Hedgers, Speculators, and Arbitrageurs - Research Paper Example

Which group of derivative investors the Three Amigos are more likely to belong hedgers, speculators, or arbitrageurs To be able to answer this question, we must first determine what the words hedger, speculator and arbitrageur mean. Hedgers are individuals and firms which are able to establish a known price level for something they intend to buy or sell later in the cash market. Buyers are thus able to protect themselves against-that is, hedge against-higher prices and sellers are able to hedge against lower prices. Hedgers can also use futures to lock in an acceptable margin between their purchase cost and their selling price. The main goal of hedgers is to protect their interests and a little on making profits. Individuals or firms who speculate in futures contracts by buying to profit from a price increase or selling to profit from a price decrease are aptly termed as speculators. Suffice it to say that speculators put their money at risk in the hope of profiting from an anticipated price change. Buying futures contracts with the hope of later being able to sell them at a higher price is known as "going long." Conversely, selling futures contracts with the hope of being able to buy back identical and offsetting futures contracts at a lower price is known as "going short." An arbitrageur is a type of investor, actually a type of speculator, who attempts to profit from price inefficiencies in the market by making simultaneous tradesthat offset each other andcapture risk-free profits.An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange, buy the undervalued shares on the one exchange while short selling the same number of overvalued shares on the other exchange, thus capturing risk-free profits as the prices on thetwoexchanges converge. Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find and require relativelyfast trading. The three amigos were certainly not hedgers as they were not concerned about protecting the interest of Getty Oil. They were, in fact, keen on making a quick buck out of buying shares of Getty Oil (which were very cheap) and selling them at a higher price when the takeover battle commences. In this regard, they can be considered as speculators as they are buying the shares in the hope of higher selling prices in the future. However, because the three amigos were taking advantage of the price inefficiency of Getty Oil which was at 30$ instead of having risen to $50 to 60, they are arbitrageurs. They were so keen in capturing risk free profits or at least an investment with very little risk. 2. Describe step-by-step their strategy. What were the major assumptions of their strategy They were relying on what type of investors to move in what way The strategy of the three amigos is to find a stock price which carried with it minimal or no risks (i.e. stock price would not go down in the future). They were looking for a company that was not closely observed by stock traders and which was very likely to have stock prices going up thereby making them earn profits in a very short period. The major assumption that the three amigos made was that Getty Oil's stock price was not likely to go down and the conditions were ripe for an increase. They arrived at this by considering that Getty Oil was selling only at a low multiple of its cash flow and had assets that can be easily valued and liquidated. Getty Oil also had assets in the right place and had proven reserves. The political, economic and oil industry's environment also showed that is highly probable that oil players will be at the winning edge in the future. The only reason that Getty Oil stock price hasn't risen yet despite all the positive factors was that the shareholders were segmented which was causing inefficiency in grabbing the opportunity. With an imminent takeover, Getty Oil will soon take advantage of the positive factors leading to higher stock prices. The three amigos predicted the likely movements of investors of Getty Oil. According to the three, the investors would behave as follows: Speculators would purchase call options once they get to hear that Getty Oil was to undergo a takeover battle. This act of theirs increases the demand and the price of calls Dealers would buy puts as part of their arbitrage transactions then sells a call Buyers of the call are, according to the three amigos, were often novice speculators, who were not as experienced as they are and would sell out early. The result was that call options traded much more often than the puts. Wealth preservers would sell shares for a profit that were stagnant for years which would delay the increase the rise of Getty Oil's stock price. The repo credit market would be very conservative regarding the sudden increase in requests for loans. This conservatism would not lead to substantial increase in interest rates. Other speculators would consider that the price of a 40 Getty put on December was too high and would not engage in such leaving the three amigos to write put options. 3. Why did they not take very seriously the idea of selling "naked" puts (i.e., simply selling 20, 50, or 100 unprotected puts at the exercise price of $40) The strategy behind naked puts is that you write them only when you are very bullish on the stock, index, or market in general. However, a statistical curve shown below indicated that the share price of Getty Oil had 50-50 probability of rising or falling below $40. The three amigos believed that the mean should be around $50. Nevertheless, the distribution is significant because it implied that Getty Oil would not be experiencing massive reforms and radical takeover. This should be the reason why the three amigos was dissuaded. Getty oil is not to experience a bullish transformation even though the conditions only points out to an increase in stock prices. Figure 1: Normal Distribution of Expected Outcomes for a $40 investment 4. Calculate the three amigos' proceeds from selling the December 40 puts on 10,000 shares. Each option is 100 shares so that's writing the December 40 puts 100 times. According to their estimates, the rise in stock price is $2.50. Calculating the proceeds Proceeds = $2.50 x 100 share per option x 100 puts = $25, 000 However, the three amigos estimated that out of the $2.50, they could obtain a profit of only $2.00. Calculating we have: Proceeds = $2.00 x 100 share per option x 100 puts = $20, 000 (Answer) 5. Suppose the three amigos bought the December 35 puts to hedge their short put position on 10,000 shares at $40 per share. a. Calculate their profit/loss on each share and their overall dollar profit/loss, if the share price fell below $35 to $32. Since the price was below their buying price, they suffered a loss of: Cost of buying = $35.00 x 100 share per option x 100 puts = $350,000 Receivables = $32.00 x 100 share per option x 100 puts = $320,000 Overall Loss = $350,000 - $320,000 = $30,000 Per Share Loss = $30,000 / 10, 000 shares = $ 3 / share b. Calculate the share price at which the three amigos would break even. Cost of buying = Sales from selling (for breakeven) If the three amigos sold all the 10,000 shares, then to attain breakeven they should sell the shares at $35.00 also. However, ince the spot price is below the hedging price, the three amigos has the option to buy extra shares. $ 35 x 10,000 = ($32 x 10, 000) + ($ 32 x Z) Where Z is the number of additional shares that needs to be purchased. Calculating for Z: Z = ($350,000- $320,000) / $ 32 Z = 937.5 shares Rounding, we have 938 shares b. Diagram the complete profit and loss profile facing the three amigos. 6. Suppose the three amigos bought the December 30 puts to hedge their short put position on 10,000 shares at $40 per share. Calculate their profit/loss on each share and their overall dollar profit/loss if the share price fell below $30 to $19. Cost of buying = $30.00 x 100 share per option x 100 puts = $300,00 Receivables = $19.00 x 100 share per option x 100 puts = $190,000 Overall Loss = $300,000 - $190,000 = $110,000 Per Share Loss = $110,000 / 10, 000 shares = $ 11/ share 7. Given the following information, use put-call parity to determine the price of a put with a $40 strike price. Working Equation: P = C + DPV(X) - S. P = $40 + ($40*0.08) - $3 P= $40.2 (Answer) Suppose the price of a call rose to $4. Use put-call parity to determine the new price of the put. Working Equation: P = C + DPV(X) - S. P = $40 + ($40*0.08) - $4 P= $39.2 (Answer) Read More