Tutor: Miss Ayushi Rama

Name of student: NALLAN KRISTENID Number: 201300314Course: MBA Specialization Financial Risk Management cohort 3

ContentsPART 1.........................................................................................................................................................1

1.1 Definition of an OPTION contract.............................................................................................1

1.4 Terminologies of option:....................................................................................................................1

1.5 There are 2 types of options:.............................................................................................................1

1.6 Difference between Bullish and Bearish..........................................................................................2

1.7 Factors Affecting Options Prices......................................................................................................2

Call option...................................................................................................................................................3

2. Definition of call option.......................................................................................................................3

A Simple understanding of a call option................................................................................................3

2.1 From Buyer point of view..............................................................................................................3

2.2 From Seller point of view..............................................................................................................3

2.3 Profit of a Purchased call...............................................................................................................4

2.4 Payoff / Profit of a written (Seller) call option...............................................................................6

Put Options..................................................................................................................................................7

3. Definition of Put option.......................................................................................................................7

3.1 Payoff of put..................................................................................................................................7

3.2 Profit of put option.............................................................................................................................8

3.3 Profit of the buyer..............................................................................................................................9

4. Put – Call parity.................................................................................................................................10

5. Conclusion..........................................................................................................................................10

Part 2.........................................................................................................................................................11

1. (a) Ratio Analysis.............................................................................................................................11

2. (b) Analysis of financial and profitability......................................................................................13

(i) Profitability.....................................................................................................................................13

(ii) Leverage......................................................................................................................................15

(iii) Liquidity.....................................................................................................................................16

(iv) Conclusion..................................................................................................................................16

References...............................................................................................................................................17

PART 1

Using examples, explain the concepts of '' Options''?

1.1 Definition of an OPTION contract

An OPTION contract is an agreement in which a seller (writer) conveys to a buyer (holder) of a contract the right, but not the obligation, to buy or sell a specific quantity of something at a specified price on or before a specified date The option writer has the obligation to fulfill his side of the contract if the option holder decides to exercise the option.

An option can be categories either as a Call or Put:

1.2 A Call Option gives the investor the right (not the obligation) to buy an underlying asset at an agreed upon price (the strike price) at a date in the future (the expiration date).

1.3 A Put Option gives the holder the right (but not the obligation) to sell an underlying asset at

an agreed‐upon‐price (the strike price) at a date in the future (the expiration date T).

1.4 Terminologies of option:1.4 (a) Strike (or exercise) price: the amount paid by the option buyer for the asset if

he/she decides to exercise

1.4 (b) Exercise: the act of paying the strike price to buy the asset

1.4 (c) Expiration: the date by which the option must be exercised or become worthless

1.5 There are 2 types of options: American option - can be exercised at any time up to the expiration date.

European option- can be exercised only at expiration date

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1.6 Difference between Bullish and BearishAn investor is said to be Bullish when it expects that stock price will increase over time. Whereas an investor is said to be Bearish when it expects that stock price will decline.

Calls Puts

Buyers

Bullish:

Have right to buy stock, when stock price is to rise

Bearish:

Have right to sell stock, when stock price is to fall

Sellers

Bearish:

Have obligation to sell stock when stock price is to fall

Bullish:

Have obligation to buy stock when stock price is to rise

1.7 Factors Affecting Options Prices The list of factors:

1. Current stock price S0 2. Strike price: K 3. Time to expiration: T 4. Volatility of stock price: σ 5. Risk-free interest rate: r 6. Dividends expected during life of option: D

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Call option

2. Definition of call optionA Call option is a contract between two parties to exchange a stock at a strike price by a predetermined date. One party, the buyer of the call, has the right, but not an obligation, to buy the stock at the strike price by the future date, while the other party, the seller of the call, has the obligation to sell the stock to the buyer at the strike price if the buyer exercises the option.

Payoff means the gain or loss that a party will have when making a transaction.

Payoff of purchaser (buyer) = Max [0, spot price at expiration – strike price]

Payoff of writer (seller) = - Max [0, strike price – spot price at expiration]

A Simple understanding of a call option Example 1:

2.1 From Buyer point of viewToday a call buyer acquires the right to pay $1,020 in six months for an index, but is not obligated to do so.

