12 Personal Investn (Ents and Hedging

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CHAPTER 12

PERSONAL INVESTN{ENTS AND HEDGING

12.1 Introduction
Irrdi'iduels and businesses have many investment opportunitic,s
in which
thel' carn pLrt available investment capiial to u,ork. Bank
savings accc)unts,
money rnarkei accounts, certificates if deposit and purchase
of a home to
li'e in are the most common investments ior the average individual. How-
ever, businesses and many individuals that have
cash to invest above their
sa'ings account and home purchase requirements generally
want to achieve
a rate of retum on invested capitar greater than
can be achieved on govern-
ment guilranteed bank account tvpe investments. There
is a seemingly
u,endin-q list of possible indir.idual or business invesiments
wittr varying
degrees of risk. Some of these investments might
include common stock,
options on common stock. bonds, debentures, mortgage
loans, commodity
futures, options on commodity futures, real estate
1sI"I as apartment build-
ings, office buildings, rental properties, farm and ranch
or undeveloped
land), manufacturing and production projects including
oil and gas and min_
ing development to name a few commo, iru"rt-.nts.
There are very signif-
icant diff-erences in the risk associated with the previous
mentioned invest_
rnents. All invesnnents ir.olve risk but sorne involve
much lzigher levels of
risk than others. Trading options on common stock, foreign
currency or
options on futures are examples of investments involving
higher levels of
risk. You may double or triple your investment capital quict<ty
rn option and
lutures i,vesrrnenrs but it is equalry likely that yo, *uy
rose all of your
investment capital. Seldom is there a free iunch. ir you g"t
trr" opportunity
to make money fast in investments such as options und
fr*tur"r, you also run
the risk of losing money fast in these investments. once
a majority of peo-
ple understand the risks associated with options and
futures"investments,
590 Economic Evaluation and lnvestment Decision Methods

they usually conclude that these are not appropriate investments


for their
situation. However, options and futures inrestments are
very legitimate and
important for business and individuar investment hedging purpor"r.
As an
example, a commodity producer can fix the price to
u" iet"ired for com_
modity product expected to be produced over rhe next year
by appropriate
sale of commodity futures or acquisition of put options
on futures. A refiner
or breakfast cereal company can pin down raw material prices
for crude oil
or grain over the next year by appropriate purchase of crude
oil or grain
futures or call options on futures. Thi use of options and
futures for busi_
ness hedging purposes involves very important every
day transactions in
many companies today. Therefore, it is very important for
company man-
agers and potential managers to be familiar with option
and futures contract
trading to understand how their companies use these investments
to mitigate
financial and economic risk in difierent company investment
situations.
Individuals can in some cases use the same option and
futures investment
strategies to hedge investment risk. put ana cill options
and futures con_
tracts are described in detail in the sections lz.3 and lz.4
of this chapter.
Discussion of various hedging strategies using options
and futures is also
presented along with discussion of upside and downside
potential associ-
ated with different hedging strategies.
Blvins on margin is an alternative to options and futures that increases
-
the risk associated with achieving the economic objective
of any invest_
tnent. "Margin" is the equity capitar that, vvhen combined
with borrowed
t,toney, will cover invesrment cost. A 40.\vo margin
means the investor puts
up 40.jvo equity combined with 60.07o debt to cover an investment
cost.
Investments with less than lo0.ovo margin involve financial
leverage. It was
demonstrated in Example 1r-rc that ieveraged investments
always have
greater sensitivity than cash equity investments to
a given change in any
evaluation parameter such as cost or revenue. Leveraged
investments com-
pared to cash investments are somewhat analogous
to options and futures
contracts on assets compa_red to direct purchase of the
assets. Leveraged
investments make money faster for inveitors than cash
equity investments
when things go right, but leveraged investments rose
money faster for
,;tt'.tl"T than cash.equity investments when things go bad. Once again,
sel_
clom rs there a free lunch.
Each investor must recognize that all investments involve
some risk. Even
government guaranteed bank savings and money
market account invest_
ments involve the risk that the government could go
bankrupt and be unable
[o cover losses from a bank failure. we all have to recognize
the risks inher_
591
Cnapter 12: Personal lnvestments and Heciging

,:nt in diflerent investments and t0 select investmeilts that are consistent


,+ith the ievel of risk that still enables us to sleep r'vell. Sonre investors do
not slee.p well with any amount of debt while others feel they should be
leveraged to the greatest extent possible as a hedge against inflation. How-
e.;i:r, for alI investors. regardiess of their risk aversi':n tentlencies, it is very
itrtportcrttt to tmderslctttd the worst that can happen from a given investnrcnt'
|-irett, orrll, invest an amot*tt of money that would not affect )'our standard
of lit,ing or investment strategy iJ'the worst case scenario occurs. In other
words, keep your money in the bank rather than investing in common stock
or real estate or other business ventures if you feel you can not afford a sig-
nificant loss of investment capital. No matter how confident you are about
an investment , remember there generally is a significant downside risk that
vou must discipline yourself to consider.
Di,-ersification of investments can be very important in the management
tf risk. Instead of investing in the common stock of just one company,
soread your common Stock inyestments over at least four or five companies
aisuming the sum of money to be invested is sufficient to make that sensible
and feasible when commissions are considered. With a diversified common
stock portfolio, bad news that depresses the price of stock for one company
or industry may be offset by good news that accelerates the price rise in
another stock. The same principles apply to bond investments. No matter
how gooci and secure a comtnon stOck or bond investment ma!' seem. do ntlt
overload your porttolio with auy one type of investment. The washington
State Power System default in the 1970's on their nuclear power plant
municipal bonds is a classic example of total failure of an investment that
seemed very safe and secure a few years earlier. Portfolio diversification
within common stock, bond or other investment areas can be a very effec-
tive hedge against risk of failure. Once your investment capital is suffi-
ciently large, you should consider having a combination of common stock,
bonds, real estate and other investments of interest. tn the 1980's and 1990's
common stock and boncl investments did very well while real estate invest-
ments in many parts of the country had mixed performance. In the 1970's
real estate investments in general did very well in most regions, while stock
and bond investments fared poorly. Diversification of your investments over
several investment areas gives you a hedge (not a guarantee) against failure
of all of your investments at the same time. Every investor must determine
the mix of investments that is appropriate for his or her financial needs.
Common stock and bond mutual funds give investors a means of investing
in very diversified stock and bond portfolios. For individuals to achieve

J
592 Economic Evaluation and lnvestment Decision Methods

mutual fund type diversification on individual stock and bond investments


requires a larger amount of capital than most people have to invest. However,
keep in mind that four or five good individual stock or bond investments
may
give you adequate dir,'ersifrcation and give you equivalent or better perfpi-
mance than many mutual funds. If you decide to go the mutual fund invest-
ment route, analysis of the many common stock and bond mutual funds
requires careful analysis of past performance and the potential for good future
performance. This is exactly what needs to be done to select individual com-
mon stock investments. Also, with mutual funds you need t<l be careful to
consider initial investment fixed fee charges which are referred to as ,,load,.
Loads can vary from Lvo to 9vo of initial investment in load funds and arc
Tvo
in "no-load' funds. In addition, annual management fees are charged that typ-
ically range from llZvo to lvo of your fund asset value each y"*. Alro, ,rr"
funds have liquidation penalty fees that may be several percent of fund value.
Sometimes the magnitude of these liquidation fees is a iunction of the length
of time your money has been invested in the fund. you will also have a stock
broker commission to pay if you acquire mutual fund shares through a broker.
In general, you need to have a long term investment horizon for mutual fund
investments to make sense but that is true for individual stock and bond
investments as well. You must do your homework carefully in selecting
a
mutual fund if you decicie that mutual fund management fees are less than the
potential benefits relative to making your own stock and bond investments.
Many people adopt the attitude that they either do not know much about
or are not interested in managing their own personal investments. Therefore,
they conclude they will stick to mutual fund investments or let a profes-
sional money manager handle their investments. This is not an unreasonable
approach for some people, but how do you select a competent m,ney man-
ager or a good mutual fund without having considerable general investment
analysis knowledge? People spend years in high school and college and
continuing education classes learning to make money, but often they do not
spend days or hours learning how to manage their hard earned cash. when
compounded over many years, what seems like a very small difference in
investment annual rate of return or "yield" can become very significant. For
example, $10,000 invested in a manner that causes it to grow at l2vo com-
pounded annually grows to about $300,000 in 30 years, while the
same
$ 10,000 invested so that it grows at l5To per year grows to about
$660,000
in 30 years. This is a very significant difference in f-uture value benefits for
you, your family or heirs. If you make investment decisions at an early
-eood
age, the time value of money is working for you for many years through
the
Chapler 12: Personal lnvestments and Hedging 593

effect of compound interest. This maxirnizes the likelihood that you will
accumulate a personal net worth that will enabie you to cover special finan-
cial re.quirements such as sending children to college, meeting major illness
costs. taking special vacations, retiring early or retiring at the normal time
r.'n i c-Ood incr')me.
As the years so by a person's investment ob-iectives often change frorn
capiral accumulation to annual income generation. When a person's age is
irr the 20's or 30's, capital accumulation for the purposes previously men-
tioned usirally is the primary investment objective. People in their 40's and
50's frequently have mixed capital accumulation and income generation as
investment objectives. For the average person over 60, income generation
for retirement living purposes tends to become a much higher priority con-
sideration. understanding what your investment objectives are and how dif-
ferent kinds of investments may best enable you to achieve your objectives
is a very important key to potential financial security. The following sec-
tions of this chapter present more detail about the mechanics and risks asso-
ciated with common stock, options, futures, options on futures, bonds and
certificate of deposit investments. The first eleven chapters of the text have
addressed the mechanics of calculating and applying the discounted cash
flow criteria for proper analysis and comparison of alternative general busi-
ruess investments in any industry. The last section of this chapter will illus-
trate comparison of the economic potential of general stock and bond
investments and tax deferred investments.

12.2 Common Stock Investments


The key to all successful investments is buying "low" and selling "high".
To achieve that objective in common stock investments over the long term
requires investing in companies with consistently increasing common stock
prices. Since common stock price changes typically reflect changes in net
income and cash flow earnings per share of common stock, long term suc-
cess irr conlmon stock investing is directl.v related to finding and investing in
companies with consistent annual increases in net income and cash flow
earnings per share of common srocft. Without regard to economic projec-
tions, stock market forecasts, interest rate predictions, balance of payments
results or inflation estimates, if you systematically invest in companies with
net income and cash flow growth, you have a very high probability of long
term common stock investment success. Following are six rules considered
appropriate for successful common stock investing in 2000 and beyond.
594 Economic Evaluation and lnvestment Decision Methods

Rule I . Decide whether you should invest in common stocks at all due
to
inherent common stock ownership risks. volatility in stock priies requires
that you be prepared financially and mentally to ride out mariet declines.
It
may be several years before increasing earnings and cash flow in the com-
panies in which you invest are reflected in higher stock prices. If your
plans
include a need to pull your money out of the market to Luy a house or send
a child to college, you are not ready for common stock investments.

Rule 2. Invest with a long-term prospective. No one has a crystal ball to


consistently predict future stock market moves. over the short term (less
than a year), the stock market as a whole, and the individual stocks that
make up the market, may go up or down in price or remain unchanged.
However, over the long run of many years, increasing company
have historically always lead to higher stock prices evenlually. "urnirg,
Rule 3. Do your homework to find companies with rong term net income
and cash flow earnings growth prospects. utilize brokerage house informa-
tion, cbmpany annual and quarterly reports, Standard and Foer's reports
and
five year earnings data, stock investment service reports and data, and any
other source of information to find companies with at least five years of
consistent past net income and cash flow earnings growth that exceeds 10
to
12 percent per year. Then use your judgement to select the companies
that
have the greatest potential to continue their earnings growth in the
future.
Rule 4. Do not worry about forecasts
for the general economy, stock mar-
ket or interest rates. over the past thirty years the common stocks of com-
panies with consistently good earnings grorvth have had consistent
increases
in stock price during both good and bad economic times. of course, every-
one wants to buy at the bottom of a stock price decline and to sell at the
top.
There is no question that over the short term, business cycles, interest rate
changes and other factors may affect stock prices. However, in practice no
one has the clairvoyant vision to predict when stock market tops and bot-
toms will occur. Systematic investing in the common stock of companies
with projected future earnings that are expected to consistently increase is
the best key to successful common stock investing.

