Anyone able to help with a finance question

[HELPNEEDED]

Hey guys,

I have an exam monday and cannot for the life of me figure out a particular question:

The question is: you own 2500 shares of RIM which are currently trading at $30, over a 3month period they can go up or down by 20%. Risk free rate is 6% per annum.

You cannot sell your shares for 6months.

You want to protect your investment from falling below $60,000. A bank will insure your investment for an upfront fee of $2000.

What would you do?

If someone can help guide me in the right direction I would really appreciate it.

Thanks,

What I know is that this is a binomial tree that has a low of 48,000. we will need to purchase put options to protect it. But how I don't know.

[Travis Munroe]

good luck....there are some real smart finance guys on here who will have no problem with it.

[Slava]

Well a 20% drop from 75k is 60k...so I guess you let it ride!

[CaramonLS]

^ ^ Which can drop to 48000 over a 6 month period.

[HELPNEEDED]

Originally Posted by Slava

Well a 20% drop from 75k is 60k...so I guess you let it ride!

But its 20% every 3months, so two periods so it can go as low as 48K, its a 2step binomial function

[Minnie]

Well, being a smartass that I am, my first question is why the hell I bought RIM stock in the first place. Just teasing.

Hope you get some excellent, non-smart-assy answers.

[Slava]

Originally Posted by CaramonLS

^ ^ Which can drop to 48000 over a 6 month period.

Originally Posted by HELPNEEDED

But its 20% every 3months, so two periods so it can go as low as 48K, its a 2step binomial function

That sentence wasn't there originally (or I should've read closer!)

Do you have values form the option premiums in the question?

[wpgflamesfan]

I'll take a shot at it:

So you're original value is 75,000
You're discount rate for 3 months would be = 1.06^(1/4) = 1.4673846%

Here are you're two binomial trees (the bottom one assumes you by the bank protection):




Since $75,760-$72,846 > $2000 (the cost of the bank protection) it would be beneficial for you to purchase the bank protection.

[wpgflamesfan]

Nvm

[HELPNEEDED]

Originally Posted by wpgflamesfan

Just realized I messed this up. I'll post a new solution shortly.

nvm your close and i'm wrong

sorry

[HELPNEEDED]

i've been reading the question wrong for 3-days FML

[squiggs96]

I like how there is a thread that has help needed by a poster named HELPNEEDED.

[wpgflamesfan]

Originally Posted by HELPNEEDED

i've been reading the question wrong for 3-days FML

Did I get it right with that last answer?

[HELPNEEDED]

Originally Posted by wpgflamesfan

Did I get it right with that last answer?

no sir,

What you have to do is work to get the Call/Put option price first thats where the risk free is used using the RNV formula.

Next step I don't know yet. Will update once i get there.

[wpgflamesfan]

Originally Posted by HELPNEEDED

no sir,

What you have to do is work to get the Call/Put option price first thats where the risk free is used using the RNV formula.

Next step I don't know yet. Will update once i get there.

Ah ok, I read the "You want to protect your investment from falling below $60,000. A bank will give you a loan for the required insurance for an upfront fee of $2000" part wrong.

[HELPNEEDED]

Originally Posted by wpgflamesfan

I'll take a shot at it:

So you're original value is 75,000
You're discount rate for 3 months would be = 1.06^(1/4) = 1.4673846%

Here are you're two binomial trees (the bottom one assumes you by the bank protection):




Since $75,760-$72,846 > $2000 (the cost of the bank protection) it would be beneficial for you to purchase the bank protection.

I edited the question, sorry just the way i was reading it wrong the bank is willing to insure your investment for 2000.

Give me 10 minutes and I'll throw the answer up here.

[HELPNEEDED]

Ok, In this case, we do not worry about PV of the future price since it is all considered at the 6month point.

So.... from $30 it can goto Su = 36, Sd=24, Suu=43.2, Sud/Sdu=28.8 and Sdd=19.2

To guarantee $60000, stock price must be $24 since $24*2500=$60,000

There for your strike price on your put option must be K=24.

now the hard part...

we know in the UU UD/DU cases that P=0

only in the DD case Pdd=4.8

you use the RNV formula (if you want details let me know its balls to type out)

to calculate a Pd which will be 2.19

use RNV again to calculate Po=$1 so you need to purchase 2500 puts to protect your investment at a cost of 2500.....so the banks offer is great you take it.

Thanks for the help, you did get me on the right track, RTFQ

[wpgflamesfan]

Originally Posted by HELPNEEDED

Ok, In this case, we do not worry about PV of the future price since it is all considered at the 6month point.

So.... from $30 it can goto Su = 36, Sd=24, Suu=43.2, Sud/Sdu=28.8 and Sdd=19.2

To guarantee $60000, stock price must be $24 since $24*2500=$60,000

There for your strike price on your put option must be K=24.

now the hard part...

we know in the UU UD/DU cases that P=0

only in the DD case Pdd=4.8

you use the RNV formula (if you want details let me know its balls to type out)

to calculate a Pd which will be 2.19

use RNV again to calculate Po=$1 so you need to purchase 2500 puts to protect your investment at a cost of 2500.....so the banks offer is great you take it.

Thanks for the help, you did get me on the right track, RTFQ

Makes complete sense now. Been a while since I've touched option pricing. Can't wait for the derivatives section of the CFA Level 2 curriculum.

[TurnedTheCorner]

If we're talking about BB at $30, I would forget the insurance and use the time machine you have access to and obtain a Grays Sports Almanac.

[HELPNEEDED]

Originally Posted by wpgflamesfan

Makes complete sense now. Been a while since I've touched option pricing. Can't wait for the derivatives section of the CFA Level 2 curriculum.

I'll probably hit up the CFA after this suckers done or a PHd, undecided as of now.

Do you work in IB or some other finance related role>