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• Two ratios that make use of the market price of the firm’s common stock in addition to its financial statements are the ratios of market to book value and price to earnings.. Essential

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investors could expect to earn for themselves (on a risk-adjusted basis) in the capital market

Think back to Table 13.9, where we showed that plowing back funds into the firm increases

share value only if the firm earns a higher rate of return on the reinvested funds than the

op-portunity cost of capital, that is, the market capitalization rate To account for this opop-portunity

cost, we might measure the success of the firm using the difference between the return on

as-sets, ROA, and the opportunity cost of capital, k.Economic value added(EVA), or residual

income,is the spread between ROA and k multiplied by the capital invested in the firm It

therefore measures the dollar value of the firm’s return in excess of its opportunity cost

Table 13.11 shows EVA for a small sample of firms drawn from a larger study of 1,000

firms by Stern Stewart, a consulting firm that has done much to develop and promote the

con-cept of EVA Microsoft had one of the highest returns on capital, at 51.8% Since the cost of

capital for Microsoft was only 12.6% percent, each dollar invested by Microsoft was

earn-ing about 39.2 cents more than the return that investors could have expected by investearn-ing in

equivalent-risk stocks Applying this 39.2% margin of superiority to Microsoft’s capital base

of $20.03 billion, we calculate annual economic value added as $7.85 billion.3Note that

ExxonMobil’s EVA was larger than Intel’s, despite a far smaller margin between return on

capital and cost of capital This is because ExxonMobil applied this margin to a larger capital

base At the other extreme, AT&T earned less than its opportunity cost on a very large capital

base, which resulted in a large negative EVA

Notice that even the EVA “losers” in this study generally had positive profits For example,

AT&T’s ROA was 4.4% The problem is that AT&T’s profits were not high enough to

com-pensate for the opportunity cost of funds EVA treats the opportunity cost of capital as a real

cost that, like other costs, should be deducted from revenues to arrive at a more meaningful

“bottom line.” A firm that is earning profits but is not covering its opportunity cost might be

able to redeploy its capital to better uses Therefore, a growing number of firms now calculate

EVA and tie managers’ compensation to it

economic valueadded, orresidual income

A measure of the dollar value of

a firm’s return

in excess of its opportunity cost.

3 Actual EVA estimates reported by Stern Stewart differ somewhat from the values in Table 13.11 because of other

adjustments to the accounting data involving issues such as treatment of research and development expenses, taxes,

advertising expenses, and depreciation The estimates in Table 13.11 are designed to show the logic behind EVA.

TA B L E 13.11

Economic value

added, 1999

Economic

A Some EVA winners Microsoft $7.85 $20.03 51.8% 12.6% ExxonMobil $6.32 $180.04 11.7% 8.2%

Bank One Corp ⫺$1.60 $45.56 8.5% 12.0%

Source: Stern Stewart.

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FINANCIAL STATEMENT ANALYSIS

In her 2003 annual report to the shareholders of Growth Industries, Inc., the president wrote:

“2003 was another successful year for Growth Industries As in 2002, sales, assets, and ating income all continued to grow at a rate of 20%.”

oper-Is she right?

We can evaluate her statement by conducting a full-scale ratio analysis of Growth tries Our purpose is to assess GI’s performance in the recent past, to evaluate its futureprospects, and to determine whether its market price reflects its intrinsic value

Indus-Table 13.12 shows some key financial ratios we can compute from GI’s financial ments The president is certainly right about the growth in sales, assets, and operating income

state-Inspection of GI’s key financial ratios, however, contradicts her first sentence: 2003 was notanother successful year for GI—it appears to have been another miserable one

ROE has been declining steadily from 7.51% in 2001 to 3.03% in 2003 A comparison ofGI’s 2003 ROE to the 2003 industry average of 8.64% makes the deteriorating time trendespecially alarming The low and falling market-to-book-value ratio and the falling price–

earnings ratio indicate that investors are less and less optimistic about the firm’s futureprofitability

The fact that ROA has not been declining, however, tells us that the source of the decliningtime trend in GI’s ROE must be due to financial leverage And we see that, while GI’s lever-age ratio climbed from 2.117 in 2001 to 2.723 in 2003, its interest-burden ratio fell from 0.650

to 0.204—with the net result that the compound leverage factor fell from 1.376 to 0.556

The rapid increase in short-term debt from year to year and the concurrent increase in terest expense make it clear that, to finance its 20% growth rate in sales, GI has incurred siz-able amounts of short-term debt at high interest rates The firm is paying rates of interestgreater than the ROA it is earning on the investment financed with the new borrowing As thefirm has expanded, its situation has become ever more precarious

in-In 2003, for example, the average interest rate on short-term debt was 20% versus an ROA

of 9.09% (We compute the average interest rate on short-term debt by taking the total est expense of $34,391,000, subtracting the $6 million in interest on the long-term bonds, anddividing by the beginning-of-year short-term debt of $141,957,000.)

inter-GI’s problems become clear when we examine its statement of cash flows in Table 13.13

The statement is derived from the income statement and balance sheet in Table 13.8 GI’s cash

TA B L E 13.12

Key financial ratios of Growth Industries, Inc.

Net Compound

2001 7.51% 0.6 0.650 30% 0.303 2.117 1.376 9.09% 8 0.58

2002 6.08 0.6 0.470 30 0.303 2.375 1.116 9.09 6 0.35

2003 3.03 0.6 0.204 30 0.303 2.723 0.556 9.09 4 0.12

Industry average 8.64 0.6 0.800 30 0.400 1.500 1.200 12.00 8 0.69

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firm’s investment in plant and equipment, by contrast, has increased greatly Net plant and

equipment (i.e., net of depreciation) rose from $150,000,000 in 2000 to $259,200,000 in 2003

This near doubling of the capital assets makes the decrease in cash flow from operations all

the more troubling

The source of the difficulty is GI’s enormous amount of short-term borrowing In a sense,

the company is being run as a pyramid scheme It borrows more and more each year to

main-tain its 20% growth rate in assets and income However, the new assets are not generating

enough cash flow to support the extra interest burden of the debt, as the falling cash flow from

operations indicates Eventually, when the firm loses its ability to borrow further, its growth

will be at an end

At this point, GI stock might be an attractive investment Its market price is only 12% of its

book value, and with a P/E ratio of 4, its earnings yield is 25% per year GI is a likely

candi-date for a takeover by another firm that might replace GI’s management and build shareholder

value through a radical change in policy

4 You have the following information for IBX Corporation for the years 2001 and

2004 (all figures are in $millions):

What is the trend in IBX’s ROE, and how can you account for it in terms of tax

burden, margin, turnover, and financial leverage?

⫹ Decrease (increase) in accounts receivable (5,000) (6,000) (7,200)

⫹ Decrease (increase) in inventories (15,000) (18,000) (21,600)

⫹ Increase in accounts payable 6,000 7,200 8,640

$ 12,700 $ 11,343 $ 6,725 Cash flow from investing activities

Investment in plant and equipment* $(45,000) $(54,000) $(64,800) Cash flow from financing activities

Short-term debt issued 42,300 54,657 72,475 Change in cash and marketable securities ‡ $ 10,000 $ 12,000 $ 14,400

ConceptCHECK

<

*Gross investment equals increase in net plant and equipment plus depreciation.

† We can conclude that no dividends are paid because stockholders’ equity increases each year by the full amount of net income, implying a

plowback ratio of 1.0.

‡ Equals cash flow from operations plus cash flow from investment activities plus cash flow from financing activities Note that this equals

the yearly change in cash and marketable securities on the balance sheet.

com-Furthermore, interpreting a single firm’s performance over time is complicated when flation distorts the dollar measuring rod Comparability problems are especially acute in thiscase because the impact of inflation on reported results often depends on the particular methodthe firm adopts to account for inventories and depreciation The security analyst must adjustthe earnings and the financial ratio figures to a uniform standard before attempting to comparefinancial results across firms and over time.

in-Comparability problems can arise out of the flexibility of GAAP guidelines in accountingfor inventories and depreciation and in adjusting for the effects of inflation Other importantpotential sources of noncomparability include the capitalization of leases and other expenses,the treatment of pension costs, and allowances for reserves, but they are beyond the scope ofthis book

Inventory Valuation

There are two commonly used ways to value inventories: LIFO(last-in, first-out) and FIFO

(first-in, first-out) We can explain the difference using a numerical example

Suppose Generic Products, Inc (GPI), has a constant inventory of 1 million units ofgeneric goods The inventory turns over once per year, meaning the ratio of cost of goods sold

to inventory is 1

The LIFO system calls for valuing the million units used up during the year at the currentcost of production, so that the last goods produced are considered the first ones to be sold.They are valued at today’s cost The FIFO system assumes that the units used up or sold arethe ones that were added to inventory first, and goods sold should be valued at original cost

If the price of generic goods were constant, at the level of $1, say, the book value of ventory and the cost of goods sold would be the same, $1 million under both systems But sup-pose the price of generic goods rises by 10 cents per unit during the year as a result ofinflation

in-LIFO accounting would result in a cost of goods sold of $1.1 million, while the end-of-yearbalance sheet value of the 1 million units in inventory remains $1 million The balance sheetvalue of inventories is given as the cost of the goods still in inventory Under LIFO, the lastgoods produced are assumed to be sold at the current cost of $1.10; the goods remaining arethe previously produced goods, at a cost of only $1 You can see that, although LIFO ac-counting accurately measures the cost of goods sold today, it understates the current value ofthe remaining inventory in an inflationary environment