Rule 5. Diversify your int'estruents over no


fewer than four and no more
than twenty common stocks or invest in a growth stock mutuat
fund. An
unexpected negative earnings report by a company can cause a fast decline
in the price of most any company stock. Diversifying your investments over
several companies reduces the downside impact of negative performance
by
Chapter 12: Personal lnvestments and Hedging 59s

Dne stock" There is a price to be paid for this reduction


of risk bv diversifi-
cation. 'fhe upside impact on your common stock portfblio is reduced from
a better than expected pertormance by one stock. [n other words. with diver-
sification, you accept reduction in maximum profit potential to reduce the
ilar imum expected loss.
Rule 6. Continue to ruonitor rour common stock investments after ypy l21ay.
Ivlonitor vour investments on a regular basis lor the increasing net income
and cash tlow earnings performance that have been the basis of your invest-
ment. If earnings prospects turn negative for the long term, sell, even if the
stock has declined in price. It probably wilt go even lower in price if earn-
ings turn sour. The wall Street axiom "take your losses and let your win-
nings ride" is based on this logic.

Sixteen blue chip companies that have had eamings per share of common
stock and stock price plus dividend growth rates between l2vo and 307o com-
pounded annually over the past 10 or more years in alphabetical order are:

1. America On-Line 9. Lucent Technologies


2. American International Group 10. Merck
3. Amgen 1 1. Microsoft Corporation
-X. Ciscc Sysiems Inc. 12. Paychex
,5. Detrl Computer i3. Pfizer
6. General Electric 14. Schwab (Charles)
7. Intel 15. Sun Microsystems
8. Johnson & Johnson 16. Wal-Mart
Past performance is certainly no guarantee of similar future performance,
but fifteen to thirty years of consistently increasing earnings in the 12vo to
307a per year range is a very strong indicator of excellent management
which is the key to future performance. This makes these companies worth
considering as potential future high earnings growth rate companies. There
are many other companies with equal or greater growth potential, but these
listed companies are considered to be indicative of the term ,,blue chip
growth stocks". There is no need to invest in small, new, highly speculative
companies to obtain good earnings growth rate potential. In fact, it is better
to stay away from new issue stocks priced under a dollar. Invest onllt in
companies that have a proven growth in net income and cash
flow earnings
per share of common stock exceeding t2vo per year for at least
five years,
with eqttal or better potential for the future. There are too many companies
with earnings potential this good or better to settle for less.
596 Economic Evaluation and lnvestment Decision Methods

At different times all stocks rend to be priced either low (,,over-sold',),


average or high ("over:bought") in comparison with what one
might.con=
sider an historical normal price. "price-iarnings Ratio,, is a common
mea_
sure of whether stock price is high, Iow or normal. It represents
the price of
one share of common stock divided by the net income earnings
per share
for a twelve month period. If a given stock over the last thirty years has
traded in a range of price-earnings ratios from ten to twenty
with an average
of fifteen, you might conclude that the stock currentty is rairty valued
or
undervalued if the current price-earnings ratio is fifteen or less.
A price-
earnings ratio greater than fifteen may indicate that the stock
is overvalued.
Price-earnings ratio is just one measure of relative stock value
and must
always be considered in conjunction with future earnings growth potential.
A higher price-earnings ratio may be justified for u .to.f wltrr nign
earnings
growth rate potential. An excellent source of net income
earnings,_ stock
price, and dividends paid annually over the past thirty-five years
(or twelve
years or twenty-two months in different books) is SRC
Five Trend Security
charts by securities Research company listed in the references.
cash flow earnings information must be obtained from company annual
reports and various brokerage company research and analysis
reports. To
find or calculate cash flow information on companies generalry requires
more work than is required to obtain net income information. with
large
blue chip growth companies, cash flow growth and net income growth
are
usually similar. It is in looking for undervalued stock situations
or in ana-
lyzing new smaller companies that there are sometimes differences
in finan-
cial report net income and cash flow earnings. For exampre, a small
or large
company with large sunk costs from marginal investment. ,nuny
years ago
may be doing very well economically now with rapidly growing
annual rev-
enue cash t-low. However, current net income financial
may be
depressed by financial depreciation still being taken on "u.ring,
sunk costs. Remem-
ber that "sunk costs" are costs that have been incurred in the past
and can-
not be affected by anything done now or in the future. If cash
flow growth
in recent years has been better than net income growth an undervalued
stock
price situation may exist, while cash flow growth lagging
net income
growth may be indicative of an overvalued siock price.*tn-general,
it is
desirable to check net income trends against revenue cash
flow (net income
plus non-cash depreciation, depletion, amorti zation, deferred
tax deduc_
tions) for several recent years for any major trend differences.
. when you buy common stock shares in order to profit from an expected
increase in stock price, you are said tobe "long" inihe common
stock. The
Chapter 12: Personal lnvestments and Hedging 597

i.rn ''long" signifies stocl.: ownership. A "bLll markel" is an advancing


market and investors who are long in common stock investments generally
nrake rnonel, in bull markets. On the other hand, a. "bear market" is a declin-
ing market and investors who are "short" in common stock investments gen-
elall.y make ntoney in bear markets. An investor who is "short" in the
conrmon stock of a company has made a short sale in the company's stock.
A "slrort srrle" involves selling stock that you do not own with the expecta-
tion of being able to buy it back later at a lower price. A short sale is made
by having a broker borrow shares from someone else so delivery of stock can
be made to the buyer of the stock from the short sale. Remember that a profit
is always made by buying low and selling high. The normal order of "buying
first and selling second" is switched when a short sale is made. If it is antici-
pated that the price of a stock will decline, making a short sale involves sell-
ing iirst at what -vou think is a high price with the expectation that you will
''cover your short sale" (buv back the contmon stock security previously
sold short) at a lower price. The Wall Street axiom "he who sells what isn't
his'n. buys it back or goes to prison" is based on the fact that every short sale
must eventually be covered. Loss potential is unlimited from short sale trans-
actions if stock price goes up instead of down. "Shofi position" is the amount
of stock that investors are short and not covered on a given date. Following is
an iilustration of profit or loss resulting from a "round lot" (100 shares of
comrnon stock) long and short sale transaction
Going back to the I9th century, stock prices in the U.S. have been quoted
on a fractional basis with pricing expressed in 8ths, l6ths,32nds and 64ths.
However, the Securities and Exchange Commission (SEC) has ordered the
stock exchanges and the National Association of Securities Dealers (NASD)
to submit a plan of gradually converting stock prices to a decimal system.
This conversion system is known as decimalization, and is expected to be
fully irnplemented by April of 2001.

EXAMPLE 12-1 "Long" and "Short Sale" Transaction Profit


or Loss

Consider the economic consequences of 1) buying (going long)


and 2) selling short (going short) one round lot (100 shares) otXYZ
Corporation common stock at $50 per share if A) the stock price
goes up to $60 per share or B) the stock price goes down to $40 per
share when you close out your investment position by either selling
or covering your short position.

4
598 Economic Evaluation and lnvestment Decision Methods

Solution:
1A) Buying at $50 per share and selling at $60 per share results in
a $i0 per share profit multiplied by 100 shares equalling a
$1000 profit.
2A) Selling short at $50 per share and covering the short at 960
per share results in a $10 per share loss multiplied by 100
shares equalling a $1000 loss.
1B) Buying at $50 per share and selling at $40 per share results in
a $10 per share loss multiplied by 100 shares equalling a
$1000 loss.
28) Selling short at $50 per share and covering the short at 940
per share results in a $10 per share profit multiplied by 100
shares equalling a $1000 profit.
Short sales may be made for speculative reasons in an attempt to profit
from an expected future decline in stock price or a short sale may be macle
for hedging purposes on stock that you already own to lock in a profit.
Assume you own shares of a stock that has advanced significantly in price.
Further assume that you feel the stock price has peaked, but to avoid having
the sale profit on this year's tax return you do not want to sell now. "selling
crgttirtst tlte box" involves making a short sale on stock that you own to lock
in the profit. If the stock price drops money is made on the short sale but an
equirl sum is lost on the stock you own. If the stock price goes up, you profit
on the stock you own but lose an equal sum on the short sale. The "selling
against the box" technique gives a hedging method of locking in profit on
stock or other assets which you own and in which short sale transactions
can be made. As a result of the Tax Revenue Act of 1997, "selling against
the box" to defer tax on the sale of a security was made illegal.
Short sctle transactiorts in comnton stock can only be made on up-ticks.
"Up-tick" is a term used to designate a transaction made at a price higher
than the previous transaction. Conversely, "dox,n-tick" is a term used to desig-
nate a transaction made at a price lower than the preceding trade. " Et'en tic.k"
is a term used to designate a transaction made at a price equal to the preced-
ing trade. The reason for restricting short sale transactions to up-tick trades is
to prevent short sellers from depressing stock prices in a down market. This
happened in the 1929 stock market crash. It was after the 1929 crash that the
Securities and Exchange Commission (SEC), which administers U.S. securi-
ties laws, established that short sales could only be made on up-ticks.
Cnapier 12: Personal lnvestments and Hecjging s99

Ccr;rmissions must be paici ttrr the purchase and sale and short saie of
corrlnlon stock, mutual funds and oprions. Foliowing is a typical 1990 dis-
cor:nt broke r comnrission schedule.

'lable 12-1 Typical Broker-Assisted Commission Schedule


Stocks
'flansaction Amount Commission
$0*2,499 $30 + 1.70Vo of principal
52,500-6,249 $56 +0.66Vo of principal
56.250-19.999 $76 + 0.34Vo of principal
$2u,000-49,999 $100 + 0.22Vo of principal
550.000-499,999 $155 + 0.l1Vo of principal
$500,000 or more $255 + 0.09Vo of principal
Overiding N{inimum: $39 per trade
Intentet commissions on equity orders will vary dramntically depending on
the bmker the number of trades you place each month, the rynpe of trade
(mcrket or limit order) as well as the price of the stock and the volume of
shares. Rates range as low as no cotnmission to $29.95 or more per trade.

Options (With a Premium $0.50 or Less)


Number of Contracts Commission
o49 $ 1.80 per contract + 1.507o of principal
50-149 $ 1. 10 per contract + I .807a of principal
150499 $0.75 per contract + 2.007o of principal
500-1,499 $0.60 per contract + 2.00Vo of principal
1,500+ $0.60 per contract + 1.50Vo of principal
Overriding Minimum: $39 per trade
Options (With a Premium Greater Than $0.50)
Transaction Amount Commission
$0-2,499 $29 + L60Va of principal
$2,500-9,999 $49 + 0.80Vo of principal
$ 10,000+ $99 + 0.30Vo of principal
Overriding Minimum: $39 per trade
Intentet commissions on options yvill also vary: W0.00 per contract on
first 2 contrctcts plus $4 per co,xtract thereafter
600 Economic Evaluation and lnvestment Decision Methods

12.3 Put and Call Option Investments


'Put
and call options issued by thq.options clearing corporation (occ)
are currently available on four types of underlying assets: common stock,
common stock indexes, government debt securities and foreign currencies.
options on other types of assets may become available in the future. Many
of the risks of buying and selling options are the same for all types of
options, although some special risks may apply separately to each type.
"Put and call options" are legal contracts that give the owner the rtgii to
sell (a put) or buy (a call) a specified amount of an underlying asset at a
specified price (called the exercise price or strike price)
for a specffied time.
options that can be exercised at any time before they expire are ctmrironly
called "American-style options". They are different than ,'European-sryll
options" which can be exercised only during a specified period before expi-
ration. The discussion in this text relates primarily to American-styte
options.
The "option buyer" is the person who obtains the rights conveyed by the
option for a fee called a "premium". The buyer is scmetimes referred to as
the "holder" or "owner". since options are legal contracts.there must be an
option writer. For receipt of the option premium fee the writer of an option
is obligated, if and when he or she is assigned an option exercise, to per-
form according to the terms of the option. The "option writer,,sometimes
is referred to as the "option selrer" and may be an individual, corporation,
trust or other organization.
call (and put) options on common stock give the holder the right to buy
(or sell) 100 shares of common stock at a specified strike price fo. a
speci-
fied time. The terms "corutract" and "option" are inteichangeable and
involve rights to buy (call) or seil (put) 100 shares of common srock. call
holders usually only make money if the price of the underlying asset
increases since that generally causes the price of the call option to increase.
Put holders usuallv only make money if the price of the underlying asset
decreases since that generally causes the price ofthe put option to increase.

EXAMPLE 12-2 Putand cail Transaction profit and Loss


Assume that in January the price of xyz common stock is g49 per
share. A person acquires 1) an April XyZ call option at a g50 stiit<e
price for a premium of $2 per share, or 2) an April XyZ put option at
a $50 strike price for a premium of $g per share. ln February the
price of XYZ stock has risen to $55 per share and A) the call price is
Challer 12: Personal lnvestments and Hedging 601

$6 per share when it is sold, or B) the put price is $0.50 per share
when:it is sold. Calculate,the profit or loss from these call and put
:"2
"'raCtiCnS
Soiutions: Each put and call option contract controls 100
shares of stock
1A) Buying the call option for $2 per share multiplied by 100
shares equals $200 cost pius commission' (A table of typical
discount broker commissions is presented at the end of Sec-
tion 12'2)' Selling the call option for $6 per share multiplied by
100 shares equals $600 income minus commission. Neglect'
ing commissions, the call transaction profit = $60.0 - $200 =
$+OO. Note it is the option price and not the underlying asset
stock price that is used in determining profit and loss on
options. \{e are interested in the underlying asset stock price
movement because it is the driving force ihat caused the call
prlce to increase and give the investor the $400 profit.
1B) Buying the put option for $3 per share multiplied by 100
shares cost $300 plus commission. Selling the put option for
$0.50 per share multiplied by 100 shares equals $50 income
less commissions. Neglecting commissions, the put transac-
tion loss or negative profit equals $50 - $300 = -$250. lf the
stock price had dropped from $49 per share to $45 per share
instead of rising to $55 per share, the put option transaction
would have generated a profit and the call transaction would
have generated a loss. To explain this, the concept of intrinsic
value and time value must be introduced.
"lntrinsic value" is the value that the holder of an option would realize
fo: exercising the option, that is, the amount, if irny, by which the option is
"in-fhe-monerr"'. By definition, an"in-the-mrrne,v" option has positive intrin-
sic vllue. An "out-of-the-ntoney" option has zero intrinsic value. "Time
value" (or "speculative value") is whatever value an option has in addition
to its intrinsic value. Time value reflects what a buyer would be willing to
pay above intrinsic value for an option to obtain the speculative right to ben-
etlt from a possible favorable change in the price of the underlying asset
before its expiration. The concepts of intrinsic value and time value apply
only to American-style options since you must be able to exercise options at
any time to realize intrinsic value.
602 Economic Evaluation and lnvestment Decision Methods

EXAMPLE 12-3 Put and Call lntrinsic Value and Time Value
Determine the intrinsic value and time value for initial and final put,
call and stock prlces described in Example 12-2. lnitial January XyZ
stock price was $49 per share when a person acquired 1) an April
XYZ call at a $50 strike price for a premium of $2 per share or 2) and
April XYZ put option at a gbO strike price for a premium of g3 per
share. Final February xYZ stock price was $s5 per share when A)
the call price was $6 per share and B) the put price was $0.50 per
share.
Solution:
The initial call premium of 92 is entirely time value since intrinsic
value is zero. A call giving the right to buy XyZ at a strike price of
$50 has no intrinsic value when the stock can be bought in the open
market at the current XYZ market price per share of $49 per share.
The initial XYZ put premium-(price) of $3 per share is partiaily time
value and partially intrinsic value. The right to sell XyZ stock at a
strike price of $S0 per share is worth g1 per share when the stock
would have to be sold at $49 per share in the open market, therefore
intrinsic value equals g1 per share. The difference in the $3 put pre-
mium and the $1 intrinsic value is g2 per share time value.
The final XYZ call price of g6 per share is $5 per share intrinsic
value and $1 per share time value. With the XyZ stock price at g55
per share, the call giving the right to buy stock at $50 per share
could be exercised with the purchased stock simultaneously sold at
the $55 per share market price. This gives a $S per share intrinsic
value that could be realized from exercising the call option. The dif-
ference in the $6 per share premium price and $S per share intrinsic
value is the $1 per share time value.
The final XYZ put price of $0.50 per share is entirely time value.
When stock can be sold in the open market at $SS per share, the
right to sell at $50 per share through use of the put has no intrinsic
value.

EXAMPLE 12-4 Comparison of Buying Stock, Selling Short or


Buying Options
Assume the price of xYZ common stock is $30 per share and you
have $3000 to invest. consider one of the following four alternatives:
Chapter' 12: Fersonal lnvestments and Hedging 603

1r buying '100 shares of the XYZ stock, or.2) acquiring call options at
a $30 strike price for $2 per share, assuming that you expect the
XYZ stock price to increase. Alternatively, if you expect the XYZ
stock price to decline, you could use the $3000 as a reserve for, 3)
cc,rering potential loss from the short saie of 100 shares, or 4)
accr:iring put options at a $30 strike price for $2 per share. Calculate
the potential profit or loss from the foui'possible transactions if:

A) The stock price rises to $40 per share, the call price increases
to $10 per share and the put price declines to zero.
B) The stock price drops to $20 per share, the call price drops to
zerc and the put price increases to $10 per share.

$olution:
The stock price increases to $40 per share for 1A through 4A.
1A) Buy Stock Pro{it = ($40 sate price-$3O initial cost)(100 shares)
= $1,000 profit
($1 ,OOO profiV$3,000 cost)(100%) = 33.3% gain

2A) CallOption Profit = ($10 sale price-$2 initialcost)(1500 shares)


= $12,000 profit
($tZ,OOO profiV$3,000 cost)(100%) = 400% gain

3A) Short Sale Loss = ($30 sale price-$4O cover cost)(100 shares)
= $1,000 loss
($1,000 loss/$3000 cost)(100%) = 33.3% loss
44) Put Option Loss = ($0 sale price-$2 initial cost)(1500 shares)
= $3,000 loss
($3,000 loss/$3,000 cost)(100%) = 100% loss

The stock price decreases to $20 per share for I B through 48.
1B) Buy Stock Loss = ($20 sale price-$3O initial cost)(100 shares)
= $1,000 loss
($t,OOO loss/$3,000 cost)(100%) = 33.3% loss

28) Call Option Loss = ($0 sate price-$2 initial cost)(1500 shares)
= g3,000loss
($3,000 loss/$3,000 cost)(100%) = 100% loss
604 Economic Evalualion and lnvestment Decision Methods

38) Short Sale Profit = ($30 sale price-$20 cover cost)(100 shares)
= $1,000 profit
($1,OOO profiV$3,000 cost)(1 OO/") 33.3% gain
=
48) Put option profit = ($10 sale price-g2 initial cost)(1500 shares)

($re,ooo protivgslBlt::,olfifJ't, = 40oo/o sain


It is clear that acquiring the XyZ stock or call options on the stock
makes money if the XyZ stock price goes up, while selling short or
buying put options makes money if the xyz stock price drops. Also
notice that the leverage associated with options compared to buying
or short selling (control of 1s00 shares versus 100 shares in this
case for the same $9,000 investment) causes a much higher per-
centage gain and loss with options. options give the investor the
opportunity to make money faster and to lose mbney faster than with
direct buy or short sale transactions.

12.3a Writing Put and Call Option Contracts


There are two sides to every legal contract. For every buyer there must be
a seller. with options,the seller is the "optionwriter,, who receives a pre-
mium for granting the buyer the right to buy (call) or sell (put) 100 shares
of
common stock at a specified exercise price for-a specified period of
time.
The primary reason for writing options is nor necessarily highly speculative.
It often appeals to the investor in quest of enhanced income fiom available
investment capital. The buyer of options may have a variety of reasons
for
purchasing options including outright speculation, insuring profits, limiting
losses, tax considerations and so forth. The seller or writer of options
usu-
ally has just one motivation, to earn extra income on investment capital
through the premium received for writing options.

EXAMPLE 12-5 Writing (Seiling) a put Option


consider that you have a "bullish" view of the market and wish to
enhance your return on available investment capital. you feel that the
XYZ stock price is going to increase from its current price of
$40 per
share. You write a 9s day put option on XyZ at a strike price of g40 for
which you receive a $2S0 premium. lf the stock price goes up as you
project, the put option will not be exercised and you wiil realizea
$2so
f-lirapter 12: Personal lnvestments arid Hedging

proiit. lf your judgement is consistenfly correct you can, in theory, do


tnis four times per year and gain $robo extra premium income. This
can be used against a possible ouflay of $4000 to exercise the put if
the XYZ stock price drops instead of going up. Discuss the transaction
economics if the XYZ stock price drops to g30 near the expiration date
of the put option and you are required io exei'cise the option.

Solution:
You have written a put option agreeing to buy 100 shares of xyz
at s40 per share. lf your option is exercised you must pay 94000 for
100 shares of XYZ. A premium of $250 was received foiwriting the
option ntaking your net cost per share $37.50. The market is now
valuing the stock at $30 per share so you will have a 97.50 per share
ioss or a total loss of $7S0 if you sell the stock.
This example has illustrated the loss to the writer from exercising
the option near its er.piration. Both writers and buyers of options can
limit losses or take profits without going through the exercise proce-
oure. They can simply liquidate their positions at any time before the
option expires. The option buyer selis an option with the same strike
price and expiration as the one being held. Likewise, the option writer
buys an option to cancel the one he wrote to liquidate his position.

EXAMPLE 12-6 Writing (Seiling) A Cail Option


ln selling a call option, lhe "option writef'commits to selling the
optioned stock at a specified strike price for a specified perioo ot
time, at the discretion of the call buyer. The objective generally is to
enhance income on stock already owned. Assume you own 100
shares of ABC stock currenily priced at $40 per share and yields
about 5"/" in annual dividends. you do not expect the stock to
increase in price over the next 3 months, so you sell a g5 day call on
ABC at a $40 strike price and receive a premium of $30c (piemiums
on call options generally are a litfle higher than on put options due to
supply-demand). lf the price of ABC stays at $40 per share or below,
the call option will not be exercised and you pocket the premium.
Doing this four times a year would yield $1200 in addition to the
annual dividends of $200. However, analyze your economic situation
if the stock price jumps to $50 per share and you are required to
exercise the option.
606 Economic Evaluation and lnvestment Decision Methods

Solution:
Exercising your option requires you to deliver the stock to
the
option holder for 940 per share. you arso received a premium
t". ot
t9^p"r share, so you receive a totat of $43 per share insteao of tho
$50 per share that you could have sold at if you had not written the
call option. This is an implicit loss of g7 per ihare or a total loss
of
$700 per contract.
when the call writer owns the stock that the option is written against, the
call option is referred to as a "covered option". when the call writer
does
not own the stock against which the option is written, the writer
must buy
the stock in the open market if the option is exercised and
the call option is
referred to as a "naked option". Naked option writing is the
riskiest form of
option writing with unlimited loss potential.
. There are two types of combination option positions which invorve posi-
tions in more than one option at the sami time. A ,,straddle,,involves
writ-
ing or buying both a put and a call on the same underlying asset,
with the
options having the same exercise price and expiration da-te. A ,,spread,,
involves being both the writer and the buyer of th" ,u." type
option (put or
call) on the same underlying asset, with the options traving different
exer-
cise prices and/or expiration dates.
The "option expiration date" for common stock put and call options
on
individual stocks and indexes of stocks is the Saturday immediately
follow-
ing the third Friday of the option expiration monrh.
"Rights" and "warrants" arc similar to call options
but generally are
issued to provide investor incentive that enhances new fund
riising ptt"r-
tial. when a company wants io raise funds by issuing additional securities
it
sometimes gives its existing stockholder s the " right; to buy the
new securi-
ties ahead of other investors in proportion to the number of
shares owned.
The document evidencing this privilege is called a ,,right',. Rights
usually
give stockholders the right to buy new stock below the market
value, so
rights have a market value of their own, are actively traded and
usually have
a relatively short life. "warrants" are similar to rights
but may be good per-
petually instead of for a finite period.
stock splits and stock dividends usually are accounted for in options
trading
by adjusting the number.of options shares proportional to the
sto& sprit or div-
idend. A"stock dividend" is a common stock dividend paid in
securities rather
than cash. A"stock split" is a division of the outstanding
common stock shares
of a corporation into a larger number of shares. with a three-for-one
split by a
Cnapter 12: Personal lnvestmenis and Hedging 507

ci)mpanv. each shareholder gets two new shares for each existing share, so the
shareholder ends up with a total of three shares for each one existing share. On
t!,.e dav the thr-ee-for-one stock split is effective. the price per share of cornmon
\tock is reduced to one-third the closing price at the close of trading cn the pre-
vir)ui de)'. The investor orvns three times as many shares at cne -thirC the price,
so vaiue is r"urchanged. Put ard cali options are adjusted simiiarly. On the dal a
litree -lirr-one option is efreclive, e:rch old put or cail ontion contrcis three-hun-
dred shares at one-third the strike price of the originai one-hundred share put
o;'call optiorl contract. The Options Clearing Corporerion has the final deci-
sion on option adjustments for stock splits and stock dividends but option
adjustments normally are proportionai to the common stock adjustments. In
the case of a 25Vc stock dividend which would involve a company issuing
trventy-five new shares for each existing one-hundred shares, old put and call
contracts would controi one-hundred-twenty-five shares after the stock divi-
clcnd ai a strike price of four-fifths of the originai stnke price.

