One of your Aunts owns a small store (called "Best Gift Ideas") that sells gift items and is located in a Mall whose Anchor tenant is "The Best Foods", a large grocery store, which does not sell any gift items. The Best Foods is the main source of traffic to the Mall. The gift store is located next to The Best Foods. If The Best Foods closes, the gift store is expected to lose 90 percent of its clients. The uncertainty is bothering your Aunt. The store wants to buy insurance on the shutting down of The Best Foods.

The owner of the Best Gift Ideas happened to be one of your friends. He knows that you are taking Investments course and came to you for suggestions. What is your suggestion? He told you that he needs to recover approximately 6 months worth of earnings. He can find another location within this time. This means he needs total of $60,000 $10,000 per month for six months.
You are given the following information:

Current stock price of The Best Foods is $15.50 per share and its annual return volatility is 28.45 percent. The effective annual risk-free rate is 2 percent per annum. There are two put options on The Best Foods stock with exercise price of $15.00 and $11.50 both options has one and half year to expiration.

(a) Find the value of the put options using 2-period option pricing model.

(b) Find the value of a 1.5 year call option with strike price equal to $12.00.

(c) Consider a derivative security (digital type) that pays $10 in one and half year if the stock price of The Best Foods in one and half year is higher than $16.5 or lower than $14.5. There are no other cash flows.

(d) Assume that all the derivative securities described above are currently trading at their fair value. What advice would you give to the owner of the Best Gifts Ideas?

Answer rating: 100% (QA)

d As store is expected to lose ... View the full answer