In contrast, under FIFO accounting, the cost of goods sold would be $1 million, and theend-of-year balance sheet value of the inventory is $1.1 million The result is that the LIFOfirm has both a lower reported profit and a lower balance sheet value of inventories than theFIFO firm

LIFO is preferred over FIFO in computing economics earnings (that is, real sustainablecash flow), because it uses up-to-date prices to evaluate the cost of goods sold A disadvan-tage is that LIFO accounting induces balance sheet distortions when it values investment ininventories at original cost This practice results in an upward bias in ROE because the in-

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In computing the gross national product, the U.S Department of Commerce has to make

an inventory valuation adjustment (IVA) to eliminate the effects of FIFO accounting on the

cost of goods sold In effect, it puts all firms in the aggregate onto a LIFO basis

Depreciation

Another source of problems is the measurement of depreciation, which is a key factor in

com-puting true earnings The accounting and economic measures of depreciation can differ

markedly According to the economic definition, depreciation is the amount of a firm’s

oper-ating cash flow that must be reinvested in the firm to sustain its real cash flow at the

cur-rent level

The accounting measurement is quite different Accounting depreciation is the amount of

the original acquisition cost of an asset that is allocated to each accounting period over an

arbitrarily specified life of the asset This is the figure reported in financial statements

Assume, for example, that a firm buys machines with a useful economic life of 20 years at

$100,000 apiece In its financial statements, however, the firm can depreciate the machines

over 10 years using the straight-line method, for $10,000 per year in depreciation Thus, after

10 years, a machine will be fully depreciated on the books, even though it remains a

produc-tive asset that will not need replacement for another 10 years

In computing accounting earnings, this firm will overestimate depreciation in the first

10 years of the machine’s economic life and underestimate it in the last 10 years This will

cause reported earnings to be understated compared with economic earnings in the first

10 years and overstated in the last 10 years

Depreciation comparability problems add one more wrinkle A firm can use different

de-preciation methods for tax purposes than for other reporting purposes Most firms use

accel-erated depreciation methods for tax purposes and straight-line depreciation in published

financial statements There also are differences across firms in their estimates of the

deprecia-ble life of plant, equipment, and other depreciadeprecia-ble assets

The major problem related to depreciation, however, is caused by inflation Because

con-ventional depreciation is based on historical costs rather than on the current replacement cost

of assets, measured depreciation in periods of inflation is understated relative to replacement

cost, and real economic income (sustainable cash flow) is correspondingly overstated.

The situation is similar to what happens in FIFO inventory accounting Conventional

de-preciation and FIFO both result in an inflation-induced overstatement of real income because

both use original cost instead of current cost to calculate net income

For example, suppose Generic Products, Inc., has a machine with a three-year useful life

that originally cost $3 million Annual straight-line depreciation is $1 million, regardless of

what happens to the replacement cost of the machine Suppose inflation in the first year turns

out to be 10% Then the true annual depreciation expense is $1.1 million in current terms,

while conventionally measured depreciation remains fixed at $1 million per year Accounting

income therefore overstates real economic income.

Inflation and Interest Expense

While inflation can cause distortions in the measurement of a firm’s inventory and

deprecia-tion costs, it has perhaps an even greater effect on the calculadeprecia-tion of real interest expense.

Nominal interest rates include an inflation premium that compensates the lender for

inflation-induced erosion in the real value of principal From the perspective of both lender and

borrower, therefore, part of what is conventionally measured as interest expense should be

treated more properly as repayment of principal

mil-an inflation premium, or compensation for the mil-anticipated reduction in the real value of the

$10 million principal; only $0.4 million is real interest expense The $0.6 million reduction in

the purchasing power of the outstanding principal may be thought of as repayment of pal, rather than as an interest expense Real income of the firm is, therefore, understated by

princi-$0.6 million

This mismeasurement of real interest means that inflation results in an underestimate ofreal income The effects of inflation on the reported values of inventories and depreciation that

we have discussed work in the opposite direction

5 In a period of rapid inflation, companies ABC and XYZ have the same reported

earnings ABC uses LIFO inventory accounting, has relatively fewer depreciable sets, and has more debt than XYZ XYZ uses FIFO inventory accounting Which

as-company has the higher real income and why?

Quality of Earnings and Accounting Practices

Many firms make accounting choices that present their financial statements in the best sible light The different choices that firms can make give rise to the comparability problems

pos-we have discussed As a result, earnings statements for different companies may be more orless rosy presentations of true “economic earnings”—sustainable cash flow that can be paid toshareholders without impairing the firm’s productive capacity Analysts commonly evaluatethequality of earnings reported by a firm This concept refers to the realism and conser-vatism of the earnings number, in other words, the extent to which we might expect the re-ported level of earnings to be sustained

Examples of the accounting choices that influence quality of earnings are:

• Allowance for bad debt Most firms sell goods using trade credit and must make an

allowance for bad debt An unrealistically low allowance reduces the quality of reportedearnings Look for a rising average collection period on accounts receivable as evidence ofpotential problems with future collections

• Nonrecurring items Some items that affect earnings should not be expected to recur

regularly These include asset sales, effects of accounting changes, effects of exchange ratemovements, or unusual investment income For example, in 1999, which was a banneryear for equity returns, some firms enjoyed large investment returns on securities held.These contributed to that year’s earnings, but should not be expected to repeat regularly.They would be considered a “low-quality” component of earnings Similarly gains incorporate pension plans can generate large, but one-time, contributions to reportedearnings For example, IBM increased its year 2000 pretax income by nearly $200 million

by changing the assumed rate of return on its pension fund assets by 0.5%

• Reserves management In the 1990s, W R Grace reduced its earnings by offsetting high

earnings in one of its subsidiaries with extra reserves against unspecified future liabilities.Why would it do this? Because later, it could “release” those reserves if and whenearnings were lower, thereby creating the appearance of steady earnings growth WallStreet likes strong, steady earnings growth, but Grace planned to provide such growththrough earnings management

• Stock options Many firms, particularly start-ups, compensate employees in large part with

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need to be paid, the value of the options should be considered as one component of

the firm’s labor expense But GAAP accounting rules do not require such treatment

Therefore, all else equal, earnings of firms with large employee stock option programs

should be considered of lower quality

• Revenue recognition Under GAAP accounting, a firm is allowed to recognize a sale

before it is paid This is why firms have accounts receivable But sometimes it can be hard

to know when to recognize sales For example, suppose a computer firm signs a contract

to provide products and services over a five-year period Should the revenue be booked

immediately or spread out over five years? A more extreme version of this problem is

called “channel stuffing,” in which firms “sell” large quantities of goods to customers, but

give them the right to later either refuse delivery or return the product The revenue from

the “sale” is booked now, but the likely returns are not recognized until they occur (in a

future accounting period) According to the SEC, Sunbeam, which filed for bankruptcy in

2001, generated $60 million in fraudulent profits in 1999 using this technique If you see

accounts receivable increasing far faster than sales, or becoming a larger percentage of

total assets, beware of these practices Global Crossing, which filed for bankruptcy in

2002, illustrates a similar problem in revenue recognition It swapped capacity on its

network for capacity of other companies for periods of up to 20 years But while it seems

to have booked the sale of its capacity as immediate revenue, it treated the acquired

capacity as capital assets that could be expensed over time Given the wide latitude firms

have to manipulate revenue, many analysts choose instead to concentrate on cash flow,

which is far harder for a company to manipulate

• Off-balance-sheet assets and liabilities Suppose that one firm guarantees the outstanding

debt of another firm, perhaps a firm in which it has an ownership stake That obligation

ought to be disclosed as a contingent liability, since it may require payments down the

road But these obligations may not be reported as part of the firm’s outstanding debt

Similarly, leasing may be used to manage off-balance-sheet assets and liabilities Airlines,

for example, may show no aircraft on their balance sheets but have long-term leases that

are virtually equivalent to debt-financed ownership However, if the leases are treated as

operating rather than capital leases, they may appear only as footnotes to the financial

statements

Enron Corporation, which filed for bankruptcy protection in December 2001, presents an

extreme case of “management” of financial statements The firm seems to have used several

partnerships in which it was engaged to hide debt and overstate earnings When disclosures

about these partnerships came to light at the end of 2001, the company was forced to restate

earnings amounting to almost $600 million dating back to 1997 Enron raises the question of

where to draw the line that separates creative, but legal, interpretation of financial reporting

rules from fraudulent reporting It also raises questions about the proper relationship between

a firm and its auditor, which is supposed to certify that the firm’s financial statements are

pre-pared properly Enron’s auditor, Arthur Andersen LLP, actually earned more money in 2000

doing nonauditing work for Enron than it did for its external audit The dual role of the

audit-ing firm creates a potential conflict of interest, since the auditor may be lenient in the audit to

preserve its consulting business with the client Andersen’s dual role has become common in

the auditing industry However, in the wake of the Enron bankruptcy, many firms have

volun-tarily decided to no longer hire their auditors as consultants, and this practice may be banned

by new legislation Moreover, big auditors such as KMPG, Ernst & Young,

Pricewaterhouse-Coopers, and Deloitte Touche Tohmatsu either have spun off their consulting practices as

independent firms or have announced their intention to separate the audit and consulting

businesses

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Deciphering the Black Box: Many Accounting Practices,

Not Just Enron’s, Are Hard to Penetrate

Just 30 years ago, the rules governing corporate

ac-counting filled only two volumes and could fit in a

brief-case Since then, the standards have multiplied so

rapidly that it takes a bookcase shelf—a long one—to

hold all the volumes.

