Introduction to derivatives, Fall 2010

BUSI 588, Case 2

Rinconete: payo tables and payo diagrams

Please prepare for class discussion on Monday, 8/30. For the past few months you have been working for Golden Sacks, one of the dominant rms in the derivatives world. Today is your day with clients - you much prefer trading days, but without bringing in the clients there is no trading, so one has to deal with them. You know you will get to trade again soon, once you clear your desk of appointments. You stare at your computer screen and see that CSCOs stock is trading at S0 = $23.25 (ask price) and S0 = $23.23 (bid price). You also have the following information on stock option prices with CSCO as the underlying asset. Calls Bid Ask Jan 20.00 Jan 22.50 Jan 25.00 4.10 2.37 1.14 4.15 2.41 1.17 Puts Bid Ask 0.83 1.58 2.84 0.85 1.60 2.87

For purposes of this case, assume the above options are European, i.e. they can only be exercised at maturity, namely in January. Ignore margin requirements, taxes and other frictions in your answers (but do account for the bid and ask prices given in the table when necessary). Part A (*) Consider the following trading strategies: (a) (b) (c) (d) (e) (f) Buy the underlying asset and buy a put with a strike of K = $22.5. Buy the underlying asset and write a call with a strike of K = $22.5. Buy a call option with a strike of K = $20 and write a call with a strike of K = $25. Buy a put option with a strike of K = $25 and write a put with a strike of K = $20. Buy a call option with a strike of K = $25 and buy a put with a strike of K = $20. Buy a call option with a strike of K = $25, buy a call with a strike of K = $20 and write two calls with a strike of K = $22.5.

Please answer the following questions using the data given above: 1. Make a table which lists the payos from each of the trading strategies above for each of the possible values for the stock price of CSCO. As an illustration, the following table lls in the values for a few of the options listed above. I let ST denote the values of CSCOs stock at the options expiration date in January. Call K = 20.0 Call K = 22.5 Put K = 20.0 Put K = 22.5 ST < 20 0 0 20.0 ST 22.5 ST 20 < ST < 22.5 ST 20 0 0 22.5 ST 22.5 < ST < 25 ST 20 ST 22.5 0 0 ST > 25 ST 20 ST 22.5 0 0

2. Plot the payos and prots from each of the trading strategies as a function of the values of CSCOs price in January. The payos are the cash ows from a given trading strategy at expiration, whereas the prots also include the initial investment (positive and/or negative).

c Diego Garc Kenan-Flagler Business School a,

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Introduction to derivatives, Fall 2010

BUSI 588, Case 2

Part B (**) You are meeting with three clients: Mr. Rinconete is a CSCO employee. He owns 20000 shares of CSCO, which he received as part of his compensation plan. He cannot sell the stock until January. In his emails he states that his main goal at the moment would be to get some cash, and, if possible, reduce his exposure to CSCOs stock. He also stated that a friend had told him that one could use derivatives to at least partially cash his restricted stock. Mr. Cortadillo is a good friend of Mr. Rinconete, and currently holds 40000 shares of CSCO stock (also restricted from sales until January). In his emails, he considers his main investment goal to protect his portfolio from the risk of a CSCO price drop, while at the same time keeping the upside investment potential of CSCOs stock. He has saved some money that he is willing to invest towards this goal. Mr. Rodaja is your last appointment of the day. He owns close to 100000 shares of CSCO, and, as the rest of your clients today, is restricted from selling them. He claims that he is not concerned at all about the direction of CSCOs stock price, but that he would like to bet on an increase in the volatility of CSCOs returns. All clients are exempt from insider trading rules and legally allowed to trade on derivatives. 1. What trading strategy, based on single options (i.e. either calls or puts), would you recommend to Rinconete? 2. What trading strategy, based on single options (i.e. either calls or puts), would you recommend to Cortadillo? 3. What trading strategy would you recommend for Rodaja? Be as specic as you can in terms of the cash ow implications (both as of today and at maturity) of each of the trading strategies you recommend. Hint: Part A is meant to help.

c Diego Garc Kenan-Flagler Business School a,

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