Case: THE ESCOBARS' INVESTMENT OPTIONS
Phil Escobar is a successful businessman in Alice Springs. The box-manufacturing firm he and his wife, Judy, founded several years ago has prospered. Because he is self-employed, Phil 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's gonna fall out'. Phil has been following the shares of Rembrandt Paper Products (RPP), and after conducting extensive analysis, he feels the share is about ready to move. Specifically, he believes that within the next six months, RPP could go to about $8 per share, from its current level of $5.75. The share pays annual dividends of $0.24 per share, and Phil figures he would receive two quarterly dividend payments over his six-month investment horizon. In studying the company, he notes that it has six-month call options (with $5 and $6 strike prices) listed on the ASX. The calls are quoted at $0.80 for the options with $5 strike prices and at $0.50 for the $6 options.
QUESTIONS
1. How many alternative investment vehicles does Phil have if he wants to invest in RPP for no more than six months? What if he has a two-year investment horizon?
2. Using a six-month holding period and assuming the share does indeed rise to $8 over this time frame:
a. Find the value of both calls, given that at the end of the holding period neither contains any investment premium.
b. Determine the holding period return for each of the four investment alternatives open to Phil scobar.
3. Which course of action would you recommend if Phil simply wants to maximise profit? Would your answer change if other factors (for example, comparative risk exposure) were considered along with return? Explain.