As the collapse of Enron has made painfully clear,

the complexity of corporate accounting has grown

exponentially What were once simple and objective

concepts, like sales and earnings, in many cases have

become complicated and subjective Add the fact that

many companies disclose as little as possible, and the

financial reports of an increasing number of companies

have become impenetrable and confusing.

The result has been a rise in so-called black-box

accounting: financial statements, like Enron’s, that are

so obscure that their darkness survives the light of day.

Even after disclosure, the numbers that some

com-panies report are based on accounting methodologies

so complex, involving such a high degree of guesswork,

that it can’t easily be determined precisely how they

were arrived at Hard to understand doesn’t necessarily

mean inaccurate or illegal, of course But, some

com-panies take advantage of often loose accounting rules

to massage their numbers to make their results look

better.

The bottom line: There is a lot more open to

inter-pretation when it comes to the bottom line.

Why has corporate accounting become so difficult

to understand? In large part because corporations, and what they do, have become more complex The ac- counting system initially was designed to measure the profit and loss of a manufacturing company Figuring out the cost of producing a hammer or an automobile, and the revenue from selling them, was relatively easy But determining the same figures for a service, or for a product like computer software, can involve a lot more variables open to interpretation.

Companies have evolved ever-more complex ways

to limit risk Baruch Lev, accounting and finance fessor at New York University, says a venture into for- eign markets creates a need for a company to use derivatives, financial instruments that hedge invest- ments or serve as credit guarantees Many companies have turned to off-the-books partnerships to insulate themselves from risks and share costs of expansion This is where the accounting has a hard time keep- ing up—and keeping track of what is going on fi- nancially inside a giant, multifaceted multinational Accounting rules designed for a company that makes simple products can end up being inadequate to por- tray a concern like Enron, which in many ways exists as the focal point of a series of contracts—contracts to trade broadband capacity, electricity and natural gas, and contracts to invest in other technology start-ups.

pro-Unfortunately, Enron was hardly alone in preparing financial statements of questionablequality or utility The nearby box points out that financial statements have increasingly be-come “black boxes,” reporting data that are difficult to interpret or even to verify As we noted

in the previous chapter, however, the valuations of stocks with particularly hard-to-interpretfinancial statements have been adversely affected by the market’s new focus on accountinguncertainty The incentives for clearer disclosure induced by this sort of market disciplineshould foster greater transparency in accounting practice

International Accounting Conventions

The examples cited above illustrate some of the problems that analysts can encounter whenattempting to interpret financial data Even greater problems arise in the interpretation ofthe financial statements of foreign firms This is because these firms do not follow GAAPguidelines Accounting practices in various countries differ to greater or lesser extents fromU.S standards Here are some of the major issues that you should be aware of when using thefinancial statements of foreign firms

Reserving practices Many countries allow firms considerably more discretion insetting aside reserves for future contingencies than is typical in the United States Becauseadditions to reserves result in a charge against income, reported earnings are far more subject

to managerial discretion than in the United States

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Germany is a country that allows particularly wide discretion in reserve practice When

Daimler-Benz AG (producer of the Mercedes Benz, now DaimlerChrysler) decided to issue

shares on the New York Stock Exchange in 1993, it had to revise its accounting statements

in accordance with U.S standards The revisions transformed a $370 million profit for 1993

using German accounting rules into a $1 million loss under more stringent U.S rules.

Depreciation As discussed above, in the United States firms typically maintain separate

sets of accounts for tax and reporting purposes For example, accelerated depreciation is used

for tax purposes, while straight-line depreciation is used for reporting purposes In contrast,

most other countries do not allow dual sets of accounts, and most firms in foreign countries

use accelerated depreciation to minimize taxes despite the fact that it results in lower reported

earnings This makes reported earnings of foreign firms lower than they would be if the firms

were allowed to follow the U.S practice

Intangibles Treatment of intangibles can vary widely Are they amortized or expensed?

If amortized, over what period? Such issues can have a large impact on reported profits

Figure 13.2 summarizes some of the major differences in accounting rules in various

coun-tries The effect of different accounting practices can be substantial

A study by Speidell and Bavishi (1992) recalculated the financial statements of firms in

several countries using common accounting rules Figure 13.3, from their study, compares P/E

ratios as reported and restated on a common basis The variation is considerable

475

(concluded)

“The boundaries of corporations are becoming

in-creasingly blurred,” says Mr Lev “It’s very well defined

legally what is inside the corporation but we must

restructure accounting so the primary entity will be the

economic one, not the legal one.”

Because of the leeway in current accounting rules,

two companies in the same industry that perform

iden-tical transactions can report different numbers Take

the way companies can account for

research-and-development costs One company could spread the

costs out over 10 years, while another might spread the

same costs over five years.

Both methods would be allowable and defensible,

but the longer time frame would tend to result in

higher earnings because it reduces expenses allocated

annually.

Another area that allows companies freedom to

de-termine what results they report is in the accounting for

intangible assets, such as the value placed on goodwill,

or the amount paid for an asset above its book value.

At best, the values placed on these items as recorded

on company balance sheets are educated guesses But

they represent an increasing part of total assets.

Further complicating matters for investors, many

companies have taken to providing pro forma earnings

that, among other things, often show profits and losses

without these changes in intangible values The result

has been virtually a new accounting system without any set rules, in which companies have been free to show their performance any way they deem fit.

Finally, add to the equation the increasing tance of a rising stock price, and investors face an un- precedented incentive on the part of companies to obfuscate No longer is a higher stock price simply de- sirable, it is often essential, because stocks have be- come a vital way for companies to run their businesses The growing use of stock options as a way of compen- sating employees means managers need higher stock prices to retain talent The use of stock to make ac- quisitions and to guarantee the debt of off-the-books partnerships means, as with Enron, that the entire part- nership edifice can come crashing down with the fall of the underlying stock that props up the system.

impor-And the growing use of the stock market as a place for companies to raise capital means a high stock price can be the difference between failure and success.

Hence, companies have an incentive to use sive—but, under the rules, acceptable—accounting to boost their reported earnings and prop up their stock price In the worst-case scenario, that means some companies put out misleading financial accounts.

aggres-Source: Abridged version of the article of the same title by Steve

Liesman for “Heard on the Street,” The Wall Street Journal,

January 21, 2002.

Comparative accounting rules

Source: Center for International Financial Analysis and Research, Princeton, NJ; and Frederick D S Choi and Gerhard G Mueller, International Accounting,

2d ed (Englewood Cliffs, NJ: Prentice Hall, 1992).

* In Austria companies issue only annual data Other countries besides the U.S and Canada issue semiannual data In the Netherlands,

companies issue quarterly or semiannual data.

** In Austria, Japan, Hong Kong, and West Germany, the minority of companies fully consolidate.

† In Austria, Hong Kong, Singapore, and Spain, the accounting treatment for R&D costs—whether they are immediately deducted or capitalized and deducted over later years—isn't disclosed in financial reports.

Accounting rules

vary worldwide

All company financial

reports include: AustraliaAustria Britain Canada France Hong KongJapan NetherlandsSingaporeSpain SwitzerlandW GermanyU.S.

Speidell and Vinod

Bavishi, “GAAP Arbitrage:

Association for Investment

Management and Research.

Reproduced and

republished from Financial

Analysts Journal with

permission from the

Association for Investment

Management and Research.

Australia France Germany Japan Switzerland United Kingdom

24.1 9.1

12.6 11.4

26.5 17.1

78.1 45.1

12.4 10.7 10.0 9.5

Reported P/E Adjusted P/E

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Fifth Edition

Such differences in international accounting standards have become more of a problem as

the drive to globally integrate capital markets progresses For example, many foreign firms

would like to list their shares on the New York Stock Exchange in order to more easily tap the

U.S equity markets, and the NYSE would like to have those firms listed But the Securities

and Exchange Commission (SEC) will not allow such shares to be listed unless the firms

pre-pare their financial statements in accordance with U.S GAAP standards This has limited the

listing of non-U.S companies dramatically

In contrast to the U.S., most large non-U.S national stock exchanges allow foreign firms

to be listed if their financial statements conform to International Accounting Standards (IAS)

rules IAS disclosure requirements tend to be far more rigorous than those of most countries,

and they impose greater uniformity in accounting practices Its advocates argue that IAS rules

are already fairly similar to GAAP rules and provide nearly the same quality financial

infor-mation about the firm While the SEC does not yet deem IAS standards acceptable for listing

in U.S markets, negotiations are currently underway to change that situation

The Enron and other accounting debacles have given U.S regulators a dose of humility

concerning GAAP standards While European IAS regulation tends to be principle-based,

GAAP regulation tends to be rules-based GAAP mandates lengthy, detailed, and specific

rules about the widest range of allowed accounting practices Critics argue that by doing so, it

gives legal protection to firms that use clever accounting practice to misportray their true

status while still satisfying a legalistic checklist approach to their financial statements In the

aftermath of Enron, Harvey Pitt, chairman of the SEC, stated his intention to move the U.S

more in the direction of principle-based standards and to require firms to explain both why

they have chosen their accounting conventions and how their results would be affected by

changes in those accounting assumptions

No presentation of fundamental security analysis would be complete without a discussion

of the ideas of Benjamin Graham, the greatest of the investment “gurus.” Until the evolution

of modern portfolio theory in the latter half of this century, Graham was the single most

W E B M A S T E R

Accounting in Crisis

The headlines in the last quarter of 2001 and the first half of 2002 were dominated by

stories related to the meltdown and bankruptcy of the energy giant Enron As the story

unfolded, issues related to the accounting industry made the front pages of the financial

press and stories related to Enron were featured on the evening news The January issue

of BusinessWeek contained a special report entitled “Accounting in Crisis,” which can be

found at http://www.businessweek.com/magazine/content/02_04/b3767712.htm.

