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SOLUTIONS TO
1. A debt/equity ratio of 1 implies that Mordett will have $50 million of debt and $50 million of
equity. Interest expense will be 0.09 $50 million, or $4.5 million per year. Mordett™s net profits
< Concept
and ROE over the business cycle will therefore be
CHECKS
Nodett Mordett

ROE†
Scenario EBIT Net Profits ROE Net Profits*
Bad year $5M $3M 3% $0.3M 0.6%
Normal year 10 6 6 3.3 6.6
Good year 15 9 9 6.3 12.6%

*Mordett™s after-tax profits are given by: 0.6(EBIT $4.5 million).

Mordett™s equity is only $50 million.

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Fifth Edition




488 Part FOUR Security Analysis


2. Ratio decomposition analysis for Mordett Corporation:

(1) (2) (3) (4) (5) (6)
Net Compound
Profit Pretax EBIT Sales Leverage
Pretax Profit Sales Assets Assets Factor
ROE Profit EBIT (ROS) (ATO) Equity (2) (5)
a. Bad year
Nodett 0.030 0.6 1.000 0.0625 0.800 1.000 1.000
Somdett 0.018 0.6 0.360 0.0625 0.800 1.667 0.600
Mordett 0.006 0.6 0.100 0.0625 0.800 2.000 0.200
b. Normal year
Nodett 0.060 0.6 1.000 0.100 1.000 1.000 1.000
Somdett 0.068 0.6 0.680 0.100 1.000 1.667 1.134
Mordett 0.066 0.6 0.550 0.100 1.000 2.000 1.100
c. Good year
Nodett 0.090 0.6 1.000 0.125 1.200 1.000 1.000
Somdett 0.118 0.6 0.787 0.125 1.200 1.667 1.311
Mordett 0.126 0.6 0.700 0.125 1.200 2.000 1.400


3. GI™s ROE in 2003 was 3.03%, computed as follows
$5,285
ROE 0.0303, or 3.03%
0.5($171,843 $177,128)
Its P/E ratio was $21/$5.285 4.0 and its P/B ratio was $21/$177 .12. Its earnings yield was
25% compared with an industry average of 12.5%.
Note that in our calculations the earnings yield will not equal ROE/(P/B) because we have
computed ROE with average shareholders™ equity in the denominator and P/B with end-of-year
shareholders™ equity in the denominator.
4. IBX Ratio Analysis

(1) (2) (3) (4) (5) (6) (7)
Net Compound
Profit Pretax EBIT Sales Leverage
Pretax Profit Sales Assets Assets Factor ROA
Year ROE Profit EBIT (ROS) (ATO) Equity (2) (5) (3) (4)
2004 11.4% 0.616 0.796 7.75% 1.375 2.175 1.731 10.65%
2001 10.2 0.636 0.932 8.88 1.311 1.474 1.374 11.65


ROE went up despite a decline in operating margin and a decline in the tax burden ratio
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because of increased leverage and turnover. Note that ROA declined from 11.65% in 2001 to
10.65% in 2004.
5. LIFO accounting results in lower reported earnings than does FIFO. Fewer assets to depreciate
result in lower reported earnings because there is less bias associated with the use of historic cost.
More debt results in lower reported earnings because the inflation premium in the interest rate is
treated as part of interest.
Bodie’Kane’Marcus: V. Derivative Markets Introduction © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




FIVE
PA RT


DERIVATIVE MARKETS


orror stories about large losses incurred price risk. One headline in The Wall Street

H by high-flying traders in derivatives mar- Journal on hedging applications using deriva-
kets such as those for futures and op- tives was entitled “Index Options Touted as
tions periodically become a staple of the Providing Peace of Mind.” Hardly material for
evening news. Indeed, there were some amaz- bankruptcy court or the National Enquirer.
ing losses to report in the last decade: several Derivatives provide a means to control
totaling hundreds of millions of dollars, and a risk that is qualitatively different from the
few amounting to more than a billion dollars. In techniques traditionally considered in portfolio
the wake of these debacles, some venerable in- theory. In contrast to the mean-variance analy-
stitutions have gone under, notable among sis we discussed in Parts Two and Three, deriv-
them, Barings Bank, which once helped the atives allow investors to change the shape of
U.S. finance the Louisiana Purchase and the the probability distribution of investment re-
British Empire finance the Napoleonic Wars. turns. An entirely new approach to risk man-
These stories, while important, fascinat- agement follows from this insight.
ing, and even occasionally scandalous, often The following chapters will explore how
miss the point. Derivatives, when misused, can derivatives can be used as parts of a well-
indeed provide a quick path to insolvency. designed portfolio strategy. We will examine
Used properly, however, they are potent tools some popular portfolio strategies utilizing
for risk management and control. In fact, you these securities and take a look at how deriva-
will discover in these chapters that one firm tives are valued.
was sued for failing to use derivatives to hedge




> 14 Options Markets
15 Option Valuation
16 Futures Markets




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Fifth Edition




14
OPTIONS MARKETS



AFTER STUDYING THIS CHAPTER
YOU SHOULD BE ABLE TO:


> Calculate the profit to various option positions as a function
of ultimate security prices.