(a) Assumed that, after 6 months (at expiration) the spot price is $1,100.

Therefore the buyer will exercise its option as his payoff= Max [0, $1,100 - $1,020]= $80

(b) What if the spot price is $900?

If the spot price is $900, the buy’s will have a payoff =$0, because he will not exercise the option.

2.2 From Seller point of viewUsing the above example a call seller is obligated to sell the index for $1,020 in six months, if asked to do so.

(a) Assumed that the option is executed in six months, where the spot price is $1,100.

Therefore the seller’s payoff = - Max [0, $1,100-$1,020]= ($80)

(b) What if the spot price is $900?

If the spot price is $900, the seller will have a payoff =$0, because the buyer will not exercise the option.

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2.3 Profit of a Purchased callProfit = Payoff – future value of option premium.

Example 2

A call option has a strike price of $1,000 and also a premium of $93 attached with a risk-free rate of 2% in 6 months.

(a) Assumed that in 6 months the spot price is $1100.

Payoff of the buyer= Max [0, $1,100-$1,000] =$100 Profit = $100 – ($93 x 1.02)

=$5.14

(b) Assumed that in 6 months the spot price is $900

Payoff of the buyer = Max[0, $900 - $1,000]= $0

Profit = $0 – ($93 x1.02)= -$94.86

Spot Price in 6 months

CallPayoff

Future valueof premium

Call profit

800 0 -$95.68 -$95.68850 0 -$95.68 -$95.68900 0 -$95.68 -$95.68950 0 -$95.68 -$95.681000 0 -$95.68 -$95.681050 50 -$95.68 -$45.681100 100 -$95.68 $4.321150 150 -$95.68 $54.321200 200 -$95.68 $104.32

This table helps to assess the point (spot price) at which the buyer will make profit.

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Price Index

This chart clearly shows that above $1000, the purchaser of the call option is making a positive payoff.

The below diagram, shows the profit earned when premium is included in the calculation. The purchaser will recover the premium when spot price is above $1020.

Price Index

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2.4 Payoff / Profit of a written (Seller) call option

A seller (writer) of a call option has an obligation toward the purchaser, if the latter intends to exercise its position.

Payoff = -max [0 , strike price– spot price at expiration]

Profit = payoff + future value of option premium

Example 3

A person entered in a call option in 6 months, at a strike price $1,000 with a premium of $93.81at a risk-free rate 2%.

(a) Assume in six months the spot price is $1100 The payoff of the seller = - max [0, 1100 – 1,000]

= -$100 Profit / (loss) of the seller = -$100 + ($93.81 x1.02) = ($4.32)

(b) Assume in six months the spot price is $900

The payoff of the seller = - max [0, $900-$1,000] = $0

Profit of the seller = $0 + ($93.81 x 1.02) = $95.68

Price Index

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Put Options

3. Definition of Put option

A “Put” option is a contract between 2 parties to exchange a stock at a strike price by a predetermined date. One party, the buyer of ‘put’ has the right, but not an obligation, to sell the stock at the strike price by the future date, while the other party, the seller of the put, has the obligation to buy the stock from the buyer at the strike price if the buyer exercises the option.

The concept of the put option is exactly same as investing in an insurance company. For example, when one buy a car, it assured (protect) his car with an insurance company against any accident.

In the Put option, the following shall be considered:

A seller of a put - is in fact the buyer; where as

A Buyer of a put– is in fact the seller.

3.1 Payoff of put

Payoff put option of seller = Max [O, strike price - spot price at expiration]

Payoff put option of buyer = -Max [ 0, spot price – strike price]

Example 4

Suppose a seller of put option has a strike price of $1000 for an index in 6 months.

(a) Assumed that in 6 months the spot price of the index is $1100.

Therefore the payoff of the seller = Max [0, $1000-$1100]= 0

Thus, it is not worth to sell the index for $1000 when the latter worth is $1100.

(b) If the spot price is $900 in 6 months

Therefore the payoff of the seller = Max [0 , $1000- $900]= $100

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3.2 Profit of put option

When calculating the profit of the seller, it is important to note that the seller has to pay a premium to the buyer.