After reading the article, identify and briefly describe the seven steps that the article

discussed for reform of the accounting industry.

Graham’s magnum opus is Security Analysis, written with Columbia Professor David Dodd

in 1934 Its message is similar to the ideas presented in this chapter Graham believed carefulanalysis of a firm’s financial statements could turn up bargain stocks Over the years, he de-veloped many different rules for determining the most important financial ratios and the crit-ical values for judging a stock to be undervalued Through many editions, his book has had aprofound influence on investment professionals It has been so influential and successful, infact, that widespread adoption of Graham’s techniques has led to elimination of the very bar-gains they are designed to identify

In a 1976 seminar Graham said4

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities This was a rewarding activity, say, forty years ago, when our textbook

“Graham and Dodd” was first published; but the situation has changed a good deal since then In the old days any well-trained security analyst could do a good professional job of selecting under- valued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

Nonetheless, in that same seminar, Graham suggested a simplified approach to identifybargain stocks:

My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets We used this approach ex- tensively in managing investment funds, and over a thirty-odd-year period we must have earned

an average of some 20% per year from this source For awhile, however, after the mid-1950s, this brand of buying opportunity became very scarce because of the pervasive bull market But it has returned in quantity since the 1973–1974 decline In January 1976 we counted over 100 such is-

sues in the Standard & Poor’s Stock Guide—about 10% of the total I consider it a foolproof

method of systematic investment—once again, not on the basis of individual results but in terms

of the expectable group outcome.

There are two convenient sources of information for those interested in trying out the

Graham technique Both Standard & Poor’s Outlook and The Value Line Investment Survey

carry lists of stocks selling below net working capital value

SUMMARY • The primary focus of the security analyst should be the firm’s real economic earnings

rather than its reported earnings Accounting earnings as reported in financial statementscan be a biased estimate of real economic earnings, although empirical studies reveal thatreported earnings convey considerable information concerning a firm’s prospects

• A firm’s ROE is a key determinant of the growth rate of its earnings ROE is affectedprofoundly by the firm’s degree of financial leverage An increase in a firm’s debt/equityratio will raise its ROE and hence its growth rate only if the interest rate on the debt is lessthan the firm’s return on assets

Essentials of Investments,

Fifth Edition

• It is often helpful to the analyst to decompose a firm’s ROE ratio into the product of

several accounting ratios and to analyze their separate behavior over time and across

companies within an industry A useful breakdown is

• Other accounting ratios that have a bearing on a firm’s profitability and/or risk are

fixed-asset turnover, inventory turnover, days receivable, and the current, quick, and interest

coverage ratios

• Two ratios that make use of the market price of the firm’s common stock in addition to its

financial statements are the ratios of market to book value and price to earnings Analysts

sometimes take low values for these ratios as a margin of safety or a sign that the stock

is a bargain

• A major problem in the use of data obtained from a firm’s financial statements is

comparability Firms have a great deal of latitude in how they choose to compute various

items of revenue and expense It is, therefore, necessary for the security analyst to adjust

accounting earnings and financial ratios to a uniform standard before attempting to

compare financial results across firms

• Comparability problems can be acute in a period of inflation Inflation can create

distortions in accounting for inventories, depreciation, and interest expense

AssetsEquity

SalesAssets

EBITSales

Pretax profitsEBIT

Net profitsPretax profits

KEY TERMS

price–earnings ratio, 464

profit margin, 459quality of earnings, 472quick ratio, 463residual income, 467return on assets, 457return on equity, 456return on sales, 459statement of cashflows, 454times interest earned, 463

PROBLEM SETS

1 The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher

than the industry average, yet its ROA is the same as the industry average How can you

explain this?

2 The ABC Corporation has a profit margin on sales below the industry average, yet its

ROA is above the industry average What does this imply about its asset turnover?

3 Firm A and firm B have the same ROA, yet firm A’s ROE is higher How can you

explain this?

4 Which of the following best explains a ratio of “net sales to average net fixed assets” that

exceeds the industry average?

a The firm added to its plant and equipment in the past few years.

b The firm makes less efficient use of its assets than other firms.

c The firm has a lot of old plant and equipment.

d The firm uses straight-line depreciation.

5 A company’s current ratio is 2.0 If the company uses cash to retire notes payable due

within one year, would this transaction increase or decrease the current ratio and asset

turnover ratio?

goodwill over 20 years goodwill over 5 years.

Property, plant, The company uses a straight-line The company uses an accelerated and equipment depreciation method over the depreciation method over the

economic lives of the assets, economic lives of the assets, which which range from 5 to 20 years range from 5 to 20 years for

Accounts The company uses a bad debt The company uses a bad debt receivable allowance of 2% of accounts allowance of 5% of accounts

• Total asset turnover 2.0

• Net profit margin 5.5%

• Dividend payout ratio 31.8%

What is the company’s return on equity?

8 An analyst gathers the following information about Meyer, Inc.:

• Meyer has 1,000 shares of 8% cumulative preferred stock outstanding, with a par value

of $100, and liquidation value of $110

• Meyer has 20,000 shares of common stock outstanding, with a par value of $20

• Meyer had retained earnings at the beginning of the year of $5,000,000

• Net income for the year was $70,000

• This year, for the first time in its history, Meyer paid no dividends on preferred orcommon stock

What is the book value per share of Meyer’s common stock?

9 The cash flow data of Palomba Pizza Stores for the year ended December 31, 2001, are

as follows:

Cash payment of dividends $ 35,000

Cash collections from customers 250,000

Essentials of Investments,

Fifth Edition

• Net cash provided by operating activities

• Net cash provided by or used in investing activities

• Net cash provided by or used in financing activities

b Discuss, from an analyst’s viewpoint, the purpose of classifying cash flows into the

three categories listed above

10 The financial statements for Chicago Refrigerator Inc (see Tables 13.14 and 13.15) are

to be used to compute the ratios a through h for 1999.

a Quick ratio.

b Return on assets.

c Return on common shareholders’ equity.

d Earnings per share of common stock.

Common stock, $1 par value 1,000,000 shares authorized; 550,000 and 829,000 outstanding,

Preferred stock, Series A 10%; $25.00 par value; 25,000 authorized; 20,000 and 18,000 outstanding, respectively 500 450 Additional paid-in capital 450 575

Total shareholders’ equity $2,868 $3,803 Total liabilities and shareholders’ equity $4,792 $8,058

\

11 In an inflationary period, the use of FIFO will make which one of the following more

realistic than the use of LIFO?

a Balance sheet

b Income statement

c Cash flow statement

d None of the above

12 A company acquires a machine with an estimated 10-year service life If the companyuses the Accelerated Cost Recovery System depreciation method instead of the straight-line method:

a Income will be higher in the 10th year.

b Total depreciation expense for the 10 years will be lower.

c Depreciation expense will be lower in the first year.

d Scrapping the machine after eight years will result in a larger loss.

13 Why might a firm’s ratio of long-term debt to long-term capital be lower than theindustry average, but its ratio of income-before-interest-and-taxes to debt-interestcharges be lower than the industry average?

a The firm has higher profitability than average.

b The firm has more short-term debt than average.

c The firm has a high ratio of current assets to current liabilities.

d The firm has a high ratio of total cash flow to total long-term debt.

14 During a period of falling price levels, the financial statements of a company usingFIFO instead of LIFO for inventory accounting would show:

a Lower total assets and lower net income.

b Lower total assets and higher net income.

c Higher total assets and lower net income.

d Higher total assets and higher net income.

15 Scott Kelly is reviewing MasterToy’s financial statements in order to estimate itssustainable growth rate Using the information presented in Table 13.16

a Identify and calculate the components of the DuPont formula.

b Calculate the ROE for 1999 using the components of the DuPont formula.

c Calculate the sustainable growth rate for 1999 from the firm’s ROE and

TA B L E 13.15

Chicago Refrigerator Inc.

income statement, years ending December 31 ($ thousands)

Total revenues $7,831 $12,410 Cost of goods sold $4,850 $ 8,048 General administrative and marketing expenses 1,531 2,025

Essentials of Investments,

Fifth Edition

16 In a cash flow statement prepared in accordance with FASB 95, cash flow from

investing activities excludes:

a Cash paid for acquisitions.

b Cash received from the sale of fixed assets.

c Inventory increases due to a new (internally developed) product line.

d All of the above.

17 Cash flow from operating activities includes:

a Inventory increases resulting from acquisitions.

b Inventory changes due to changing exchange rates.

c Interest paid to bondholders.

d Dividends paid to stockholders.

