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Understanding and Managing Leverage 167
In two years, you are obligated to pay your counterparty $65 if you
want to hold the stock, but the decision as to whether to take possession
of the stock in return for payment is solely at your discretion. In essence,
then, you can look at buying a call option as a conditional borrowing of
funds sometime in the future. Buying the call option, you are saying, “I
may want to borrow $65 two years from now. I will pay you some interest
up front now, and if I decide to borrow the $65 in two years, Ill pay you
that principal then. ”
In graphic terms, we can think about this transaction like this:
5/18/2012 5/20/2013 249 499 749 999
-
10
20
30
40
50
60
70
80
90
$1.50 “prepaid interest”
Contingent loan, the future repayment
of principal is made solely at the
investors own discretion.
Fair Value Estimate
Advanced Building Corp. (ABC)
Date/Day Count
Stock Price
GREEN
If the stock does indeed hit the $85 mark just at the time our option
expires, we will have realized a gross profit of $20 (= $85 $65) on an
investment of $1.50, for a percentage return of 1,233 percent! Obviously,
the call option works very much like a loan in terms of altering the
investors capital at risk and boosting subsequent investment returns.
However, although the leverage looks very similar, there are two impor -
tant differences: