Case 34: Microsoft

Chris Jubran is an avid follower of technology stocks. He currently owns 500 shares of Microsoft's common stock. Today the price of each share is $89. Tomorrow, Microsoft will announce whether a much anticipated business deal with long-distance phone service giant, AT&T, will go through. If the deal is made, the stock price of both firms should increase substantially. While most of the investment community believes the agreement will occur, Chris feels otherwise.

Chris is very concerned that the value of his holdings, $44,500($89 x 500 shares), will greatly decrease if the Microsoft/AT&T deal does not pan out. One way out of this predicament is to sell off his Microsoft holdings, wait for the announcement and the corresponding decrease in the stock price, then repurchase the shares at a lower rate. Although this would not result in a profit, Chris would avoid the loss associated with holding the shares.

After calling his discount broker at Charles Schwab to determine the transaction costs associated with selling off the 500 shares, Chris found that the round trip transaction costs would be far too expensive. Instead, his broker recommended the use of put options.

The following information is a reprint from a recent edition of the Wall Street Journal on December 15:

Table 1

Questions

1. How can Chris use put options to hedge himself against the possibility that Microsoft and AT&T will not come to an agreement? Be sure to indicate which specific contract should be used.

2. If Chris buys 5 put contracts (i.e. on 500 underlying shares) with an exercise price of $90 and an expiration in December for $1.50 per option, how will his overall wealth position change if the stock price jumps up to $93 after the announcement? What if the stock price falls to $85? For simplicity, ignore transaction costs and margin requirements.

3. Microsoft's options trade on a January, April, July, October cycle. Why then do we see that options are offered with a maturity month in December as well?

4. Consider the four call options with a strike price of $90. What appears to be the relationship between time to maturity and volume? What appears to be the relationship between the price of the call and the time to maturity? Do these relationships hold for the corresponding put options as well? Explain why or why not.

5. Most trading volume in calls occurs in contracts where the exercise price is above the current stock price. Why does this make sense?

6. In a call option, when the strike price is far below the current stock price, the call option price tends to be extremely high (in of the money) and when the strike price is far above the current stock price, the call option price tends to be extremely low (out of the money). Why does this relationship make perfect sense?