of leverage with options. First,
consider 100-share investments using each of the four vehicles
and assuming Hector is correct about the price appreciation, and
the other figures in question 2 are correct.
Investment Vehicles
Per Share
Common Stock
Warrants
$50 Call

$60 Call
Investment
$57.50
$15.00
$8.00
$5.00
Dividends
1.20
0
0
0
Price in six months
80.00
38.50
30.00
20.00
Capital gain
22.50
23.50
22.00
15.00
Profits
23.70
23.50
22.00
15.00
Times 100 shares = Total profits
$2,370
$2,350
$2,200
$1,500
Dollar profits are highest for the common stock. However,
recall that HPR is highest for the $60 call and that it requires
the smallest investment. Now let us assume we put the same
amount into each investment, $5,750 (assuming we can purchase
fractional options for illustration only).

Investment Vehicles
Totals
Common Stock
Warrants
$50 Call
$60 Call
Investment
$5,750
$5,750
$5,750
$5,750
Dividends
120
0
0
0
Value in six months
8,000
14,758
21,563
23,000
Capital gain
22,250
9,008
15,813
17,250
Total profits
$ 2,370
$9,008
$15,813
$17,250
With equal dollar investment, the $60 call options would
have the largest profit (in both dollar and percentage terms);
therefore, if Hector wants to maximize profits, he would invest
in the $60 calls. However, they (along with the $50 calls) also

possess the greatest risk— the total investment can be lost if the
stock fails to move over the six-month life on the options.
Thus, given risk-return considerations, we may want to
consider another course of action. This leads us back to the first
illustration. In effect, we could consider the leverage attributes
of warrants and calls and seek investment outlets which reduce
our required investment but capture all or most of the capital
gains potential. Of the two calls, the $50 is an “in-the-money”
and the $60 is an “out-of-the-money” option; we actually have
the most (profit) to gain and the least to lose with the “in-the-
money” option, so it should be preferred over the $60 call. Note
that if the price of the stock does not move by the expiration
date, the most we will lose with the $50 call is $50 ($57.50 –
$50.00 =
$7.50 ´ 100 = a value at expiration of $750) versus a total loss
of $500 with the “out-of-the-money” option.
The warrant has attributes similar to the $50 call, but it also has
a much longer life. Thus, we can reduce risk even more by
selecting the warrants rather than the $50 calls. But note that
because of their higher current cost, we will also be reducing
the rate of return potential. Unless current income is important,
which can be obtained only through the stocks, it looks like
Hector will have to decide between the $50 calls and the
warrants based on his risk-return preferences

Case Problem 15.2 Jim and Polly Pernelli Try Hedging with Stock In.docx

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