Case Problem 14.1 A-C (page 588)Case Problem 14.2 A-D (page 589)Case Problem 15.1 A-D (page 622)Case Problem 15.2 A-D (page 623)Format your submission consistent with APA guidelines.Click the Assignment Files tab to submit your assignment.
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April 16, 2018
Case Problem 14.1 The Franciscos Investment Options
1. LG 3
2. LG 4
Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm
he and his wife, Judy, founded several years ago has prospered. Because he is selfemployed, 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 will 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 six 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 six-month investment horizon.
In studying RPP, Hector has learned that the company has six-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.
a. How many alternative investments does Hector have if he wants to invest in RPP for no
more than six months? What if he has a two-year investment horizon?
b. Using a six-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.
2. Determine the holding period return for each of the three investment alternatives
open to Hector Francisco.
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.
Case Problem 14.2 Lukes Quandary: To Hedge or Not to Hedge
1. LG 3
2. LG 4
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).
a. Given the circumstances surrounding Lukes current investment position, what benefits
could be derived from using the puts as a hedge device? What would be the major
b. What will Lukes 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?
Case Problem 15.1 T. J.s Fast-Track Investments: Interest Rate Futures
1. LG 5
2. LG 6
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 teenagerhe 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 hes 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 futuresinterest 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 couldnt go wrong with interest rate futures) and soon set up a trading
account with Vinnies firm, Bananos 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.
a. Assume T-note futures ($100,000/contract; 32s of 1%) are now being quoted at 10316.
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: Itll 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 10316 and then covers
when five-year T-note contracts are quoted at 9800? 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 1058?
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?
Case Problem 15.2 Jim and Polly Pernelli Try Hedging with Stock Index
1. LG 5
2. LG 6
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, midcap 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 thats 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 conditionsalthough 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 futuresin particular, the S&P MidCap 400 futures contractas a
way to protect (hedge) their portfolio of common stocks.
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
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
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 cto 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
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