You are thinking of investing in a stock that is selling for $60 and that you th

Question

You are thinking of investing in a stock that is selling for $60 and that you think will go up in price over the next six months. The six-month call option with exercise price = $60 sells for a premium of $5. The risk-free rate is 1% annually. Consider the following strategies for investing $5,000:

            (i) invest everything in the stock

            (ii) invest everything in the call options

            (iii) invest $1,000 in the call option and the rest in the risk-free rate

(a) create a table that shows the rate of return on each investment if the following stock prices occur in six months: 30, 40, 50, 60, 70, 80, 90, 100

(b) draw a chart that shows how the rate of return varies with the stock price for each of the investment alternatives

Explanation / Answer

a. Returns

Rate of return (%)

Stock Prices 30 40 50 60 70 80 90 100 Invest everything in stock -2490 -1660 -830 0 830 1660 2490 3320 Invest everything in call options -5000 -5000 -5000 -5000 5000 15000 25000 35000 invest $1,000 in the call option and the rest in the risk-free rate -980 -980 -980 -980 1020 3020 5020 7020

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