> Formulate option strategies to modify portfolio risk-return
attributes.


>
Identify embedded options in various securities and
determine how option characteristics affect the prices of
those securities.




490
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Essentials of Investments, Companies, 2003
Fifth Edition




The toolbox is an excellent source that allows you to
Related Websites
simulate different options positions and examine the
http://www.cboe.com/LearnCenter pricing of options.
http://www.amex.com/?href=404.html?/options/ http://www.numa.com
education
http://www.phlx.com/educat/index.html
These sites contain online option education material.
The above sites have extensive links to numerous
They have extensive programs to learn about the use of
options and other derivative websites, as well as
options, options pricing, and option markets.
educational material on options.
http://www.options.about.com/money/options
http://www.cme.com
This site has extensive links to many other sites. It
http://www.amex.com
contains sections on education, exchanges, research,
http://www.cboe.com
and quotes, as well as extensive sources related to
futures markets. http://www.nasdaq.com
http://www.optionscentral.com http://www.cbt.com
This site provides extensive educational material The above sites are exchange sites.
including access to the freely available Options Toolbox.




erivative securities, or simply derivatives, play a large and increasingly impor-

D tant role in financial markets. These are securities whose prices are deter-
mined by, or “derive from,” the prices of other securities. These assets also
are called contingent claims because their payoffs are contingent on the prices of
other securities.
Options and futures contracts are both derivative securities. We will see that
their payoffs depend on the value of other securities. Swaps, which we discussed in
Chapter 10, also are derivatives. Because the value of derivatives depends on the
value of other securities, they can be powerful tools for both hedging and speculation.
We will investigate these applications in the next three chapters, beginning in this
chapter with options.
Trading of standardized options on a national exchange started in 1973 when
the Chicago Board Options Exchange (CBOE) began listing call options. These con-
tracts were almost immediately a great success, crowding out the previously existing
over-the-counter trading in stock options.
Options contracts now are traded on several exchanges. They are written on
common stock, stock indexes, foreign exchange, agricultural commodities, precious
metals, and interest rate futures. In addition, the over-the-counter market also has
enjoyed a tremendous resurgence in recent years as its trading in custom-tailored op-
tions has exploded. Popular and potent for modifying portfolio characteristics, options
have become essential tools that every portfolio manager must understand.
This chapter is an introduction to options markets. It explains how puts and calls
work and examines their investment characteristics. Popular option strategies are
considered next. Finally, we will examine a range of securities with embedded options
such as callable or convertible bonds.
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




492 Part FIVE Derivative Markets


14.1 THE OPTION CONTRACT
A call option gives its holder the right to purchase an asset for a specified price, called the
call option
exercise or strike price, on or before some specified expiration date. For example, a July call
The right to buy an
option on Microsoft stock with exercise price $80 entitles its owner to purchase Microsoft
asset at a specified
stock for a price of $80 at any time up to and including the expiration date in July. The holder
exercise price on or
before a specified of the call is not required to exercise the option. The holder will choose to exercise only if the
expiration date. market value of the asset to be purchased exceeds the exercise price. When the market price
does exceed the exercise price, the option holder may “call away” the asset for the exercise
exercise or strike price. Otherwise, the option may be left unexercised. If it is not exercised before the expira-
price tion date of the contract, a call option simply expires and no longer has value. Therefore, if the
stock price is greater than the exercise price on the expiration date, the value of the call option
Price set for calling
(buying) an asset or will equal the difference between the stock price and the exercise price; but if the stock price
putting (selling) an is less than the exercise price at expiration, the call will be worthless. The net profit on the call
asset.
is the value of the option minus the price originally paid to purchase it.
The purchase price of the option is called the premium. It represents the compensation the
premium
purchaser of the call must pay for the ability to exercise the option if exercise becomes prof-
Purchase price of an itable. Sellers of call options, who are said to write calls, receive premium income now as
option. payment against the possibility they will be required at some later date to deliver the asset in
return for an exercise price lower than the market value of the asset. If the option is left to ex-
pire worthless because the market price of the asset remains below the exercise price, then the
writer of the call clears a profit equal to the premium income derived from the sale of the op-
tion. But if the call is exercised, the profit to the option writer is the premium income derived
when the option was initially sold minus the difference between the value of the stock that
must be delivered and the exercise price that is paid for those shares. If that difference is larger
than the initial premium, the writer will incur a loss.


To illustrate, consider an April 2002 maturity call option on a share of Microsoft stock with an
exercise price of $70 per share selling on January 4, 2002, for $4.60. Exchange-traded op-

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