.!2.3b
Index Options
A "cornmon stock index" is a measure of the value of a group of stocks.
Other indexes have been developed to cover a variety of interests such as
debt securities, foreign currencies, and the cost of living. However, only
.stocl; ittder€.r are curreiriiy' the suhject of option trading. Different stock
indexes are celculated in different ways. Often the market prices of the
stocks irr the index qrorrp are "value rveighted". That is, in calculating the
index value. the market price of each common stock is multiplied by the
number of shares outstanding. Another method is to add up the prices of the
stocks in the index and divide by the number of stocks, disregarding num-
bers of shares outstanding. No matter how the index is calculated, investors
should keep in mind that an index responds only to price movements in
stocks on which it is based. No index gives a true reflection of the total
stock market. 14/hen an index option is exercised, the exercise is settled by
patntcnt oJ casl4 not by delivery of stock.

EXAMPLE 12-7 Exercising An lndex Option


Assume that the holder of a May $300 strike price call on the XYZ
lndex chooses to exercise it on a date when the exercise settlement
value of the index is $325. lf the multiplier for options on the XYZ
lndex is 100, the assigned call option writer would be obligated to
pay the call option holder $2,500 in cash.
608 Economic Evaluation and lnvestment Decision Methods

$2,500 = ($g2S tiquidation price - $000 strike price)(l00)

_ The multipliers for options on different indexes may be different.


Persons interested in trading index options should
make sure that
they know the appricabte muttiplier for each index invorved
in the
trading. This affects the investment magnitude and financial
expo_
sure and risk. lndex put options can be useful as an insurance
type
hedging mechanism that can reduce the negative financiat
impact on
a.common stock portfolio due to a sharp stock market
decline. The
following example illustrates this concept.

EXAMPLE 12'8 rndex put options for portfotio rnsurance


suppose that in February an investor wants to hedge g100,000
a
common stock portfolio against a spring decline in thJstock
rnarket.
After examining the characteristics of ihe malor stock-incexes,
the
investor concludes that the standard & poor's 100
lndex comes
closest to matching the portfolio. Assume the s&p 100
lndex stands
a|272 and the multiplier is 100. The value then for one index
option
contract is $27,200, requiring four put contracts to
approximate the
$100,000 portfolio value. tne invesior might decide to'buy four May
$260 strike price puts.
.Since these puts are "out-of-mo ney,, by 12
points they are relatively cheap at about $4, or $+OO per contract.
Four put contracts would cost gj,600 or 1.60/o of the portfolio
value.
suppose the market drops 20"/" bringing the stindaro poor,s
&
100 lndex down to 2'rg. Each May 260 put would
have intrinsic varue
ot 42 points ($2oo-$zt8) or g+,e00 per contract. Four contracts
would be worth $16,900 reaving g15,2oo in profit after
subtracting
the $'1,600 cost of the four puts. -A 20% market decline
would reduce
the value of the $100,000 portfolio by 920,000 so the index put
option insurance covered about 7s% ;t the 'ross. ay
acquiring put
options 12 points below market price (strike price of
$2OO when mar_
ket.price is 9272), the investor effectivery insured the portforio
against losses incurred after the first 12 poinis of the
index,s decline.
Had the investor been wiiling to bear more of the market
risk, the
cost of the insurance could have been reduced by purchasing
puts
with a lower strike price. Another way to reduce the insurance
cost is
to sell the put options before they expire. out-of-the-money put
options (strike price below the mar(et price) often lose
most of their
value in the final six weeks before expiration. Selling
the insurance
Cir3pls' 12: Perscnal lnvestments and Hedging 609

FUt ootions every month or two and replacing them with longer life
options may reduce the hedging cost.
Index options also are utilized in trading strategies that attempt to
apcly arbitrage techniques. "Arbitrage" is a technique employed to
take advantage of differences in price to lock rn a profit' "Pro-
grammed trading" involves rnonitoring the prices and values of the
stocks that make up a Stock index as weli aS the value of the index.
Sometimes differences occur in the values of the index and underly-
ing common stock values so that simultaneous sale of the index and
purchase of the underlying stock (or purctrase of the index and
simultaneous sale of the underlying stock) will lock in a profit. To
handle these transactions fast enorrgh to make them effectively
simultaneous, they are computerized. Thus the lerm "programmed
t:eCing".

12.3c t'oreign Currency and Debt Options


Foreign currency and riebt options provide a basis for hedging against
fbreign currency exchange rate or interest rate changes. "Debt options" ate
cptions on L].S. Treasurl' securities that require delivery of the underl-ving
securities upon exercise of the options . " Foreign currency options" are
traded on the currencies of many individual nations and also on the Euro-
pcan Clurrency Lrnit (ECU), which is the oftlcial medium of exchange of the
European Econornic Cc'mmunity's Monetary System. Option contract sizes
on foreign currencies vary from 62,500 West German marks or Swiss francs
per contract to 50,000 Canadian or Australian dollars per contract,
6,250,000 Japanese yen per contract or 31,250 British pounds per contract.
Debt options on U.S. Treasury Bonds and Notes cover a $100,000 principal
amount of underlying Treasury securities.
"Exercise prices of debt options" are expressed as a percent of par. For
e.rample, a Treasury Bond cali with an exercise price of 102 would entitle
the holiler to purchase the underlying bond for $102,000 (lAZVo of
$100.000) plus accrued interest on the bond from the date of issue or the
last interest payment date, whichever is later, through and including the
exercise settlement date.
"Exercise prices on foreign currencies" are expressed in U.S. cents per
unit of foreign currency, with the exception of the Japanese yen which is
expressed in hundredths of U.S. cents per yen. For example, a put covering
62,500 West German marks with an exercise price of 60 would entitle the
610
Economic Evaluation and lnvestment Decision
Methods

put holder to sell 62,500 marks for a price


of $37,500 ($.60 multiplied by
62,500). The " expimtion dnte
fo, yor"ign c urre ncy,, options is the saturday
immediaterv preceding ttre ttriia w"anJrauy
to your broker for debt option expiration "i# ,;;ffi;ronth. Refer
dates.
"Premiums for Treasury Boni
and Note optionr" are expressed in
of points and 32nds, with each r/32 representing terms
r/32 of r% of the unit of
o:lirq:frr exampre, if a Treasury Noie optionls purchased
at a premium
of 2 16/32, rhe cosr of the option will be
$2JOO (2 l^/2Vo of $ 100,000).
."Premiums on fcreign clt*ency', are expressed the same as exercise
price, in u.S. cents p:r u.nit of foreign
currency, again with the exception of
the Japanese yen, which is expresseJ
in hundredthi of u.S. cents per yen.

EXAMFLE 12-9 Foreign Currency


Options illustrated
suppose that the Austrarian doilar exchange
rate is 75.5 cents
U's' per 100 cenrs now (iebrua,v).-nssum"in"t
A) acquire a June put luslrarlln you can
at a 75 strike [rice tor a premium cf 2.60
or B) acquire a June cail at a 75 sirike price cents
cents' Neglect commissions and calculaie
ior pr"*i*
of s.sO
" oi ioss that
the profii will
result from either transaction if the
options are exercised on the June
expiration date and 1) in June the Austrarian
doriar .*.h"ng" rate is
78 cents or 2) in June the Austrarian
doilar rare is 72
cents. "*.nrnl"
Solution: Australian dollar = 1 unit with 50,000 units/contract
1

There wi' be no option time varue at


the expiration date so pre-
gffi I:i:: and exercise vatue both equat intrinsic vatue
at tre expi-

Al) The right to seil Austrarian doilars at zs cents is worthress


yhen they can be sord in the open market at 7g cents. The
finat put vatue is therefore bo. L;;;-;.;'tS]ozo
cosVunit)(50,000 units) $1300
iniriat
=
A2) The right to sefl Austrarian coilars at 75
cents is worth 3 cents
per unit intrinsic varue when the
market varue is 72 cents.
Profivunit = ($.os - $.oeo initiar cost)
= 0.4 cents oi$.oo+lunit
Total profit = ($.004/unitXsO,OO0 units; g20O
=
Bl) The right to buy Austrarian doilars at 75 cents
is worth 3 cents
per unit in intrinsic varue when they
cost 7g cents in the open
Charler 12: Personal lnvestments and Hedging 611

market. However, the original call cost 3.5 cents per unit so
we have a loss.
Lcssiunit = $.03 final price - $.035 initial cost = -$.00S profit
Total Loss = ($.005/unitx50,000 units) = $2S0
Even though the Australian dollar st;"engthened you lost
money on this call because the 3 cent per unit time value in
the call premium was greater than the 2.5 cent increase in
intrinsic value.
82) The right to buy Australian dollars at 7s cents is worthtess
when they can be bought in the open mai"ket at T2 cents, so
the June call premium value is $0.
Total Loss = (g0.035iunit)(S0,000 units) = 91750

ii is important to emphasize that the buyer of a put or call option acquires


''the right" to sell or buy at the strike price until the oprion expires, but that
no assets have abtuaily been sold or bought unless and until the option is
exercised. This is important because it limits an investor's maximum loss to
the amrrunt invested in the option. In the next section futures contracts are
dcscribed as legal contracts involving the actual purchase or sale of assets
for delivc'ry ar a specified future time. Since you are actually buying or sell-
ing lbr l'uture delir,'ery witir futures contracts, maximum loss potential is
r-rnlinrited. Not being able to loss nr.),. nloney than your initial investnrcnt
in put and call options contracrs oi'ten is considered to be a significant
adyantaqe over dealing in futures contracts with unlimited loss potential.

12.4 Futures Contract Transactions


Unlike common stock investments, futures contract investments, like
option investments, have finite lives. Futures are primarily used for either;
l) hedging commodity price fluctuation risks or 2) price speculation for tak-
ing advantage of potential commodity price movements.
The "brr.r'cr oJ' a.fi$ures c:oriract" (.the part1, with a long position) agrees
on a fixed purchase price to buy the underlying commodity (for example,
gold, u.heat or T:Bonds) fiorn the seller at a future contract expiration date.
The "seller of afutures contract" (the party with a short position) agrees to
sell the underlying commodity to the buyer at a fixed sale price at a future
contract expiration date.
"Futltres contracts" are legal contracts to buy or sell a specified amount
of some commodity at a specified price for delivery at a future contract
612 Economic Evaluation and lnvestment Decision Methocls

expiration date. However, in most cases, delivery never


takes prace. Instead,
both the buyer and selrer, acting independently of each
otheiusua[y liqui_
date their long and short positions beiore the contract
expires. This is done
by buyer selling an equivalent futures contract and the seller
fe
equ ivalent futures contract.
buying an

Each futures market and contract has characteristics


described by
answers to the following six questions:

l. What commodity do the contracts represent?


