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Tuesday, May 3, 2011

Perpetual Bond, Call option, Put Options, Intrinsic Value, Extrinsic Value, Strike Price

7-2       Two investors are evaluating General Motors’ stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Motors’ stock. True or false? Explain.
The statement is true. Price of stock is present value of a stream of cash flow (dividend). Both investors are buying stock in the same year and both investors are agreed on value of D1, risk, and growth rate.
The price of constant growth stock is calculated as:
P^ 0 =                           D1 (Expected dividend in 1 year)
                        rs (required rate of return) – g (growth rate)
Whether investor hold stock for two years or for 10 years value of stock in current year is the same. When the first investor sell his/her stock after two years value of stock will be different from P0 because of growth in dividend. Similarly when the second investor sell his/her stock after ten years the prices of stock will be different than P2.

7-3       A bond that pays interest forever and has no maturity date is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock, and to a share of preferred stock?
Bond has fixed time to maturity with fixed interest. A perpetual bond does not have maturity provides fixed interest for unlimited period of time. A no-growth stock is one that does not have growth in dividends. No growth stock holders also get fixed amount of dividend.
Preferred stock is hybrid type of security which has feature of both common stock as well as preferred stock. Preferred stock holder gets fixed income like bond holders. Perpetual bond, no growth stock and preferred stock give fixed amount of interest or dividend for unlimited period of time and hence they are similar on getting paid by corporation as well as their maturity period.

7-4       In this chapter and elsewhere we have argued that a stocks market price can deviate from its intrinsic value. Discuss the following questions if all investors attempt to behave in an entirely rational manner, could these differences still exist? In answering this question think about information that’s available to insiders versus outsiders, the fact that historical probabilities of financial events are “fuzzier” than probabilities related to physical items and the validity of concepts of animal spirits, herding and anchoring.
Answer:            Intrinsic value of stock is actual value or real worth of the company’s stock where as market value of stock is prices that are prevailing in the market which is determined by demand and supply of the stock and price that investors are ready to pay. The answer for question if all investors attempt to behave in an entirely rational manner, could these differences still exists is Yes, the differences still exists. The reasons are that we as investors are outsiders who can only acts based on given information from the company. Most of the time company window dresses their information to make them superior than their competitors. In reality Company’s position might not be better as they are presenting. Investors invest into stock looking the information but because of the bad financial condition company may go bankruptcy or go down though their financial information looks fine. In addition to that company might plan to lunch new product, extend their geographical locations or acquire their largest competitors as a result their performance could go up. Only the insider people know about all those information unless they are published that makes stocks demand different.
            However efficient market hypothesis theory assumes that all investors are not rational and stock market price reflects intrinsic values. New information causes stock’s intrinsic value to move to new intrinsic value. Whenever intrinsic value of stock differ from market price investors take advantages of undervalued/overvalued stock and start buying/selling stocks which increase/decrease demand of stocks and make stock price equilibrium.

8-1       Define each of the following items:
a.       Option; call option; put option
Option: Option is a contract between two parties (option writer and option holder) that gives holder right but not obligation to buy (in case of call option) or sell (in case of put option) underling assets (stocks, gold, commodities, currency and others) on predetermined price during a specified period of time. Price of option varies with the change in the price of underlying assets. At the time of maturity if option exercised the option writer is responsible to provide predetermined quantity of underlying assets. If holder does not exercise option, it expires at maturity date. In America and Europe options are exercised differently. In America option can be exercised any time during its maturity period while in Europe option can only be exercised at the maturity date.

Call Option: Call option is right but not obligation to buy underlying assets (stocks, gold, commodities, currency and others) at predetermined price during a specified period of time. During the time of continuous price rises of underlying assets call option protect holder to pay extra dollars because holder has right to buy underlying assets on predetermined fixed price. Price of call option depends on price of underlying assets. When price of underlying assets increases price of call option also increases and vice versa. Option holder can sell the option to third party at any time before it expires.

Put Option: Put option is right but not obligation to sell specified number of underlying assets at predetermined price during a specified period of time. Put option is favorable to holders at the time when price of underlying assets is decreased because holder can buy underlying assets in cheaper price from the market and sell them in predetermined higher price to option writer.

b.      Exercise value; strike price
Exercise Value:             Exercise Value is the maximum of either difference between current market price of stock (underlying assets) and strike price or Zero. In another word exercise value is worth of option if they are exercise now. The minimum of exercise value is zero; it will never go negative because holder will not exercise the option if current stock price is lower than strike price.  For example, if the current market price of stock is $35 and the strike price of the stock is $20 then exercise value is $15 ($35 - $20). Again suppose if the current market price of stock is $20 and the strike price of the stock is $35 then exercise value is 0.

Strike price:      Strike price is a predetermined agreed price on which holder of option is ready to buy (in case of call option) or sell (in case of put option) underlying assets, if holder decided to exercise option. In case of call option holder is profitable if market price is higher than strike price while in case of put option holder is profitable if market price is lower than strike price.

c.       Black-Scholes Option Pricing Model
Black-Scholes Option pricing model is developed by Fischer Black and Myron Scholes. This model focuses on concept of riskless hedges by buying shares of stocks and simultaneously selling call options on that stock. According to Fisher and Myron, investor can create a riskless investment position by offsetting losses on stock using call option. The rate of return on riskless hedged position should be equal to risk free rate of return otherwise arbitrage get opportunity to exist to equilibrium the price of option.

8-2       Why do options sell at prices higher than their exercise values?
Option gives holder right to buy or sell predetermined number of underlying assets in some specified price at some specified time in the future. Option is future oriented and it worth more in the future than in present. Option price has two components Exercise value [Max (Current market price – strike value), 0] and time value of option. Therefore options sell at prices higher than their exercise value. Further, longer the time of option to mature higher the chances that value of underlying assets will significantly go up.

8-3       Describe the effect on a call option’s price caused by an increase in each of the following factors:
(1)    Stock price: If stock price in the market increase, price of call option also increase because holder has right to buy stocks on predetermined strike price which is lower than prevailing market price.

(2)    Strike price: If strike price increase, price of call option decrease because holder are obligate to exercise call option only on strike price. 

(3)    Time to expiration: If time to expiration is long then price of call option increases because in long run there is greater chances that stock price could significantly go up.

(4)    Risk-free rate: Options are exercised in future but call option’s value depends upon present value of cost to exercise option. If risk-free rate increases that makes present value of cost of exercise low, that increase option’s value.

(5) Variance of stock return: Higher the variance of return more the price of call option. Stocks’ return is extremely volatile hence the stock price moves more volatile. There is a higher chance for call option holder to gain high profit if stock price go up significantly.


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