Profit the seller = Max [ 0, strike price – spot price at expiration] – future value of option premium.

Example 5

A seller of put option has a strike price of $1000 for an index in 6 months with a risk-free rate of 2% and a premium of $74.20.

Therefore the future value of option premium = 1.02 x $74.20 =$75.68

(a) Assume that the spot price of the option is $1100

Therefore the payoff of the seller = Max [0, $1000 - $1100]= 0

Profit of the seller = 0- $75.68=-$75.68 (loss)

Thus the seller will not exercise its position as it is incurring a Zero payoff and a loss.

(b) If the spot price is $900,

Therefore the payoff of the seller = Max [0, $1000- $900]=$100

Profit of the seller = $100- $75.68=$24.32

In this situation the seller will exercise the put option.

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Spot Price in 6 months

PutPayoff

Future valueof premium

Put profit

800 $200 -$75.68 $124.32850 $150 -$75.68 $74.32900 $100 -$75.68 $24.32950 $50 -$75.68 -$25.681000 0 -$75.68 -$75.681050 0 -$75.68 -$75.681100 0 -$75.68 -$75.681150 0 -$75.68 -$75.681200 0 -$75.68 -$75.68

3.3 Profit of the buyerProfit of put option for buyer = - Max [0, Strike price – Spot price] + future value of option premium

Using the same example as above

(a) If spot price is $1100

The payoff will be zero because the seller will not exercise.

However the profit will equals to $75.68 which is the premium paid by the seller to the buyer.

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(b) If sport price is $900

The payoff of the buyer = -max [0, $1000 -$900]

=-$100

Therefore profit = -$100 + $75.68

=-$24.32

4. Put – Call parity

Put-call parity is a principle that defines the relationship between the price of European put options and European call options of the same class, that is, with the same underlying asset, strike price and expiration date. Put-call parity states that simultaneously holding a short European put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration and a forward price equal to the option's strike price.

5. ConclusionOptions are sophisticated trading tools that can be dangerous if one don't educate oneself before using them. Options are forms of derivatives to minimizing risk and maximizing investment. Option is different to other derivatives tools such as futures and forward contract and swaps. In all depends on the risk appetite of the investors. If option is rightly exercise in the right time, it is meaning a hedge against failure or fall in worth investment can be prevented. The hedger's aim is to prevent price changes in the price of the underlying security from affecting the value of his portfolio.

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Part 2

1. (a) Ratio Analysis

Ratio Alpha Delta

1. Return on Capital employed

= Profit before Interest∧tax

Capital Employed

3000−48012000+5000

=15%

5000−10006600+6400+6000+1000

=20%

2. Pre-tax on return on equity

= Profit before tax

Equity

217012000

=18%

26506600

=40.15%

3. Net asset turnover

= turnover

Net assets

2900020600

=1.4 times5000019200

=2.6 times

4. Gross profit Margin

= Gross profit

Turnover x 100

300029000

=10.3%

500050000

=10%

5. Operating profit margin

= operating profit

Turnover x 100

252029000

=8.7%

400050000

=8%

6. Current ratio

= current assets

current liabilities

110009200

= 1.20 : 1

1560012400

= 1.26 : 1

7. Closing inventory holding

500026000

x 365

=70days

840045000

x 365

=68days

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= closing inventory

Cost of sales x 365days

8. Trade receivable collection period

= trade receivable

Credit sales x 365

days

= 4800

29000 x 365days

= 60 days

720050000

x 365days

=53 days

9. Trade payables payment period

= trade payables

Credit purchases x 365

days

= 7200

26000 x 365days

= 101 days

= 8500

45000 x 365days

= 69 days

10. Leverage

= Debts

Equity+Debts x 100

= 5200

12000+5200

=30%

= 6400+6000+1000

6600+6400+6000+1000

=67%

11. Interest cover

= NPBI

Interest

= 2520350

= 7.2 times

= 4000

600+750

= 3 times

12. Dividend cover

=NPA∫¿Tax

Dividend per share

= 1870500

=3.74 times

= 23001400

=1.6 times

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2. (b) Analysis of financial and profitability

(i) Profitability

The ROCE of 20% Delta is more than 15% of the return of Alpha. This means that Delta is efficiently using its Net Assets (Capital and Non-Current liabilities invested).

