Problem:
A company is the target of a hostile takeover. Prior to the announcement of the offer to purchase the stock for $72 a share, the stock had been selling for $59. Right after the offer, the stock rose to $75, a premium over the offer prices. Such premiums ar often indicative that investors expect a higher price to be forthcoming. Such a higher price could occur if a bidding war erupts or if management leads an employee or management buyout of the firm. If neither of these happen the price could fall back to the $72 offer price. In addition, if the offer were to be withdrawn or defeated by management, the price of the stock could fall below teh original stock price. There is no reason to anticipate that any of these possibilities will be the final outcome, but it needs to be realized tha the price of the stock will not remain at $75. If a bidding war erupts, the price could easily exceed $100. If the takeover fails, the price could decline below $55 a share, since it was previously believed that the price of the stock was overvalued at $59. Currently there are several 3 month put and call options traded on the stock. Their strike and market prices are:
Strike price Market price of call Market price of put
50 26.00 0.125
55 21.50 .50
60 17.00 1.00
65 13.25 1.75
70 8.00 3.50
75 4.25 6.00
80 1.00 9.75
It's decided the best strategy is to purchase both put and call option to establish a straddle. Determine the potential profits and losses from various positions, developing profit profiles at various stock prices by filling in this chart for each position:
Price Intrinsic Profit Intrinsic Profit Net
of Stock value of call on call value of put on put Profit
50 0 (#1) 10 $9 $8
55
60
65
70
75
80
85