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Principles of Corporate Finance + S&P Market Insight (10th Edition)

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Problem

Discuss briefly the risks and payoffs of the following positions:

a. Buy stock and a put option on the stock.

b. Buy stock.

c. Buy call.

d. Buy stock and sell call option on the stock.

e. Buy bond.

f. Buy stock, buy put, and sell call.

g. Sell put.

Step-by-step solution

Option payoff is the profit or the earnings distributed that result from the trading of an option contract.

Comment

a)

Buy stock and a put option on the stock

Here, the investment made in put option is less risky than buying stock. The risk will be reduced at the cost of the option premium amount.

Comment

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b)

Buy stock

Buying stock will benefit the investor when it goes upside and brings loss to the investor when it goes downside.

Comment

c)

Buy call

Buying call option will bring a naked position for the holder which is riskier than the underlying asset. In call option, investor benefits when the stock price goes up but loses the entire investment if the exercise price is more than the stock price.

Comment

d)

Buy stock and sell call option on the stock

Investor may exchange unknown or uncertain upside changes in the stock price for the known up-front income that comes from the option premium.

Comment

e)

Buy a bond

Buying a bond is the safest investment which is free from risk.

Comment

f)

Buy stock, buy put and buy call

This indicates the put-call parity theory which holds good for European options. Hence the investment is safe.

Comment

g)

Sell put

This is another investment that will bring unprotected state of investment and high-risk position to the investor along with an expected direct income, but will result in a downward movement in the stock price.

Comment

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