2. How much of that commodity and what grade of the commodity
do
the futures contract represent?
3. Which exchange handles the futures trades?
4. In what month and on what day do the contracts
expire?
5. is the monetary value of the smallest move the contract
!_hat can make?
6. what is the maximum move the contract is aflowed to make
during
one day?

EXAMPLE 12'1a A Gord Futures contract firustration


suppose the price of gord is $420 per ounce in May and you
.. feer:
(A) the price is going.to move up shaipry in
the future montns so you
?yy-"n october gord contract ior a futures contract setfle price of
$440 per ounce, or (B) the price is going to move down so you
seil
an october gold contract for 9440 per ounce. carcurate
the profit
loss from these transactions if ihe contracts are liquidated or
in
September when the October gold future setile price
is i ) $SOO p",
ounce, 2) $+OO per ounce.
solution: (Gold futures contracts cover 100 troy ounces.)
41) Buying gold at 9440 per ounce and selling at
$SO0 per ounce
give_s a 960 per ounce pr:ofit, times 100 otinces equals $6,000
profit.
A2) Buying gold at $440 per ounce and seiling at
$400 per ounce
gives a $40 per ounce loss, times 100 ounces equals
a
$4,0001oss.
B1) selling gold at $440 per ounce and buying it back
at $500 per
ounce results in a loss of $00 per ounce, times 100 ounces
equals a $6,000 loss.
Ohapter 12: Personal lnvestments and Hedging 613

82) Selling gold at $440 per ounce and buying it back at $400 per
ounce gives a $40 per ounce profit, times 100 ounces equals
a $4,000 profit.

corlrnodity Exchange transactions do not have to be paid for in cash. For


nr()st futilres transactions an investor must deposit a"margin" in the amount
trl 10',1, t,: 15Vo of the underlving tirtures contract dollar value. Some bro-
kers reltr to the margin requirement on futures as a "good faith deposit"
since thcre is no cost rncurred until the future transaction is completed by
either erecuting the futures contract or making an offsetting transaction.
N'Iinirnunr margins are set by the exchanges for different commodities and
may be adjusted periodicaiiy due to commodity volatility changes. Notice
that in the last E-xample L2-10, the investor bought or sold gold futures at
$4-lt) per ounce) so each 100 ounce contract had a value of $44,000. with a
iu% rnargin requirement the investor put up $4,400 equity margin to realize
a' l3S9b return ($6,0001$4,40t,)( 100%) on equiiy invesrment in .A1,, and
1-a6?o loss (-$6,000/54.400)(1007o) on equity investmenr in "81". It can be
seen that percentage gain or loss on y our equity investment in futures con-
tracts can be very large and is limited only by commodity price movement.
"I'led|:ers" and "speculators" are the two basic caiegories of futures
contract inl'estors. In general "hedgers" use futures for protection against
advcrrse tuture price movements in the underlying commodity. The rationaie
oi hc:dging is based upon the demonsrrated tendency of cash commodiry
spot price: and futures plices to move in tandem. Hedgers are often busi-
nesses or individuals who deal in the underlying commodity. Take for
example a breakfast cereal producer that requires wheat and oats for cereal
processing throughout the year. For protection against higher wheat and oat
prices that could occur due to drought in the farm belt or increased sales to
a foreign country the processor can "hedge" the risk exposure by buying
wheat and oats contracts to cover the amount of grain that is expected to be
boucht in the future. If grain prices rise. profits on the futures contracts will
otTret the higher cost of grain, locking the price in at today's future contract
price. Frnancial institutions, pension funds, insurance companies and corpo-
rations hedge their common stock and bond portfolios against market down
turns by selling stock index futures, T:-Bond or T-Bill futures. This is analo-
gous to the use of index put options for portfolio insurance discussed in
Example l2-8. If these same organizations have future financing require-
ments they can hedge against interest rate increases by buying T:.Bond or
T-Bill futures.
614
Economic Evaluation and lnvestment Decision
Methocts

"speculators " typicalry do not deal in the commodities


underlying the
futures theJ trade. Instead, they are in the
market to profit by buying futures
contracts they expect wilI rise in price
and by selrin! futures contracts they
expect will fall. Successful speculators uruuily
are lisciplined traders who
study the market carefully. They know when
tocut their losses or when to let
their profits run. otherwise they quickly are
forced into another line of work.

12.4a Options on Futures


so far we have discussed and illustrated how specurators
and hedgers buy
or sell furures contracts depending on their views
and obj";;i""r. you may
also wish to,participate in the futures market
by buying or writing (selling)
options on futures. Trading of options on futures-belan
name impries, "options on
in r9g3. As the
futures;'are options to buy ("a calr) or selr (a put)
a specified amount of commodity futures
at a specified price for a specified
time'"options onfutures" geneiaily expire a riw
oays u"ror" tt. underly-
ing futures contracts expire so that iutures positions "
treated by
- exercise of
an option can be reversed before the futures
contract
options on futures offer the trader four investment "_r;;r.
position choices: buy-
ing or writing a cail, or buying or writing a put.
Direit futures trading onry
offers the investor two basic choices: bu5Tingor
selling a fut*", contract. It
is important to note that by investing in iuying
optiois on futures you can_
not lose more than you invest whereas by buying
futures contracts directly
you havd unlimited loss potenti ar. The
buye, of options on futures can profit
greatly if his view is correct and the market
continues to move in the direc_
tion he expected. If he is wrong he cannot rose
more money than the pre-
mium he paid up front to the optlon wrirer.
on the other hand, the writir of options ort
futures contracts whose view
is correct gets to keep the premium payment
received from the buyer. This
is the most he can make. Ifthe writer is wrong
he may lose part or alr of the
p.emium or if the buyer exercises the
option before it exiires, the writer
may be assigned a losing position in the futures
market. Furthermore, the
writer whose position moves against him is "marked
to the market daity,,
which means he must put up new investment
money daily to cover rosses.
lote the sharp differences in the risk profiles of options buyers and writers
.(sellers)' The option buyer will profit if his view is correct
and suffer limited
l0sses if he is wrong. For this potentiar
advantage, he pays the writer a pre-
mium. on the other hand the writer has limited
p.ont potential (the premium
is the maximum profit) and is exposed to unlimit"d
lorr", if he is wrong.
Chapter 12: Personal lnvestments and Hedging 615

Brtth v'riters end buyers of options c(m linit losses or tetke prt{its at an)'
time by liquidating their positions at any time before the option expires. To
i1.; this. the option b,,ryer" sells an option with the same strike price and expi-
ration as the one he is holding and the option writer buys an option to can-
cei ili,: one he wrote.

EXAMPLE 12-11 Options on Futures lllustration


Suppose today is February 1 and a February West German
Deutsche Mark (DM) futures contract is trading at $0.595 per DM.
(The DM futures contract and options futures contract both cover
125,000 DM and are priced in cents per DM.) You are buitish and
expect the DM to rise to $0.650 over the next four months. You turn
to the futures markets where you can buy DM futures, buy a call
option of DM futures or write a DM put to take economic advantage
of the expected DM strength. All three futures investment alterna-
tives r,vill make money if the DM strengthens, but they carry different
elements of risk and reward. You decide to brry an "at-the-ffioney"
June DM call option (strike price equals market price) on the June
futures to give yourself unlimited profit potential with limited risk. The
June DM futures contract currently is trading at $0.600. The at-the-
money June 60 call (the strike price is $0.60 per DM) is trading at
$0.01S. Therefore, the total premium is $0.0'15/DM x 125,000DM =
$1,875.
lf tiie DM strengthens in value to $0.650 per DM as expected, you
can profit by either; 1) exercising your call and obtaining a futures
contract position or, 2) reverse your call by selling it at a profit.
The call option on a DM futures contract gives you the right to buy
a June DM futures contract at $0.600. You have already invested
$0.015 per DM to secure this right, so the June futures must rise
above $0.615 per DM before a profit will be realized from executing
the call to buy the futures and simultaneously sell them. For exarnple
assume that on May 15 the June DM future price hits $0.650. lf you
exercise your option to buy the DM futures contact and simultane-
ously sell a June DM 60 futures contract, you realize a profit of:
($O.OSlOtrll - $0.61 s/DM)(1 25,000DM) = $4,375
By exercising the option on May 15 instead of selling it you lost the
opportunity of realizing any time value included in the call option pre-
616 Economic Evaluation and lnvestment Decision Methods

mium on May 1s. To illustrate assume that on May 15 the


DM call
option premium is $0.0s5 per DM. seiling the cari at
$0.0s5 gives
profit of:
($O.OSS
Sate price/DM -
$0.015 CosUDM) (12S,000DM) = $5,000
lf you had bought the futures contract on February 1 instead
of the
call option on the futures contract, your profit would have been
greater as follows:
($0.0S
Sate price/DM - $0.60 CosVDM) (12S,000DM) = $6,250
By buying the call option on the futures contract instead of the
-
future we realized less profit to have finite loss risk with the
call option
compared to unlimited loss risk with a futures contract investment.

12.5 Net r/Vorth, Stock Equity, Bonds and Debentures


The'"net worth" ol u person, corporation or other organization
equals
total assets minus total liabilities. From an economic viewpoint,
positive net
worth is a desirable attribute of all entities. The net worti
of corporations
represents the corporate "equity" value, where ,'equity"
is the ownership
interest of common and preferred stockholders in i ,i*pory.
whenever a
person, corporation or other organization applies for
a loan, they usually are
required to provide information that detirmines their net
worth for the
lender. Since the concept of net worth relates to a variety
of investment situ_
ations in different ways, it is very important to develop a good
understand-
ing of net worth and how to explicitly determine it. Th; foll,owing
terms and
discussion are intended to enhance understanding of net
worth.
,ssers" represent the value of everything a person, corporation
-"Total or
other organization owns or has due it. "To,tar assets" generally
are broken
into two components called current assets and fixed assets. ..current
assets" are convertible into cash within a
)rear by normal operations. They
typically include cash, accounts receivable on iealized saies,
inventories,
and shom term loans due to the investor within one year. ,,Fixed
assets,, are
assets that in the normal course of business vvill
not be conr-erted to caslt
tritlin otxe )'ear such as rand, ruinerar rights, buildings, equipment artd
business interests.
"Total liabilities" are all the
financial claims against an individual, cor_
poration or other organization, and are generally broken
into two compo-
nents called current (short term) liabilities and long term
liabilities. ..car_
;
*
I
$

