Case Problem 141: The Franciscos Investment Options

Case Problem 141 The Franciscos Investment Optionshector Francisco I

Hector Francisco is a successful businessman in Atlanta who has accumulated substantial funds in his retirement account through aggressive investments primarily in stocks. He is considering investing in Rembrandt Paper Products (RPP), which he believes will appreciate significantly within six months, reaching approximately $80 per share from its current $57.50. Hector also has knowledge of the company’s call options, with certain strike prices listed on the CBOE, and is evaluating his investment options over different time horizons.

He wants to understand how many investment alternatives are available to him for a six-month and two-year investment horizon, especially focusing on stock investments and options, and to assess which options yield the highest potential returns. Additionally, Hector aims to analyze the expected returns and risk profiles linked to purchasing the stock outright, buying call options, or engaging in other derivative strategies. His decision-making involves evaluating potential profits, risk exposures, and investment strategies aligned with his goal of maximizing profit while managing risk.

Paper For Above instruction

Introduction

Investors, particularly those with a substantial capital base and aggressive investment posture like Hector Francisco, regularly explore various investment channels to maximize returns within their time horizons. Understanding the different investment alternatives, including direct stock purchases, options, and other derivative instruments, allows investors to tailor strategies to their risk appetite and profit expectations. This paper provides an analysis of Hector's investment options regarding RPP, considering his six-month and two-year horizons, and evaluates the profitability and risk implications of each choice.

Investment Alternatives for Hector

Hector’s primary options for investing in RPP over a six-month period include purchasing the stock outright, buying call options, or utilizing a combination of both. If his investment horizon extends to two years, additional strategies such as long-term options or other derivatives might come into play.

1. Buying the stock outright is straightforward, involving purchasing shares at the current price of $57.50 and holding them until the desired exit point. This method provides direct exposure to the stock’s price movement but exposes him to full downside risk.

2. Purchasing call options provides a leveraged approach, where Hector pays a premium for the right—but not the obligation—to buy shares at a specified strike price within a designated period. Currently, the CBOE quotes calls at $8 for the $50 strike and $5 for the $60 strike. With these options, Hector can benefit from significant price appreciation of RPP with limited downside risk equal to the premium paid.

3. Combining stock and options, such as buying stock and protective puts, can hedge against downside risk while maintaining upside potential, especially over a longer horizon like two years.

Profitability and Return Calculations Over Six Months

If Hector’s prediction holds and RPP reaches $80 within six months, he anticipates a capital gain of ($80 - $57.50) = $22.50 per share. With a dividend of $2.40, he would receive two dividend payments of $1.20 each over six months, adding to the total return.

Calculating the return on investing directly in RPP shares:

• Gains in stock price = $22.50 per share.
• Dividends received = 2 × $1.20 = $2.40 per share.
• Total proceeds = $80 + $2.40 = $82.40.
• Initial investment per share = $57.50.
• Holding period return (HPR) = ($82.40 - $57.50) / $57.50 ≈ 43.4%.

This substantial return demonstrates the leverage and reward potential of direct stock investment combined with dividends.

Option Value and Strategic Analysis

Using the given option quotes, we analyze the potential of call options:

• The $50 strike call is priced at $8. If RPP reaches $80, the intrinsic value of this call will be $30 (i.e., $80 - $50).
• The value of the call at expiration considering zero time premium would be $30, but premium paid is $8, leading to a net profit of $22 per option.
• Similarly, the $60 strike call is worth $20 at $80 stock price, with an initial premium of $5, yielding a profit of $15 per option.

Calculating the total return involves subtracting the premium paid from the intrinsic value at expiration and comparing it to the initial premium outlay, scaled by the number of options purchased.

Comparison of Investment Strategies

Assuming Hector holds the stock and options until the six-month horizon, the potential payoff differs significantly among the alternatives:

• Holding the stock offers maximum upside potential (~43.4% return) but exposes him to full downside risk if the stock declines.
• Buying call options caps the maximum loss at the premium paid ($8 or $5 per option), but the total profit depends on stock appreciation exceeding the strike plus premium (break-even points at $58 and $65, respectively).

Over a two-year horizon, Hector might consider rolling over options, adopting a longer-term options strategy, or diversifying investments to mitigate risk while seeking growth opportunities.

Risk-Return Considerations and Recommendations

If Hector’s primary goal is profit maximization—taking into account manageable risk—buying call options with favorable strike prices provides leverage with limited downside risk. The choice between buying stock or options depends on his risk tolerance and market outlook.

In a conservative view, combining the stock purchase with protective puts could hedge downside risk, especially over a longer horizon where market volatility is expected. Conversely, if Hector’s confidence in stock appreciation is high, straightforward stock purchase maximizes upside but entails higher risk.

Conclusion

Hector’s decision hinges on his risk appetite, investment horizon, and market outlook. For aggressive profit seeking within a short period, call options with favorable strike prices offer compelling leverage. For longer-term planning and risk management, a hybrid strategy incorporating stock purchases and protective options is advisable. Careful analysis of the intrinsic and extrinsic value of options, as well as understanding hedge implications, is critical for making informed investment choices.

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