18 Janet Ludlow is a recently hired analyst After describing the electric toothbrush

industry, her first report focuses on two companies, QuickBrush Company and

SmileWhite Corporation, and concludes:

QuickBrush is a more profitable company than SmileWhite, as indicated by the 40% sales

growth and substantially higher margins it has produced over the last few years

Smile-White’s sales and earnings are growing at a 10% rate and produce much lower margins We

Total liabilities $ 850 $ 900 Stockholders’ equity 2,100 2,200 Total liabilities and equity $2,950 $3,100 Book value per share $7.92 $8.46 Annual dividend per share 0.55 0.60

a Criticize Ludlow’s analysis and conclusion that QuickBrush is more profitable, as

defined by return on equity (ROE), than SmileWhite and that it has a highersustainable growth rate Use only the information provided in Tables 13.17 and13.18 Support your criticism by calculating and analyzing:

• The five components that determine ROE

per share data)

December December December

Revenue $3,480 $5,400 $7,760 Cost of goods sold 2,700 4,270 6,050 Selling, general, and admin expense 500 690 1,000 Depreciation and amortization 30 40 50 Operating income (EBIT) $250 $400 $660

December December December 3-Year

COGS as % of sales 77.59% 79.07% 77.96% 78.24% General & admin as % of sales 14.37 12.78 12.89 13.16 Operating margin (%) 7.18 7.41 8.51

Pretax income/EBIT (%) 100.00 100.00 100.00 Tax rate (%) 24.00 27.50 32.58

December December December

Essentials of Investments,

Fifth Edition

b Explain how QuickBrush has produced an average annual earnings per share (EPS)

growth rate of 40% over the last two years with an ROE that has been declining Use

only the information provided in Table 13.17

19 The DuPont formula defines the net return on shareholders’ equity as a function of the

per share data)

December December December

Revenue $104,000 $110,400 $119,200 Cost of goods sold 72,800 75,100 79,300 Selling, general, and admin expense 20,300 22,800 23,900 Depreciation and amortization 4,200 5,600 8,300 Operating income $ 6,700 $ 6,900 $ 7,700 Interest expense 600 350 350 Income before taxes $ 6,100 $ 6,550 $ 7,350 Income taxes 2,100 2,200 2,500 Income after taxes $ 4,000 $ 4,350 $ 4,850 Diluted EPS $2.16 $2.35 $2.62 Average shares outstanding (000) 1,850 1,850 1,850

December December December 3-Year

COGS as % of sales 70.00% 68.00% 66.53% 68.10% General & admin as % of sales 19.52 20.64 20.05 20.08 Operating margin (%) 6.44 6.25 6.46

Pretax income/EBIT (%) 91.04 94.93 95.45 Tax rate (%) 34.43 33.59 34.01

December December December

Cash and cash equivalents $ 7,900 $ 3,300 $ 1,700 Accounts receivable 7,500 8,000 9,000 Inventories 6,300 6,300 5,900 Net property, plant, and equipment 12,000 14,500 17,000 Total assets $33,700 $32,100 $33,600 Current liabilities $ 6,200 $ 7,800 $ 6,600 Long-term debt 9,000 4,300 4,300 Total liabilities $15,200 $12,100 $10,900 Stockholders’ equity 18,500 20,000 22,700 Total liabilities and equity $33,700 $32,100 $33,600 Market price per share $23.00 $26.00 $30.00 Book value per share $10.00 $10.81 $12.27 Annual dividend per share $1.42 $1.53 $1.72

Essentials of Investments,

Fifth Edition

• Financial leverage

• Income tax rate

Using only the data in Table 13.19:

a Calculate each of the five components listed above for 1998 and 2002, and calculate

the return on equity (ROE) for 1998 and 2002, using all of the five components

b Briefly discuss the impact of the changes in asset turnover and financial leverage on

the change in ROE from 1998 to 2002

TABLE 13.19

Income statements and balance sheets

Income statement data

Operating income 38 76 Depreciation and amortization 3 9 Interest expense 3 0 Pretax income 32 67

Net income after tax $ 19 $ 30 Balance sheet data

Fixed assets $ 41 $ 70 Total assets 245 291 Working capital 123 157

Total shareholders’ equity $159 $220

1 Use Market Insight ( www.mhhe.com/edumarketinsight ) to find the profit margin

and asset turnover for firms in several industries What seems to be the

relationship between margin and turnover? Does this make sense to you?

2 Choose a few firms in similar lines of business, and compare their return on

assets Why does one firm do better or worse than others? Use the DuPont

formula to guide your analysis For example, compare debt ratios, asset

turnover, and profit margins.

Financial Statement Analysis

Go to http://moneycentral.msn.com/investor and review the financial results for EMC

Corporation (EMC) and Network Appliance Inc (NTAP) The financial result area has

sections on highlights, key ratios, and statements You will need information on all

three to answer the following questions.

1 Compare the price-to-book and price-to-sales ratios of the companies How do

they compare with the average for the S&P 500?

2 Are there any substantial differences in the gross and net profit margins for

the companies?

3 Compare the profitability ratios of the companies as measured by return on

equity and return on assets.

4 Are there any significant differences in efficiency ratios?

5 Are there any significant differences in the financial condition ratios?

6 Compare the growth in sales and income for the two companies over the last

five years.

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

and ROE over the business cycle will therefore be

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

† Mordett’s equity is only $50 million.

ConceptCHECKS

<

4 IBX Ratio Analysis

Net Compound

ROE went up despite a decline in operating margin and a decline in the tax burden ratio 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.

$5,285 0.5($171,843 ⫹ $177,128)

Horror stories about large losses incurred

by high-flying traders in derivatives kets such as those for futures and op-tions periodically become a staple of the

mar-evening news Indeed, there were some

amaz-ing losses to report in the last decade: several

totaling hundreds of millions of dollars, and a

few amounting to more than a billion dollars In

the wake of these debacles, some venerable

in-stitutions have gone under, notable among

them, Barings Bank, which once helped the

U.S finance the Louisiana Purchase and the

British Empire finance the Napoleonic Wars

These stories, while important,

fascinat-ing, and even occasionally scandalous, often

miss the point Derivatives, when misused, can

indeed provide a quick path to insolvency

Used properly, however, they are potent tools

for risk management and control In fact, you

will discover in these chapters that one firm

was sued for failing to use derivatives to hedge

price risk One headline in The Wall Street

Journal on hedging applications using

deriva-tives was entitled “Index Options Touted asProviding Peace of Mind.” Hardly material for

bankruptcy court or the National Enquirer.

Derivatives provide a means to controlrisk that is qualitatively different from thetechniques traditionally considered in portfoliotheory In contrast to the mean-variance analy-sis we discussed in Parts Two and Three, deriv-

atives allow investors to change the shape of

the probability distribution of investment turns An entirely new approach to risk man-agement follows from this insight

re-The following chapters will explore howderivatives can be used as parts of a well-designed portfolio strategy We will examinesome popular portfolio strategies utilizingthese securities and take a look at how deriva-tives are valued

www.mhhe.com/bkm

15 Option Valuation

16 Futures Markets

Calculate the profit to various option positions as a function

of ultimate security prices

Formulate option strategies to modify portfolio risk-returnattributes

Identify embedded options in various securities anddetermine how option characteristics affect the prices ofthose securities

>

>

>

OPTIONS MARKETS

Essentials of Investments,

Fifth Edition

Companies, 2003

Derivative securities, or simply derivatives, play a large and increasingly

impor-tant role in financial markets These are securities whose prices are mined by, or “derive from,” the prices of other securities These assets also

deter-are called contingent claims because their payoffs deter-are contingent on the prices of

other securities

Options and futures contracts are both derivative securities We will see thattheir payoffs depend on the value of other securities Swaps, which we discussed inChapter 10, also are derivatives Because the value of derivatives depends on thevalue 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 thischapter with options

Trading of standardized options on a national exchange started in 1973 whenthe Chicago Board Options Exchange (CBOE) began listing call options These con-tracts were almost immediately a great success, crowding out the previously existingover-the-counter trading in stock options

Options contracts now are traded on several exchanges They are written oncommon stock, stock indexes, foreign exchange, agricultural commodities, preciousmetals, and interest rate futures In addition, the over-the-counter market also hasenjoyed a tremendous resurgence in recent years as its trading in custom-tailored op-tions has exploded Popular and potent for modifying portfolio characteristics, optionshave become essential tools that every portfolio manager must understand

This chapter is an introduction to options markets It explains how puts and callswork and examines their investment characteristics Popular option strategies areconsidered next Finally, we will examine a range of securities with embedded optionssuch as callable or convertible bonds

Related Websites

http://www.cboe.com/LearnCenter

http://www.amex.com/?href=404.html?/options/

education

These sites contain online option education material.

They have extensive programs to learn about the use of

options, options pricing, and option markets.

http://www.options.about.com/money/options

This site has extensive links to many other sites It

contains sections on education, exchanges, research,

and quotes, as well as extensive sources related to

futures markets.

http://www.optionscentral.com

This site provides extensive educational material

including access to the freely available Options Toolbox.

The toolbox is an excellent source that allows you to simulate different options positions and examine the pricing of options.

http://www.numa.com http://www.phlx.com/educat/index.html The above sites have extensive links to numerous options and other derivative websites, as well as educational material on options.

http://www.cme.com http://www.amex.com http://www.cboe.com http://www.nasdaq.com http://www.cbt.com The above sites are exchange sites.