617
lhe.oter 12: Personai lnvestments and Hedging

loans dtte
re,:t' or ,,short term liabilities" are accounts pttyable, notes and
"funded debt") are tlle
within one year "Lang term liabilities"(also called
more than one year
btvtd. Cebenture and tong-tnr* loan -finttncing ptiyable
!
g
ir rhrr .futto'e. not incltullrg ,n**on and preferred stock' which are equiry
{ rship :ecuriti es rLfiller thcut tiebt ;ecurities'
ot,. t, i:
"fr;ill
assets minus total liabiiities gives "net worth"
rvhich represents the
c(,).ibirled preferred a:rd common stock equity 'alue
of a corporation.
.,ccmm0n stock" securities represent an ownership in",eresi in a corporatron'
and pre-
li the corporation has also issued "preferred Stock", both common stock holder
preferred
fened stock holders have ownership rights, but the
event of liquidation'
nrrrrnally has first claim on dividends, and assets itt the
are paid at a specified rate while com-
Preferred stock dividends normally
of the corporation' com-
nron srock dividends t"iuctuate with the earnings
generally exercise
fl mon srock holders, therefore, assume the greater risk, but
greater control through voting right preferences over
preferred stock' "vot-
Preferred
f, ing rights" on .o*,ilon stock usually are one vote per share'
are in default.
shirrelr;,tders usually only vote if preferred dividends
"Cumulative
There are several ditferent caiegories of preferred stock.
rjividends are
preferred stock" has a provision that states if one or more
paic before any dividends may be
omitted, the omitted dividends must be i'Nan
-curnulative preferred stock"
paid on the cornpany,s common stock.
di" idends are
ioes nt-,t allow for trre accrual of unpaid divitlends so omitted
srocl<".is entitled to its
essenrially non-recoverable. "Participatirtg preferre'd
on a specified basis upon
stated dividend and also to ad<Jitional dividends
payrnent of dividends on the common stock of the company'
i

at the head of the


In the event of a corporate liquidation, bond holders ale
holders are sec-
creditor line to be paid off with available funds, debenture
ond,preferredstockholdersthird,andcommonstockholdersarelast.Com-
monstockinvestmentgivesthegreatestrewardpotentialfrompossible
stock value' This
increasing tlividends ani capital appreciation in common
risk of losing the investment
greater reward potential is bffset by greaier
o.r preferred stock invest-
frincipal in comparison with bond, debenture
ments.
"Bortds" are promissory notes of a corporation or government entity
usu-
of a debt for which
ally issued in multiples oi $1OOO. R Uond is evidence
amount of interest for
the issuer promises io puy the bondholder a specified
face value on the
a specified length of iime, and then to repay the bond
expiration date. In every case a bond ."pr"rin* debt,
which means the bond
troider is a creditor and not a part owner as is the case
of a common or pre-
618 Economic Evaluation and lnvestment Decision Methocls

fe*ed stock holder. property or securities that have been pledged


by a bor_
rower to secure repayment of a loan is called "collateral,,,
Bonds are
backed by the assets of a company as collateral
"Debentures" are similar to bonds except that
they are backed only by
the general credit and name of the issuing company
and not by the assets of
the company. To entice investors to accept the greater risk
associated with
debenture investments, debentures typicaiy have higher dividend
rates than
bonds. "convertible debentures" are debentures that may be
exchanged by
the owner for common stock or another security of the
same company in
accordance with the terms of the issue. "convertible bonds',
and ,,convert_
ible preferred stock" have characteristics similar to those of ,,convertible
debentures".
An "indenture" is a written agreement under which bonds, debentures
and preferred stock are issued, setting forth interest or dividend
rates, matu-
rity dates, sinking fund requirements, etc. A "sinking holds money
fund',
set aside regularly by a company to redeem bonds, debentures
or preferred
stock in accordance with the indenture.
Bonds, debentures, preferred and common stock investments
generaily
are considered to be very "liquid' investments because they
are easily con-
verted to cash. v,/hen a very large brock of common stock
of a company is
sold, often it is done through a secondary distribution . A .,secondary
diitri-
bution" involves redistribution of a large block of common stock
sometime
after the initial "primary distribution; by the issuing company.
The sec-
ondary distribution sale is handled by a securities firm
o. g.oup of firms,
and the shares usually are offered at a fixed price which
is reiated to the cur-
rent price of the stock. rrt a "thin ntarket" in which there
are comparatively
few bids to buy or offers to sell, it may be more difficult to
liquidate bond,
debenture or stock investments at "your" price than in
a ,,tiquid market,,
u'|ere there are many bids to buy and offers to sell. Bonds
are either traded
''flat" or "and interest". Most bonds are traded ,,anJ interesr',
which means
the buyer pays tc the seller the bond market price plus
accrued interest since
the last dividend payment date. "Flat" means that the
bond price includes
consideration for all unpaid accrued interest.
Bonds are a yery popular method of debt financing for corporations
and
government organizations so there are many different
types of bonds. As pre_
sented in Chapter 3, section 3.5, "u..s. Treasury Bonds,'are
securities issued
by the u.S- government with lives from five to thirty years. ,,(J.s.
Treasury
Notes" have lives of one to five years and,,U.S. Treaiury Bills,,
have three,
six or twelve month maturity dates. Treasury Bond, Note and Bill
invest-
l

I Chapter' 12: Personal lnvestments anC Hedging 619

!
i
nients are perceived to be antong the safest investments in the r,vorld today
I
l,
and, as a result, are often used as the basis for a risk free rate. Conventional
-l-rca:;rrrv
or corporate bond interest rates are paid semi-annually witn matu-
ritv virlue equal to the face value of the bond. All bonds issued since the mid-
i')o0's :ue registeretl bonds. " Registeretl boncls '' are botrds that are registered
orl the books of the issuing companv or go!'erntnetrt organization in the nrne
rii thc ()\\'ner and can only be transferred to a new owner r.r'hen endorsed by
the iJqistcrecl owner. "Bearer bonds" are not registered on the books of the
i\siiins company, so the bearer of the bon<i is the owner. No signature is nec-
ess:rry to transt-er ownership; they are "neSotiahle" like cash. In the mid
1980's Congress outlawed the issuance of new bearer bonds, but bonds in
existence at the time of the law change rvill be traded for another twent)' to
trt'enry-five years. Beorer bonds are "coupon bonds"; bonds with coupons
attlched. The coupons are clipped as they come due and are presented by the
hoidcr for payment of interest (usually through a local bank).
''Zt:ro coupon bonds" are bonds that pa)'no semi-annual dividends; the
diviciend coupons have a value of zero. Ztro coupon bcnds can be created
by stripping the dividends from the maturity value and selling the rwo cotn-
pondnts separateh', or by setting up a new bond issue on a zero coupon bond
basis. Zero coupon bonds are sold at a discount from face value.

EXAMPLE 12-12 Conventional and Zero Coupon Bonds


A conventional $10,000 U.S. Treasury,30 yeai bond will pay divi-
dends at a rate of 8"h compounded semi-annually. What are the pre-
sent values of the dividend stream and the maturity value respectively?
Solution:
Conventional C=$'10,000 Piv=$400. . . . Div=$400
Maturity Value = $10,000
BonC
0 1 ...60semi-annualPeriods
22.623
PW Div. = $400(P/A4,60) = $9,049
.0951
PW Maturity Value = $10,000(P/Fa,6g) = $951
Total Conventional Bond Present Value = $9,049 + $951 = $10,000
lf you sell the year 30 maturity value of $10,000.00 separately for
$951.00 at year 0, it is azero coupon bond transaction.

4
620 Economic Evaluation and rnvestment
Decision Methods

By selring the dividend stream


and the maturity varue separatery,
people rooking for maximum retired.
annuar income achieve ttreir
ing the dividend .I"1T a.1o obiective by buy-
they might not expect to live 1oiil;;'," p"y r"r,r,"ii ii.ty ruru", which
rorg io utitir.. p"rri*'rrrds for indi_
viduals, corporations or government "no-ugt
irganizations
bonds to obtain investments G;;"
that lock in the bond int"r"ri
zero coupon
ment rate of growth over the rui! at the invest_
rife of the zero coupon bond.
u'S' often do not find zero .orfo, u*ds Individuars in the
attractive iru"ri*"nr, for non_
pension fund or non-tax deferred
annurty investme;*#r. ,ris
individuars must pay tax on u...u"oir*rest is because
each year whether the accrued
interest is physicaily received
or roi. n"ople ofteniav" *-u*r.ion
ing tax on revenue they.do ,ot to pay_
r.tuuiiy i"."iu" until a Iater date.
Bond investmenl.valu,:s can be
v"ry s"nsitive to interest-rate changes.
Many people oo n:l rearize-that
they lan lose money in the
jusr as fast or faster than bond market
in rhe stock;;ket.

EXAM,LE 12'19 Bond varue sensitivity


to rnterest Rates
Assume that you invest
$1O,O0O in a 30 year, U.S. Treasury
paying 8% interest compounoeo Bond
semi-annually. you invest another
$10,000 in a 30 year, U.S freasu[r'zero
rnterest compounded semi_annrrffv, coupon bond paying g%
giving V!rr, iO ,l,rriry
of $105,1e6 (glof?,^:l/Fa,6sj.''rlrrher " vatue
after you buy these.!.:10:, assume that one week
kets' interest rates jumR to 1t"i;r'change occurs in financiat mar_
10"/o'per year compounded
ally' You need to se, these semi-annu-
oonos io" meet other finanlLr
calculate your one-week perceniror.'tro,, ootigations.
each bond investment.
Solution: Bond sare varues
period interest at the time are based on S,/oper semi-annuat
ot ttre-Ji b (l*,/ocompounded
annualty). semi_

Regular C=$1O,OOO Div=g4gg. . . .


Div=g4g6
Bond
;-------. . . . ousemr_annualperiods
_ Maturity Vatue = $10,OOO
One week later, present worth
is:
18.929 .0535
= $400(P/A5,60) + $10,000(pf;6) = $8,107
i

li:l.,rer '12: Fersonal lnvestments and Hedging

Percent Lcss = [($tO,OOO - $8,107)/$10,000](100%) = 18.93%

Ze';o c=$10,00c
r Maturity Value = $105,196
C:r, li,,cn Bond
4 1 . . . . .. . .. 60semi-annualPeriods
I
On.-. waek later, present worth is:

.0535
l
j = $105,19S(P/F5,69) = $5,628
I
Percent Loss = [($10,000 - $5,628)](100%) = 43.72%

I These are very significant percent changes in investment values. In this


I c*se and in general. zero coupon bond values are much more sensitive to
inilrest rate changes than conventional bonds. Unless investm.ents are long-
tenll to locl.:-in a satisfactor,"- rate of money growth, zen coupon investment
are very speculative investments that can either lose or make rnoney quickly
over the short term. It is wise to choose very high ra*eC A plus zero coupon
il bond investrnents. Since no money is received until far into the future' you
want to be certain about investment security. The only zero coupon br:nd
investr-nents recommended here are U.S. Treasury zero coupon bonds.
U.S. Government Savings Bonds, Series EE are directly analogous to
rero coupon bonds except for one very significant income tax diff'erence.
'lax on accrucd interest on EE Savings Bonds is deferred to the future point
in time when you cash them, while zero coupon bond accrued interest is
taxed annually. However, to offset the tax advantage of Series EE Savings
Bonds, a lower interest rate is paid than on conventional bonds. All Series
EE Bonds bought on or after November 1,1982, and held at least five years
earn interest at 85Vo of the average yield on five year Treasury securities
during the holding period, or a minimum of 6.0Vo in 1993, which the
Treasury changes from time to time as interest rates fluctuate.

EXA,MPLE 12-14 Zero Coupon Bonds and Series EE Savings


Bonds
compare the after-tax future value accumulated 5 years in the
future from investment of $10,000 in a 9% annual interest rate,5
year zero coupon bond, ot d 7.650/o Series EE Savings Bond. The
622 Economic Evaluation and lnvestment Decision
Methods

7.65%.rate is BS% of the g% rate. Effective


annuar interest rates and
annual interest payments are assumed here to,.,irpil.iiT
of carcura-
tions rather than using the actuar semi-annuar perioiratJs
tnat appry
to bonds. Assume aBZy" effective federar prus
state income tax rate
for an individuar. Assume the money paid in tax
every year on
accrued interest on the zero coupon bond would
be invested in addi-
tional new EE savings bonds at7.65"/" interest p",
y""i-it that arter_
native were elected.
Solution:

Accrued Taxable lnterest per year


Zero Coupon C=$i0,00e
_Q9gg $981 $1,06g_ql1qq__$l?70 Maturity
Bond,9"/"/yrffi4sVarue=g15,3g6
lncome Tax @ 38./" $288 $314 $342 $SZS $+OO
-The tax to be paid.eve_ry year is additionar
outside investment nec-
essary to generate thg 915,3g6 year 5 zero coupon
value which is after-tax cash frow. Assume money nono maturity
equivarent in
amount and- timing zero coupon bond interest i",
1g !h. i"vrn"nts is
invested in series EE savings gonos
each year for a fair comparison.
Series EE C=$1!,090 $288 $314 $uz $373 $406 Maturity
Bond, 7.65% yr
Value=?

Maturity Varue = g10,000( ,',!l.Z!u,A . zaa6)ilf,lu,o1


1.2475 1.1589
+ Bt4(F/p7.65,g) + 342(F1p7.6S,2)

,.zzss)!131,,I .406 = g16,0s3


The difference in the $16,033 maturity varue
and cumurative invest-
ment amount is taxable atB2/o.
lncome Tax = ($tO,Ogg - $11,723 Cum.
Costx.32) = $1,g7g
After-tax Series EE year S CF
= 916,033 _ g1,37g = g.14,654
Cnaprer i2: Personal lnvestments and Heiging 623

This Series EE Savings Bond future value of $'14,654 after taxes is less
than the zero coupon bond future value of $15,386 after tax, so the
zero coupon investment is economically preferable, Flemember that
these numbers are to illustrate general concepts and methods only.
Tne analysis should be re-run for actual savings bond and zero coupon
bcnd rates that are applicable at the time of your investment decision.

