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