Essentials of Investments,

Fifth Edition

Companies, 2003

Acall optiongives its holder the right to purchase an asset for a specified price, called the

exercise orstrike price,on or before some specified expiration date For example, a July calloption on Microsoft stock with exercise price $80 entitles its owner to purchase Microsoftstock for a price of $80 at any time up to and including the expiration date in July The holder

of the call is not required to exercise the option The holder will choose to exercise only if themarket value of the asset to be purchased exceeds the exercise price When the market pricedoes exceed the exercise price, the option holder may “call away” the asset for the exerciseprice Otherwise, the option may be left unexercised If it is not exercised before the expira-tion date of the contract, a call option simply expires and no longer has value Therefore, if thestock price is greater than the exercise price on the expiration date, the value of the call optionwill equal the difference between the stock price and the exercise price; but if the stock price

is less than the exercise price at expiration, the call will be worthless The net profit on the call

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 thepurchaser of the call must pay for the ability to exercise the option if exercise becomes prof-

itable Sellers of call options, who are said to write calls, receive premium income now as

payment against the possibility they will be required at some later date to deliver the asset inreturn 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 thewriter 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 largerthan the initial premium, the writer will incur a loss

Aput optiongives its holder the right to sell an asset for a specified exercise or strike price

to exercise the option to buy at $70 Indeed, if Microsoft stock remains below $70 by the piration date, the call will be left to expire worthless If, on the other hand, Microsoft is selling above $70 at expiration, the call holder will find it optimal to exercise For example, if Mi- crosoft sells for $73 on April 19, the option will be exercised since it will give its holder the right

ex-to pay $70 for a sex-tock worth $73 The value of the option on the expiration date will be

Value at expiration
Stock price  Exercise price
$73  $70
$3

Despite the $3 payoff at maturity, the investor still realizes a loss of $1.60 on the investment

in the call because the initial purchase price was $4.60:

Profit
Final value  Original investment
$3 $4.60
$1.60

Nevertheless, exercise of the call will be optimal at maturity if the stock price is above the cise price because the exercise proceeds will offset at least part of the investment in the option The investor in the call will clear a profit if Microsoft is selling above $74.60 at the maturity date At that price, the proceeds from exercise will just cover the original cost of the call.

exer-Essentials of Investments,

Fifth Edition

Companies, 2003

its owner to sell Microsoft stock to the put writer at a price of $70 at any time before

expira-tion in April, even if the market price of Microsoft is less than $70 While profits on call

op-tions increase when the asset increases in value, profits on put opop-tions increase when the asset

value falls A put will be exercised only if the exercise price is greater than the price of the

un-derlying asset, that is, only if its holder can deliver for the exercise price an asset with market

value less than the exercise price (One doesn’t need to own the shares of Microsoft to

exer-cise the Microsoft put option Upon exerexer-cise, the investor’s broker purchases the necessary

shares of Microsoft at the market price and immediately delivers or “puts them” to an option

writer for the exercise price The owner of the put profits by the difference between the

exer-cise price and market price.)

An option is described as in the moneywhen its exercise would produce a positive payoff

for its holder An option is out of the moneywhen exercise would be unprofitable Therefore,

a call option is in the money when the exercise price is below the asset value It is out of the

money when the exercise price exceeds the asset value; no one would exercise the right to

pur-chase for the exercise price an asset worth less than that price Conversely, put options are in

the money when the exercise price exceeds the asset’s value, because delivery of the lower

valued asset in exchange for the exercise price is profitable for the holder Options are at the

moneywhen the exercise price and asset price are equal

Options Trading

Some options trade on over-the-counter (OTC) markets The OTC market offers the advantage

that the terms of the option contract—the exercise price, maturity date, and number of shares

committed—can be tailored to the needs of the traders The costs of establishing an OTC

op-tion contract, however, are relatively high Today, most opop-tion trading occurs on organized

exchanges

Options contracts traded on exchanges are standardized by allowable maturity dates and

exercise prices for each listed option Each stock option contract provides for the right to buy

or sell 100 shares of stock (except when stock splits occur after the contract is listed and the

contract is adjusted for the terms of the split)

Standardization of the terms of listed option contracts means all market participants trade

in a limited and uniform set of securities This increases the depth of trading in any particular

option, which lowers trading costs and results in a more competitive market Exchanges,

therefore, offer two important benefits: ease of trading, which flows from a central

market-place where buyers and sellers or their representatives congregate, and a liquid secondary

mar-ket where buyers and sellers of options can transact quickly and cheaply

put optionThe right to sell an asset at a specified exercise price on or before a specified expiration date.

Profit and Loss from a Put Option on Microsoft

To illustrate, consider an April 2002 maturity put option on Microsoft with an exercise price of

$70 selling on January 4, 2002, for $5.40 It entitles its owner to sell a share of Microsoft for

$70 at any time until April 19 If the holder of the put option bought a share of Microsoft and

immediately exercised the right to sell at $70, net proceeds would be $70  $68.90

$1.10 Obviously, an investor who pays $5.40 for the put has no intention of exercising it

im-mediately If, on the other hand, Microsoft is selling at $62 at expiration, the put will turn out

to be a profitable investment The value of the put on the expiration date would be

Value at expiration
Exercise price  Stock price
$70  $62
$8

and profit would be $8.00  $5.40
$2.60 This is a holding-period return of $2.60/$5.40

481 or 48.1%—over only 105 days! Obviously, put option sellers (who are on the other

side of the transaction) did not consider this outcome very likely.

in the money

An option where exercise would be profitable.

out of the money

An option where exercise would not be

profitable.

at the money

An option where the exercise price and asset price are equal.

Essentials of Investments,

Fifth Edition

Companies, 2003

Figure 14.1 is a reproduction of listed stock option quotations from The Wall Street Journal.

The highlighted options are for shares of Microsoft The numbers in the column below the pany name represent the last recorded price on the New York Stock Exchange for Microsoftstock, $68.90 per share.1The first column shows that options are traded on Microsoft at exer-

com-cise prices of $65 through $75, in $5 increments These values also are called the strike prices.

The exercise or strike prices bracket the stock price While exercise prices generally are set

at five-point intervals for stocks, larger intervals may be set for stocks selling above $100, andintervals of $21⁄2may be used for stocks selling below $30.2If the stock price moves outsidethe range of exercise prices of the existing set of options, new options with appropriate exer-cise prices may be offered Therefore, at any time, both in-the-money and out-of-the-moneyoptions will be listed, as in the Microsoft example

The next column in Figure 14.1 gives the maturity month of each contract, followed by twopairs of columns showing the number of contracts traded on that day and the closing price forthe call and put, respectively

When we compare the prices of call options with the same maturity date but different ercise prices in Figure 14.1, we see that the value of the call is lower when the exercise price

ex-is higher Thex-is makes sense, for the right to purchase a share at a given exercex-ise price ex-is not asvaluable when the purchase price is higher Thus, the April maturity Microsoft call option withstrike price $70 sells for $4.60, while the $65 exercise price April call sells for $7.70 Con-

versely, put options are worth more when the exercise price is higher: You would rather have

the right to sell Microsoft shares for $70 than for $65, and this is reflected in the prices of theputs The April maturity put option with strike price $70 sells for $5.40, while the $65 exer-cise price April put sells for only $3.50

Throughout Figure 14.1, you will see that some options may go an entire day without trading

A lack of trading is denoted by three dots in the volume and price columns Because trading is

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1 Occasionally, this price may not match the closing price listed for the stock on the stock market page This is because some NYSE stocks also trade on the Pacific Stock Exchange, which closes after the NYSE, and the stock pages may reflect the more recent Pacific Exchange closing price The options exchanges, however, close with the NYSE, so the closing NYSE stock price is appropriate for comparison with the closing option price.

Essentials of Investments,

Fifth Edition

Companies, 2003

infrequent, it is not unusual to find option prices that appear out of line with other prices You

might see, for example, two calls with different exercise prices that seem to sell for the same

price This discrepancy arises because the last trades for these options may have occurred at

dif-ferent times during the day At any moment, the call with the lower exercise price must be worth

more, and the put less, than an otherwise-identical call or put with a higher exercise price

Figure 14.1 illustrates that the maturities of most exchange-traded options tend to be fairly

short, ranging up to only several months For larger firms and several stock indexes, however,

longer-term options are traded with maturities ranging up to three years These options are

called LEAPS (for Long-term Equity AnticiPation Securities)

1 a What will be the proceeds and net profits to an investor who purchases the April

maturity Microsoft calls with exercise price $70 if the stock price at maturity is

$60? What if the stock price at maturity is $80?

b Now answer part (a) for an investor who purchases an April maturity Microsoft

put option with exercise price $70

American and European Options

AnAmerican optionallows its holder to exercise the right to purchase (if a call) or sell (if a

put) the underlying asset on or before the expiration date European optionsallow for

exer-cise of the option only on the expiration date American options, because they allow more

lee-way than their European counterparts, generally will be more valuable Most traded options in

the U.S are American-style Foreign currency options and some stock index options are

no-table exceptions to this rule, however

The Option Clearing Corporation

The Option Clearing Corporation (OCC), the clearinghouse for options trading, is jointly

owned by the exchanges on which stock options are traded The OCC places itself between

options traders, becoming the effective buyer of the option from the writer and the effective

writer of the option to the buyer All individuals, therefore, deal only with the OCC, which

effectively guarantees contract performance

When an option holder exercises an option, the OCC arranges for a member firm with

clients who have written that option to make good on the option obligation The member firm

selects from among its clients who have written that option to fulfill the contract The selected

client must deliver 100 shares of stock at a price equal to the exercise price for each call

op-tion contract written or must purchase 100 shares at the exercise price for each put opop-tion

con-tract written

Because the OCC guarantees contract performance, option writers are required to post

mar-gin to guarantee that they can fulfill their contract obligations The marmar-gin required is

deter-mined in part by the amount by which the option is in the money, because that value is an

indicator of the potential obligation of the option writer upon exercise of the option When the

required margin exceeds the posted margin, the writer will receive a margin call The holder

of the option need not post margin because the holder will exercise the option only if it is

prof-itable to do so After purchasing the option, no further money is at risk

Margin requirements also depend on whether the underlying asset is held in portfolio For

example, a call option writer owning the stock against which the option is written can satisfy

the margin requirement simply by allowing a broker to hold that stock in the brokerage

account The stock is then guaranteed to be available for delivery should the call option be

exercised If the underlying security is not owned, however, the margin requirement is

ConceptCHECK

<

American optionCan be exercised on

or before its expiration.

European optionCan be exercised only

at expiration.

op-Other Listed Options

Options on assets other than stocks also are widely traded These include options on marketindexes and industry indexes, on foreign currency, and even on the futures prices of agricul-tural products, gold, silver, fixed-income securities, and stock indexes We will discuss these

in turn

Index options An index option is a call or put based on a stock market index such as theS&P 500 or the New York Stock Exchange index Index options are traded on several broad-based indexes as well as on several industry-specific indexes We discussed many of these in-dexes in Chapter 2

The construction of the indexes can vary across contracts or exchanges For example, theS&P 100 index is a value-weighted average of the 100 stocks in the Standard & Poor’s 100stock group The weights are proportional to the market value of outstanding equity for eachstock The Dow Jones Industrial Average, by contrast, is a price-weighted average of 30 stocks.Options contracts on many foreign stock indexes also trade For example, options on theNikkei Stock Index of Japanese stocks trade on the Chicago Mercantile Exchange and options

on the Japan Index trade on the American Stock Exchange Options on European indexes such

as the Financial Times Share Exchange (FTSE 100) and the Eurotrak index also trade TheChicago Board Options Exchange as well as the American exchange list options on industryindexes such as the high-tech, pharmaceutical, or banking industries

In contrast to stock options, index options do not require that the call writer actually liver the index” upon exercise or that the put writer “purchase the index.” Instead, a cash set-tlement procedure is used The payoff that would accrue upon exercise of the option iscalculated, and the option writer simply pays that amount to the option holder The payoff isequal to the difference between the exercise price of the option and the value of the index Forexample, if the S&P index is at 1,280 when a call option on the index with exercise price1,270 is exercised, the holder of the call receives a cash payment equal to the difference,1,280 1,270, times the contract multiplier of $100, or $1,000 per contract

“de-Figure 14.2 is a reproduction of listings for a few index options from The Wall Street

Jour-nal The option listings are similar to those of stock options However, instead of supplying

separate columns for put and calls, the index options are all listed in one column, and the

letters p or c are used to denote puts or calls The index listings also report the “open interest”

for each contract, which is the number of contracts currently outstanding Options on themajor indices, that is, the S&P 100 contract, often called the OEX after its ticker symbol, theS&P 500 index (the SPX), and the Dow Jones Industrials (the DJX) are by far the mostactively traded contracts on the CBOE Together, these contracts dominate CBOE volume

Futures options Futures options give their holders the right to buy or sell a specified tures contract, using as a futures price the exercise price of the option Although the deliveryprocess is slightly complicated, the terms of futures options contracts are designed in effect toallow the option to be written on the future price itself The option holder receives upon exer-cise net proceeds equal to the difference between the current futures price on the specified assetand the exercise price of the option Thus, if the futures price is, say, $37, and the call has an ex-

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Foreign currency options A currency option offers the right to buy or sell a quantity

of foreign currency for a specified amount of domestic currency Currency option contracts

call for purchase or sale of the currency in exchange for a specified number of U.S dollars

Contracts are quoted in cents or fractions of a cent per unit of foreign currency

There is an important difference between currency options and currency futures options.

The former provide payoffs that depend on the difference between the exercise price and the

exchange rate at maturity The latter are foreign exchange futures options that provide payoffs

that depend on the difference between the exercise price and the exchange rate futures price at

maturity Because exchange rates and exchange rate futures prices generally are not equal, the

options and futures-options contracts will have different values, even with identical expiration

dates and exercise prices Today, trading volume in currency futures options dominates by far

trading in currency options

F I G U R E 14.2

Index options

Note: Prices are for February 26, 2001.

Source: The Wall Street Journal, February 27, 2001 Reprinted by permission of The Wall Street Journal, © 2001 Dow Jones & Company, Inc All Rights

Reserved Worldwide.

Call Options

Recall that a call option gives the right to purchase a security at the exercise price If you hold

a call option on Microsoft stock with an exercise price of $60, and Microsoft is now selling at

$70, you can exercise your option to purchase the stock at $60 and simultaneously sell theshares at the market price of $70, clearing $10 per share Yet if the shares sell below $60, youcan sit on the option and do nothing, realizing no further gain or loss The value of the call op-tion at expiration equals

Payoff to call holder at expiration
S T  X if S T  X

0 if S T  X where S T is the value of the stock at the expiration date, and X is the exercise price This for-

mula emphasizes the option property because the payoff cannot be negative That is, the

op-tion is exercised only if S T exceeds X If S T is less than X, exercise does not occur, and the

option expires with zero value The loss to the option holder in this case equals the price

orig-inally paid More generally, the profit to the option holder is the payoff to the option minus the

original purchase price

The value at expiration of the call on Microsoft with exercise price $60 is given by the lowing schedule

For Microsoft prices at or below $60, the option expires worthless Above $60, the option

is worth the excess of Microsoft’s price over $60 The option’s value increases by one dollarfor each dollar increase in the Microsoft stock price This relationship can be depicted graph-ically, as in Figure 14.3

S T

Cost of option ProfitPayoff = Value at expiration

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The solid line in Figure 14.3 depicts the value of the call at expiration The net profit to the

holder of the call equals the gross payoff less the initial investment in the call Suppose the call

cost $14 Then the profit to the call holder would be as given in the dashed (bottom) line of

Figure 14.3 At option expiration, the investor has suffered a loss of $14 if the stock price is

less than or equal to $60

Profits do not become positive unless the stock price at expiration exceeds $74 The

break-even point is $74, because at that price the payoff to the call, S T  X
$74  $60
$14,

equals the cost paid to acquire the call Hence, the call holder shows a profit only if the stock

price is higher

Conversely, the writer of the call incurs losses if the stock price is high In that scenario, the

writer will receive a call and will be obligated to deliver a stock worth S T for only X dollars.

Payoff to call writer
(S T  X) if S T  X

0 if S T  X

The call writer, who is exposed to losses if Microsoft increases in price, is willing to bear this

risk in return for the option premium

Figure 14.4 depicts the payoff and profit diagrams for the call writer These are the mirror

images of the corresponding diagrams for call holders The break-even point for the option

writer also is $74 The (negative) payoff at that point just offsets the premium originally

re-ceived when the option was written

Put Options

A put option conveys the right to sell an asset at the exercise price In this case, the holder will

not exercise the option unless the asset sells for less than the exercise price For example, if

Microsoft shares were to fall to $60, a put option with exercise price $70 could be exercised

to give a $10 payoff to its holder The holder would purchase a share of Microsoft for $60 and

simultaneously deliver it to the put option writer for the exercise price of $70

The value of a put option at expiration is

Payoff to put holder
0 if S T  X

X  S T if S T  X

The solid line in Figure 14.5 illustrates the payoff at maturity to the holder of a put option

on Microsoft stock with an exercise price of $60 If the stock price at option maturity is above

F I G U R E 14.4Payoff and profit to call writers at expiration

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$60, the put has no value, as the right to sell the shares at $60 would not be exercised Below

a price of $60, the put value at expiration increases by $1 for each dollar the stock price falls.The dashed line in Figure 14.5 is a graph of the put option owner’s profit at expiration, net ofthe initial cost of the put

Writing puts naked (i.e., writing a put without an offsetting short position in the stock for

hedging purposes) exposes the writer to losses if the market falls Writing naked money puts was once considered an attractive way to generate income, as it was believed that

out-of-the-as long out-of-the-as the market did not fall sharply before the option expiration, the option premiumcould be collected without the put holder ever exercising the option against the writer Be-cause only sharp drops in the market could result in losses to the writer of the put, the strategywas not viewed as overly risky However, the nearby box notes that in the wake of the marketcrash of October 1987, such put writers suffered huge losses Participants now perceive muchgreater risk to this strategy

2 Consider these four option strategies: (i) buy a call; (ii) write a call; (iii) buy a put; (iv) write a put.

a For each strategy, plot both the payoff and profit diagrams as a function of the

final stock price

b Why might one characterize both buying calls and writing puts as “bullish”

strategies? What is the difference between them?

c Why might one characterize both buying puts and writing calls as “bearish”

strategies? What is the difference between them?

Options versus Stock Investments

Purchasing call options is a bullish strategy; that is, the calls provide profits when stock pricesincrease Purchasing puts, in contrast, is a bearish strategy Symmetrically, writing calls isbearish, while writing puts is bullish Because option values depend on the price of the under-lying stock, the purchase of options may be viewed as a substitute for direct purchase or sale

of a stock Why might an option strategy be preferable to direct stock transactions? We canbegin to answer this question by comparing the values of option versus stock positions inMicrosoft

Suppose you believe Microsoft stock will increase in value from its current level, which we

Price of put

S T

Concept

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could fall in price Suppose a six-month maturity call option with exercise price of $70 sells

for $10, and the semiannual interest rate is 2% Consider the following three strategies for

in-vesting a sum of $7,000 Remember that Microsoft does not pay any dividends

Strategy A: Purchase 100 shares of Microsoft

Strategy B: Purchase 700 call options on Microsoft with exercise price $70 (This would

require 7 contracts, each for 100 shares.)

Strategy C: Purchase 100 call options for $1,000 Invest the remaining $6,000 in

six-month T-bills, to earn 2% interest

Let us trace the possible values of these three portfolios when the options expire in six

months as a function of Microsoft stock price at that time

501

The Black Hole: Puts and the Market Crash

THEIR SALES OF “NAKED PUTS” QUICKLY

COME TO GRIEF, DAMAGE SUITS ARE

FILED

When Robert O’Connor got involved in stock-index

op-tions, he hoped his trading profits would help put his

children through college His broker, Mr O’Connor

ex-plains, “said we would make about $1,000 a month,

and if our losses got to $2,000 to $3,000, he would

close out the account.”