''lvlttrticipal bonds" (or "ta-r exempt bonds") are the bonds of state, city,
count) and other public authorities specihed under federal law, the interest
on whrch is either wholly or partly exempt from federal income tax and
sometimes exempt from state income tax. Whereas the accrued interest on
Series EE savings bonds is tax deferred to the future time when the bonds
are sold, municipal bond interest is "tax-tiee". The only exceptioir is related
to municipal bonds that are subject to alternative minimum tax. If the funds
irom nrunicipal bonds are used fbr private development purposes rather that
publlc pLrrposes, thase municipal bonds are subject to aiternative minimtrm
tax ruies for individuals or corporations, which may cause part or all of
rnunicipal bond interest to be taxable. It is advisable to check with a tax
accountant or knowledgeable broker concerning alternative minimum tax
status of specific municipal bond issues belore investing.
As in comparing the tax savirigs of Series EE Savings Bonds to zero
coupon bonds, the potentictl tax savings o1 "taxfree" ntuticipal bottds arc
n()t reLt|lr tux-fre e. Int,e.stttr',; accept irtte rest rates in municipal bond invest-
ntents tlrat tvpicaily are sey'eral percentage points less thctn can be obtainetl
in conventional taxable bond investn'Lents. Therefore, implicit tax is actually
being paid on municipal bortds. The public municipalities benefit from the
lower interest rates that investors are willing to accept to avoid paying tax
on the interest.

EXAMPLE 12-15 A Municipal Bond lnvestment Compared to a


Taxable Zero Coupon Bond lnvestment
Compare the Example 12-i4 $10,000 cost, 97o annual interest 5
year zero coupon bond investment which had after-tax future value
of $"15,383 with the f uture value of a municipal bond investment.
Consider investing the initial $10,000 and the annual tax that would
be paid on annual accrued interest on the zero coupon bond invest-
ment in municipal bonds paying 7.5"/" inlerest per year. Assume
annual municipal bond interest can be reinvested every year in other
624 Economic Evaluation and lnvestment Decision Methods

municipal bonds paying z.s/o inrerest per year. Assume


the munici_
paIbondisnotsubjecttoalternativeminimumtax.
Solution:
Zero Coupon Bond year 5 Value $15,gg6 after-tax,
=
from Example 12-14
Municipal Bond year 5 Value

1.4356 1.33ss 1.2423 1.1556


= $10,000(FlP7.s,5) + 2BB(Ftp7.s,4) + 914(FtpZ.;,g) + 3a?:fftpi.i,Z)

1.075
+ 373(F/P7.S,1) + 406 = g15,927 after_tax
For the assumed rates in this anarysis the municipar
bond invest-
ment is projected to give the greaier iuture vatue
OV SSaf . For rela-
tively high tax bracket individuals, municipal bond
investments often
are preferable to other taxable fixed interest rate
preferred stock, certificate of deposit or
b;il: debenture,
money market account type
investments. However, for tax deferred annuities
where income tax does not have to be paid untir
,rJp"n.ion funds
the funds are riqui_
dated, the lower municipar bond interest rate is
a disadvantage. Each
investment anarysis situation must be anaryzed
carefufly with special
attention paid to income tax considerations
and risk differences.
The final bond subject concerns junk
bonds. *Junk bonds,, are the bonds
of highly leveraged corporations that have questionabre
(,Junky,,) assets
backing the bonds as coilareral.
Arthough bonds are ahead ofdebenture and
preferred and common stock
creditors,"they fbilow rong term loans in the
creditor pecking order in the event
of bankruptcy liquidation. The highry
leveraged buy-outs of major
out with such rarge amounts-of ""d;;, ;; recenr years have been carried
rong term debt, that bonds previously
thought to be safe, secure and high
.lut.d huu" been pushed down to the
risky 'Junk bond" category arter tJverag"o
uuy-orrr. Today, investors must
be aware that a reveraged buy-out
the bonds of almost any com-
"un "-*"
pany to take on the "junk bond" laber
overnight. This makes the security of
u'S' Treasury Notes and Bonds root
good today. Bond invest-
ments can be much riskier than many ".p""ially
peopl" ."rlil", matirg:,high quality,,
of utmost importance.
Ciiacter 12: Personal lnvestments and Hedging 625

12.6 Placing Orders to Buy or Sell Stocks, Bonds, Debentures,


Options and Futures

To marimize the likelihood that you will achieve your objective in buying
or rclling stocks, bonds. ciebenfures, options, futures c;r other securities, it is
cli-:.irable tr-i be a,-vare that there are many different wa3.-s r-ri placing orders to
bu1 or sell. The most common order utilized rs a market order. A "ttiarket
t,rrlrtr" is an order to buy or sell a stated amount of a security at the most
rrlr'antaqeous price obtainable after the order is represented in the Tr:tding
{lrowd.'The "Tradirtg crowd" is the group of traders at the trading loc:rtions
where securities are bottsht and sold on the floor of- the New York Stock
Exchange or other stock, bond, option or conrmoditv lutures exchanges. Bro-
kers and the broker's src)ck exchanqe representative are legally obligated
uncler Securities and Exchange Commission (SEC) law to obtain the best
!-.dce possible for their clients when a market order is
placed. A " limit order"
is an orilcr to buy or sell a ,steted amount of a securitli at a specitied price, or
at a better price if obtainable, after the order is represented in the Trading
Crowd. The terms "limited order" and "limited price order" are interchange-
abie with "limit order". Limit orders enable investors to specify the price they
are wiliing to pay to bu1, or sell securities. Especially rvhen you are buying or
sellrng stocks inthe oy,er-the-counter market it is desirable to consider placing
limit orders rather than market orders. The "over-the-counter" market is a
nrlrket tbr securities conducted primarily by telephone by securities dealers
rvlio may or ntay not be members of a securities exchange. When investors
pllrce liLuit orders they redr.tce the necessity to rely on the integrity of brokers
they clo not know. A large majority of brokers represent their clients well with
the highest level of integrity. However, in any walk of life, there is a small
percent of people who will "take you to the cleaners" and separate you from
your financial capital if you give them the opportunity. Limit orders reduce
this likelihood in securities transactions. With respect to the over-the-counter
mirrket in stocks, the prices of more widely traded common stocks are
reported on the National Association o1 Securities Dealers Automated Quota-
tion (NASDAQ) system. This is an automated communications system that
allovvs securities dealers throughout the country to see quickly the bid and
asked price quotation range of all brokers making a market in a specific issue.
The "bid and asked" price or "quotation" or "quote" is the highest price
anyone wants to pay to buy (the bid) and the lowest price anyone wants to sell
fbr at the same time (the asked). Many small company stocks are not regu-
lai'ly reported on the NASDAQ stock listings.

r
626 Economic Evaluation and lnvestment Decision
Methods

There are many variations of market and limit


orders to achieve specific
trading objectives with specified timing constraints.
A ,,good till canceiled
order" or "open order" is an order to uuy or sell
which remains in effect
until it is either executed or cancelled. An ,order good
until a specified
tinte" is a market or rimit order which is to be reprlsented
in the Trading
crowd until a specified time, after which such order,
or portion thereof, not
executed is to be treated as though it were
cancelred. A ,day order,, is an
order to buy or seil which, if not ixecuted expires
, arthe eniof the trading
day on which it was entered. An "at the opening
order,, or ,,et the opening
only order" is a market or limit order which is
to be executed at the opening
(the initial trade ofthe day) ofthe stock
or not at all, and any such order, or
portion thereof, not so executed is treated as
canceiled. An ,,at the close
order" is a market order which is to be executed
at the close, or as near the
close as practicable. A "time order" is an order
,o uuy or seil which
becomes a market or limit order at a specified
time.
A "fill or kill order" is a market or limit order that is to be executed
in its
entirety as soon as it is represented to the Trading
crowd. If not so exe_
cuted, the order is treated as cancelred. An *ail
or none order,, is a market
or limit order which is to be executed in its entirety
or not at ail. unlike a
"fill or kill" order, it is not treated as a canceiled order
soon as it is represented in the Trading Crowd.
if not executed as
A "stop order" is an order to buy (or selr) which becomes an
executabre
market order to buy (or seil) when a transaction
in the securitf occurs at or
above (or below with a stop order to sell) the
stop price. Stop oroe.s may be
used in an effort to protect paper profit, or
to try and rimit ross to a certain
amount, or to take advantage of perceived
technical or fundamental consid_
erations affecting the market. Thi term .,technicar
anarysis,, appries to vari_
ous internal factors affecting the market such
as the size of the short inter_
est, whether the market has had a sustained
advance or decline without
interruption, whether sharp advances or declines
have occurred on smalr or
large volume and so forth. "Fundamentar
anarysis,, rerates to fundamental
economic factors such as current earnings, earnings
trends, new orders, div-
idends, current and projected interest lui"r,
economic conditions and so
forth.
A "stop limit order" is an order to buy (or sell) which becomes
an exe_
cutable limit order to buy (or sell) when a transaction
in the security occurs
at or above (or berow with a stop rimit order
to sell) the stop price. An
"ahernative order", sometimes.uir"d
an,,either/or order,, is an order to do
either of two alternatives, such as either seil (or
buy) a particurar stock at a
627
Ch:r::ter 1? Perscnal lnvestments and Hedging

Iimit 1:r'iceor sell (or buy) on a stop ortler. If the order is executed upon the
bappening of one alternative, the order on the other alternative is treated as
cuiriclle,l. Il the order is for an amount of securities larger than one unit of
t:.r,-ling. r-he nitmber of units erecuted determines the amount of the alterna-
ri'.e oldcr to be treated as cancelled.

12.7 Orimparison of Alternative Personal Investments


ln,Jivirjuals can make nany different types of investtnents ri ith widely
viir."'ing trrr ramifications. For example, any person with available capital
hrrs a choice of investing in common or prefened stocks, bonds, debentures,
t'lrnk money market accounts and certificates of deposit. itrsurance annu-
ities, leesing ventures, real esiate, farm and ranch or raw lat-id, mining or
netr(-.leum developmcllts or tax deferred annuities, petlsion plans and indi-
i iCuiil retirement accounts to name some of the contmon possibilities' This
rnakcs personal investment analyses of alternative investment choices as .
cornplicated, or nu)re compiicated than many corparate analyses. As with
general busin.-ss analyses, personal investment evaluations may involve the
anal,vsis of either mutually exclusive or non-mutually exclusive alternatives'
Like bLrsiness analyses, ali personal investnlerit analyses must be done atler-
i:rx. cop:islently usilg either escalated or Constant dollarS. Horvever, escll-
lated clollar analvsis is recommended. Consistent levera-qe (borrorved money
to equ:l1. ratio) mr:st also be usecl in all evlluatiorr.i if they are not being
done t.p a cash equity (l00%c rnargitl) investment basis. Fair snalysis com-
parison of tax deferred, tax tiee and taxrible inyestments requires very care-
iul handling of the after-tax analysis income tax considerations.
For investors in all tax brackets the tax deferred aspects of investments in
a traditional individual retirement account (IRA), tax deferred annuities
and
pension plans create very complex and competitiye alternatives with many
other taxabie income aiternatives liom earnecl interest in bonds or CD's or
taxal-.le income tiom investment opportunities. The Roth IRA is somewhat
inverted to a traditional IRA. With traditional IRA'S' initial investments up
to the limit amount are deductible from ordinary taxable income in that year
and r,, ithdrawals after age 59Vt ate taxed as ordinary income' With a Roth
lRA, initial investments are not tax deductible and withdrawals aftet 59Vz
are not taxed. In fact, you can withdraw the equity invested in a Roth at any
time and not be subject to tax or penalties. Below is a summary of some of
the principal features differentiating a Roth IRA from a Regular IRA as of
late 2000:
628 Economic Evaluation and lnvestment Decision Methods

Traditional IRA

up to $2,000 may be invested annually with all federal income tax


deferred until withdrawals are realized beginning at age 59y2.
with few exceptions, any withdrawar prior to age siyzis subject to a
l0% penalty in addition to the ordinary income tax due on the amount
withdrawn.
a Mandatory minimum distributions enforced at ageTOr/2.
a No contributions allowed after age 70y2.
a For anybody other than a spouse that might inherit an IRA, the amount
of the IRA may be subject to both estate taxes and ordinary income
tax on any subsequent withdrawals from the account.
In qualifying to contribute to a traditional IRA individuals and married
couples are subject to constraints on their Adjusted Gross Income
and
any participation in an employee sponsored retirement program.