Alpha Delta0%2%4%6%8%

10%12%14%16%18%20%

0.15

20%

ROCE

The above statement can be supported by the company Net Asset Turnover, where Delta is generating 2.6 times of its revenue from its net assets compared to Alpha which is only 1.4 times. This means that $1 invested by Delta generates $2.6 of revenue compare to $1.4 for Alpha.

Alpha Delta0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0.18

40.15%

Return on Equity

A major element of ROCE is to assess the carrying amount of the non-current assets. In this given scenario, it can be found that Alpha held its own premises whereas Delta does not held its

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own premises. Thus, Delta has to pay a rental fees compared to Alpha. In addition, Delta owned plant is nearing the end of its useful life as it remains only 25% on its cost and it seems that Delta is about replacing owned plant with leased plant. In the Alpha side, it has revalue its factory which means the latter is at current value.

Another ratio that need due consideration is the Gross Profit Margin. It can be noted that Alpha has slightly a better gross profit margin of 8.7% compare to Delta which is 8%. This might be that Alpha is able to pass over cost on customer than Delta, or Alpha is purchasing goods at lower price.

Alpha Delta7.60%

7.80%

8.00%

8.20%

8.40%

8.60%

8.80%0.087

8%

Profit Margin

The ROCE measures the overall efficiency of management, however, as Gamma Plc is considering to buy the equity of one of the 2 companies, therefore, it would be useful to consider the return on equity (ROE)- as this is what Gamma Plc is buying. ROE means how much profit is available as dividend for each share held. ROE of Alpha is 18% which is worst compared to Delta with a ROE of 40.15%. It can be noted that revaluation of Alpha’s factory is making its ROE worst.

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(ii) Leverage

The leverage ratio of Delta is 67% which mean that 67% of its assets are financed by borrowing fund compare to Alpha is only 30%.

Alpha Delta0%

10%

20%

30%

40%

50%

60%

70%

0.3

67%

Leverage

In addition, the interest cover of Delta is 3 times whereas Alpha is 7.2 times. The interest cover explained how many times profit available can meet interest payment. Thus, Delta has fewer profits to cover its interest payment compared to Alpha. This shows that Delta’s profit is vulnerable to any small change in the operating activity. For example, a small reduction in revenue will reduce gross profit and eventually interest changes might not be covered.

Alpha Delta0

1

2

3

4

5

6

7

8 7.2

3

Interest cover

It is important to note that Alpha enjoys the government grant which is a risk less finance and same is not available to Delta.

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(iii) Liquidity

Measuring the current ratio, both companies have a relatively low liquid ration of 1.20 and 1.26 for Alpha and Delta respectively. Delta seems to have a better Alpha, but is important to note that Alpha has $1.2 million in the bank whereas Delta has $2.5 million as bank overdraft.

The working capital cycle of Alpha is 29 days whereas Delta is 52 days. This means it took 29 days of Alpha, for cash to flow in the business compared to Delta.

(iv) Conclusion

Gamma investment will depend on its risk appetite. Delta is more profitable in terms of higher revenue compared to Alpha, but, it is among the riskier of the 2 companies as it depends a lot on external fund. Gamma should assess the long term objective of the 2 companies and their market shares. Moreover, taking over a business having many debts might increase liquidity problem therefore Gamma must assess where it will recover its initial investment in a short period and as well as maximizing its wealth.

It is important to note that accounting information is always published with a delay. Thus, accounts published after 5 months of the year end might not bear any relation to the company’s present situation.

Gamma plc has to see the credit rating of the 2 companies and assess their financial risk in the following terms:

Ability to honour the stipulate payments and The specific characteristics of the borrowing, notably its guarantees and legal

characteristics.

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References

Books

Robert L McDonald (1995) Derivatives Market (2nd Edn), Northwestern university, Chapter 2.

Pascal et al (2011) Corporate Finance: Theory and Practice (3rd Edn), Chapter 2

Web Site:

1. http://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/f7/specimen/f7-specimen-d14.pdf [Accessed on 14 Oct 2015]2. http://www.mkaranasos.com/FEOptions.pdf [ Accessed on 11 Oct 2015]

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