Instead, Mr O’Connor, the 46-year-old owner of a

small medical X-ray printing concern in Grand Rapids,

Michigan, got caught in one of the worst investor

blowouts in history In a few minutes on October

19, he lost everything in his account plus an

addi-tional $91,000—a total loss of 175% of his original

investment.

SCENE OF DISASTER

For Mr O’Connor and hundreds of other investors, a

little-known corner of the Chicago Board Options

Ex-change was the “black hole” of Black Monday’s market

crash In a strategy marketed by brokers nationwide as

a sure thing, these customers had sunk hundreds of

millions of dollars into “naked puts”—unhedged, highly

leveraged bets that the stock market was in no danger

of plunging Most of these naked puts seem to have

been options on the Standard & Poor’s 100 stock index,

which are traded on the CBOE When stocks crashed,

many traders with unhedged positions got margin calls

for several times their original investment.

THE ‘PUT’ STRATEGY

The losses were especially sharp in “naked,

out-of-the-money puts.” A seller of puts agrees to buy stock or

stock-index contracts at a set price before the put

expires These contracts are usually sold “out of the money”—priced at a level below current market prices that makes it unprofitable to exercise the option so long

as the market rises or stays flat The seller pockets a small amount per contract.

But if the market plunges, as it did October 19, the option swings into the money The seller, in effect, has

to pay pre-plunge stock prices to make good on his contract—and he takes a big loss.

“You have to recognize that there is unlimited tential for disaster” in selling naked options, says Peter Thayer, executive vice president of Gateway Investment Advisors Inc., a Cincinnati-based investment firm that trades options to hedge its stock portfolios Last Sep- tember, Gateway bought out-of-the-money put options

po-on the S&P 100 stock index po-on the CBOE at $2 to $3 a contract as “insurance” against a plunging market By October 20, the day after the crash, the value of those contracts had soared to $130 Although Gateway prof- ited handsomely, the parties on the other side of the trade were clobbered.

FIRM SUED

Brokers who were pushing naked options assumed that the stock market wouldn’t plunge into uncharted terri- tory Frank VanderHoff, one of the two main brokers who put 50 to 70 H.B Shaine clients into stock-index options, says he told clients that the strategy’s risk was

“moderate barring a nuclear attack or a crash like 1929.” It wasn’t speculative The market could go up

or down, but not substantially up or down If the crash

had only been as bad as ’29, he adds, “we would have made it.”

SOURCE: Abridged from The Wall Street Journal, December 2, 1987 Reprinted by permission of The Wall Street Journal, © 1987 Dow

Jones & Company, Inc All Rights Reserved Worldwide.

Portfolio A will be worth 100 times the share value of Microsoft Portfolio B is worthless

unless Microsoft sells for more than the exercise price of the call Once that point is reached,the portfolio is worth 700 times the excess of the stock price over the exercise price Finally,

portfolio C is worth $6,120 from the investment in T-bills ($6,000  1.02
$6,120) plus anyprofits from the 100 call options Remember that each of these portfolios involves the same

$7,000 initial investment The rates of return on these three portfolios are as follows:

These rates of return are graphed in Figure 14.6

Comparing the returns of portfolios B and C to those of the simple investment in Microsoft stock represented by portfolio A, we see that options offer two interesting features First, an option offers leverage Compare the returns of portfolios B and A When Microsoft stock fares poorly, ending anywhere below $70, the value of portfolio B falls precipitously to zero—a rate

of return of negative 100% Conversely, modest increases in the rate of return on the stock sult in disproportionate increases in the option rate of return For example, a 5.9% increase inthe stock price from $85 to $90 would increase the rate of return on the call from 50% to

F I G U R E 14.6

Rate of return to three

strategies

100 80 60 40 20 0

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503

> Options, Stock, and Lending

An Excel model based on the Microsoft example discussed in the text is shown below The model allows you to use any variety of options, stock, and lending or borrowing with a set investment amount and demonstrates the investment flexibility of options.

You can learn more about this spreadsheet model by using the interactive version available on our website at www.mhhe.com/bkm.

100% In this sense, calls are a levered investment on the stock Their values respond more

than proportionately to changes in the stock value

Figure 14.6 vividly illustrates this point For stock prices above $70, the slope of the

all-option portfolio is far steeper than that of the all-stock portfolio, reflecting its greater

propor-tional sensitivity to the value of the underlying security The leverage factor is the reason that

investors (illegally) exploiting inside information commonly choose options as their

invest-ment vehicle

The potential insurance value of options is the second interesting feature, as portfolio C

shows The T-bill plus option portfolio cannot be worth less than $6,120 after six months, as

the option can always be left to expire worthless The worst possible rate of return on

portfo-lio C is12.6%, compared to a (theoretically) worst possible rate of return of Microsoft stock

of100% if the company were to go bankrupt Of course, this insurance comes at a price:

1 3 5 7 9 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60

A B C D E F G H I J K

Chapter 14 Microsoft Example Comparison of Options, Equity and Combined Bills and Options Basic Data for Spreadsheet

Current Stock Price $70 Options Price $10 Exercise Price $70 Ending Stock Price

T-Bill Rate Annual 2%

Ending Stock Price $80 Ending Value Per Option $10 Option 65 70 75 80 85 90 Investment Amount $7,000 Total Ending Value $7,000 0 0 3500 7000 10500 14000

Options Only Strategy

Options Purchased 700 Ending Value per Option $10 Stock 65 70 75 80 85 90 Total Ending Value $7,000 Total Ending Value $8,000 6500 7000 7500 8000 8500 9000 Total Profit $0

Return on Investment 0.00%

Stock Only Strategy Bills & Option 65 70 75 80 85 90 Shares Purchased 100 Total Ending Value $7,120 6120 6120 6620 7120 7620 8120 Total Ending Value $8,000

Total Profit $1,000 Return on Investment 14.29%

Addit Combinations 65 70 75 80 85 90

Bills and Options Strategy Total Ending Value $7,424 3,824 4,024 5,724 7,424 9,124 10,824 Number of Options Purchased 100

Investment in Options $1,000 Investment in Bills $6,000 Ending Value of the Options $1,000 Option 65 70 75 80 85 90 Ending Value on the Bills $6,120 Return 0.00% -100.00% -100.00% -50.00% 0.00% 50.00% 100.00%

Total Ending Value $7,120 Total Profit $120 Return on Investment 1.71%

Stock 65 70 75 80 85 90

Additional Combinations: Return 14.29% -7.14% 0.00% 7.14% 14.29% 21.43% 28.57%

Bills, Options and Stock

Total Investment Amount $7,000 Options Purchased 300 Options Investment $3,000 Bill & Option 65 70 75 80 85 90 Stock Purchased 40 Return 1.71% -12.57% -12.57% -5.43% 1.71% 8.86% 16.00%

Stock Investment $2,800 Bill Investment $1,200 Ending Value of the Options $3,000 Ending Value of the Stock $3,200 Addit Combinations 65 70 75 80 85 90 Ending Value of the Bills 1224 Return 6.06% -45.37% -42.51% -18.23% 6.06% 30.34% 54.63%

Total Ending Value $7,424 Total Profit $424 Return on Investment 6.06%

Average Returns for Sample Returns

This simple example makes an important point While options can be used by speculators

as effectively leveraged stock positions, as in portfolio B, they also can be used by investors who desire to tailor their risk exposures in creative ways, as in portfolio C For example, the call plus T-bills strategy of portfolio C provides a rate of return profile quite unlike that of the

stock alone The absolute limitation on downside risk is a novel and attractive feature of thisstrategy In the next section we will discuss several option strategies that provide other novelrisk profiles that might be attractive to hedgers and other investors

Option Strategies

An unlimited variety of payoff patterns can be achieved by combining puts and calls with ious exercise prices Below we explain the motivation and structure of some of the more pop-ular ones

var-Protective put Imagine you would like to invest in a stock, but you are unwilling to bearpotential losses beyond some given level Investing in the stock alone seems risky to you be-cause in principle you could lose all the money you invest You might consider instead in-vesting in stock and purchasing a put option on the stock

Table 14.1 shows the total value of your portfolio at option expiration Whatever happens

to the stock price, you are guaranteed a payoff equal to the put option’s exercise price becausethe put gives you the right to sell the share for the exercise price even if the stock price is be-low that value

Figure 14.7 illustrates the payoff and profit to this protective putstrategy The solid line inFigure 14.7C is the total payoff The dashed line is displaced downward by the cost of estab-

lishing the position, S0  P Notice that potential losses are limited.

It is instructive to compare the profit on the protective put strategy with that of the stock

in-vestment For simplicity, consider an at-the-money protective put, so that X
S0 Figure 14.8

compares the profits for the two strategies The profit on the stock is zero if the stock price

re-mains unchanged, and S T
S0 It rises or falls by $1 for every dollar swing in the ultimate stock price The profit on the protective put is negative and equal to the cost of the put if S Tis

below S0 The profit on the protective put increases one for one with increases in the stock price once the stock price exceeds X.

14.3 EXAMPLE

Protective Put

Suppose the strike price is X
$55 and the stock is selling for $52 at option expiration Then

the value of your total portfolio is $55: The stock is worth $52 and the value of the expiring put option is

X  S T
$55  $52
$3

Another way to look at it is that you are holding the stock and a put contract giving you the

right to sell the stock for $55 If S  $55, you can still sell the stock for $55 by exercising the

put On the other hand, if the stock price is above $55, say $59, then the right to sell a share

at $55 is worthless You allow the put to expire unexercised, ending up with a share of stock

proceeds equal to the

put’s exercise price.