Roth IRA

up to $2,000 may be invested annually, but deposits are not deductibre


in the year incurred so the annual amount deposited is subject to state
and t-ederal income taxes each year. This is probably the only signifi-
cant drawback of a Roth, relative to a traditional IRA.
Investors may withdraw r00vo of the accumulated investment (equity)
at any time and not be subject to any penarty or tax. only the accrued
interest or wealth must remain in the account.
while intended for retirement, after five years you may elect to with-
draw up to $10,000 for down payment on a new home. This is
nor sub-
ject to any penalty or other tax. This could make opening
a Roth for
children earned income very desirable.
A child with earned income can invest each year in a Roth IRA the
lesser of their earned taxable income for the year or
$2,000 (in the year
2000). If a child has no earned income for a year, then no Roth
IRA
deposit can be made. However, the deposit to a Roth IRA could
come
from a gift from parents or grandparents and still qualify provided
the
child's earned income really exists! For children under lg the creation
of a Roth IRA will require a custodial account and proof of income
such as check receipts, w4 or w2 forms. Each brokei will likely
have
their own proof of income requirements to establish the account.
After 5 years, at age 59vz any amount may be withdrawn from a Roth
tax free. No limitations exist.
Chaoter 12: Personal lnvestments and Hedging 629

o There are no mandatory minimum distributions at70t/2.


o Contributions may continue to be made after age 70Y2 it you have
ermcd income.
c H,-.irs to a Roth account get a tax dedLrction for federal estate taxes
pard on any withdrar'vals the heirs make from the accoul1t.

Ttr cpraiify to contribute to a RothIRA single in.ii'. icii;;l" and tneri icd couples
arc subjecr to constraints on their adiusted gross inctrina. io. va1ic:''ls seenarios.

Decisions on whether you qualify for an Ili.A, and which account to


esttblish. can be ditftcult. Not because of time value of monev issues but
rnore due to the conrplexity of the tax code, estaie considerations. the flexi-
bility of anticipateil wittr,lrawals ciuring the retirement years' etc. This is
clearly an area whcre the financial and intangible considerations addressed
in C'hapter 1 are relet'ant.
'l-ite iirliori'ing example illustrates some of thc time value o1'nr.rney basics
f'or ihe different types ol savings alternatives you might be considering for
featirering your retirem3nt nest egg.

EXAMPLE 12-16 Traditional lRA, Roth IRA and


Taxable Savings Plans
Consider a 4Q-year-old individual with $2,000 of annual before-tax
salary that is being considered for investment. ASSume the first
deposit (investment) would be made one year from today. The
investor is currently in a 31% effective federal plus State tax bracket
but upon retirement 20 years from today, the corresponding tax rate
on ordinary income should drop to 18% as the income level drops.
Develop the appropriate time diagrams and compare the after-tax
future value that would be available 20 years from today by investing
the money in the following alternatives:
A) The individual opens a traditional IRA and invests the before-
tax salary in a conservative governrnent bond mutual fund that
is anticipated to earn 8.0% before taxes per year for the next
20 years. Tax on any income is deferred until the account is
liquidated which is assumed to occur 20 years from today'
B) The individual opens the same traditional IRA but invests the
before{ax salary in a growth fund that is anticipated to grow at
12.O"/" per year for the next 20 years before taxes.
530 Economic Evaluation and lnvestment Decision Methods

c) The individual opens a Roth IRA and invests the after-tax


money in a conservative government bond mutual fund that is
anticipa.ted to earn 9.0% before taxes per year for the next zo
years. Tax on any account accrued income is eliminated
by tax
code definition of a Roth lRA.
D) The individual opens the same Roth IRA but invests in a
growth fund that is anticipated to grow at 12.0% per year for
the next 20 years before-taxes.
E) suppose this individual can't qualify for either IRA and considers
investing the 92,000 of before-tax salary in the stock market.
The stock to be acquired pays no dividend and will hopeful grow
at the 12.0% average growth rate similar to the other fund. *ow-
ever, in this case, if the stock is sold afier 2o years, it will qualify
for long-term capital gains at an assumed tax rate of 1s%.
(currently stock investments made after year 2000 and held for
at least 5 years qualify for a maximum longterm capital gain tax
rate of 18.0%).

Solution:
A) Traditional lRA, Earning g.O% per year
with the traditional lRA, taxpayers have the ability to keep 1oo/o
of their tax dollars working until retirement 20 years from now
45.7620
F = $2,000(FlAg/".2g)
2 ......20 = $91,524
Year 20 ATCF = $91 ,524(1- 0. jg year 20 tax rate) g7S,050
=
Note: lf the Year 20 tax rate remained at 31%, ATCF
= 63,152
B) Traditional lRA, Earning 12.0% per year
Again, with the traditionar rRA, taxpayers have the abirity
to keep
100% of their tax dollars working until'reiirement
20 years from now.
- g2,ooo g2,ooo . . $2,ooo 72.0524
F = $2,000(F/A12y.,2g)
2 ......20
= $144,105
Year 20 ATCF = $144,105(1 0.1g year 20 tax rate) g11g,166
- =
Note: lf the Year 20 tax rate remained at 01%, ATCF gg,432
=
Chapter 12: Personai lnvestmenis and Hedging 631

C) Roth lRA, Earning 8.0% Per Year


The disadvantage of the Roth IRA is the loss of available dollars
working for you due to income taxes - until retirement 20 vears from
ncw For an investor r,vith an anticipated tax rate of 31.0%, the after-
tax income available to invest would be:

v.?af 1-20
Ta;<able Saiary 2,000
- income Taxes @ 31% - 620
After-Tax Salary (ATCF) 1,390

$1,380 . $1,380 45.7620


$1,380
F = $1,380(FiAg..z..29)
c 1 2......2A = 963,152
\ear 20 ATCF = $63,152
Note tnis result is identical to the case A traditional IRA result for a
31% tax rate in year 20.

D) Roth lRA, Earning 12.0o/o Per Year


Again, the only change in this analysis from case c is the increase
in the annual interest or rate of growth for the account as follows:

- $1,380 $1,389_:!180 72.0524


F = $1,380(F/A1 Z"/",20)
2 ......20 = $99,432
Year 20 ATCF = $99,432
This result is the same as the case B traditional IRA result for a
319i, tax rate in year 20.

E) Ordinary Taxable lnvestment in Common Stock


The disadvantage here is that not only is your salary still taxable,
but now the gain realized 20 years from today would also be taxable
at the applicable long-term capital gains tax rate assumed to be
15.09'. for this example.
632 Economic Evaluation and lnvestment Decision
Methods

Year 1-20
Taxable Salary 2,000
- lncome Taxes @ 31% - 620
After-Tax Salary (ArcF) 1,390

$1,380 $1,390. $1,390 72.0524


0 2........20 = $Lil3f^12/",20)
Year 20
Stock Sale Value 99,432
- Stock Book Value -27,600
Long-Term Capital Gain 71,932
- lncome Taxes @ 15% -10,775
Net lncome 6'1,057
+ Stock Book Value 27,600
ATCF 88,657

Note that due to the doubre taxation of sarary


and stock appreci-
ation, the after-tax value of this opportunity is oiminisned
relative
to investing in either the traditionar rRA or the Roth
rRA.
Looking back at cases A, B, c and D you can see
that the biggest
impact has more to do with the forecasted tax rates
and the timing of
withdrawals at retirement. lf tax rates are held the
same, the same
after-tax cash flow is generated with each alternative.
Forecasted
higher future tax rates would favor the Roth while
lower future tax
rates favor the traditionar rRA as iilustrated in this
"*u*pr".
For investors who feel that it is reasonable to expect
to be able to select
common stock investments analogous to those listed
in Section r2.2 with the
potential to grow at l2vo per year or better in the
foreseeable future, common
stock investments are very competitive with conventional
and municipal bond
investments for long term capital accumuration
purposes. However, as the eco-
nomic "gloom and doom" advocates continually remind
us, an economic crash
worse than any seen since 1929 could be just around
the corner. Therefore,
maintaining a diversified in'estment portfoiio in the
highest quality common
stocks, bonds, real estate ancl other investments
of interest p.ouauty is best.
Chapter 12: Personal lnvestments anci Hedging 633

12.7a Life Insurance Alternatives

There are two primary sitr-rations where an individual nray need life insur-
ance. The first situation is when a person has dependents such as a spouse
aird cirildren that financiaill'sutler it'the person died withrut Iit'e
"r'ould
in'umnce. Tire second situation is lvhere a relativc-ly u,ealthy and oldc'r per-
son hus a sisniticantly large estate tied up in illriluid assets and thcrefo;e,
u,'irnts to lear.e the estate enough cash flow to cover estate ta\es upon death.
A significant tax consideration related to iit'e insurirnce is that beneficia-
ries owe no inconre tax on policy values received upon death of the
insured. There may, however be estate tax. By handling the establishment
of a life insurance policy and payment of policy premiums in a legally
appropriate manner, the beneficiary may avoid estate tax as well as income
tax upon death of the insured. Good legal counsel is necessary to achieve
this objective.
By far the most common need for life insurance relates to a person want-
ins to leaye their spouse arrd children in reasonable financ:ial shape if uner-
pected death o1'the person occllrs. It is important to keep in rninci in this sit-
uation tliat the insurance deiith beriefit is the rteeded co!erage for this
siiu:"rtion. Accumulating a casir value in the iusurance policy is a secondary
consiCeration.
There are tu,o basic ty'pes o1' tife insurance policies with many variations
of euch: ll terni insuriinc'e. and 2) whole life. ordrnarl, Iife. or universal lite
insurani:c. f'errn insurance is pure insurance on the insured's lit'e with no
cash value accrued at any tirne during the policy. Whole life, ordinary life
and universal life insurance involve a combination of insurance and a sav-
ings plan that has a future after-tax value. Therefore, annual premiums are
greater for whole life type policies than term insurance. Whole life and
ordinary life insurance policies generally have uniform annual premiums
over the policy life and specified cash values at different future points in
tirne. Universal life insurance is a modern day variation of whole life insur-
:
ancc. "Ihe key difference is lvrth universal lif-e insurance policies you can
I
vary vorlr premiums from year to year. Of course this alfects your death
il
benefit and cash value from year to year rather than having fixed benefits
l
and cash values as with whole life insurance.
The least expensive life insurance is term insurance. If the primary objec-
tive is to provide insurance death benefit to beneficiaries upon unexpected
death, term insurance is best in most situations. For those under 50 years of
age, buying term insurance and investing extra dollars elsewhere in stocks,

-&-
634 Economic Evaluation and lnvestment Decision
Methocts

bonds or real estate usually wil give greater


future cash varue than paying
higher premiums annuaily ror a wrroie rife, ordinary
life or universal life
type policy. This generauy is true even considering
tax
cash iarue is";;;;;;;;;
accrued interest component of whole life poricy
deferred. For
either term or whore rife policies, paying extra
premium for increased acci_
dental death benefit often makes r"nr", iir""
un"*pected death by accident
is a major reason for life insurance.
quantitativery evaruate the economic differences
.To between term and
whole life type insurance policies, you must
compare insurance premiums
and cash values for equal levers of inru.un."
over the same period of time.
Incremental analysis of the difference in values
for whole life versus term
insurance gives the incremental varues that
the incremental ir.r;";
mium costs generate for whore life versus term
insurance.
;;;:

EXAMPLE 12'17 Term versus whore Life rnsurance


Anatysis
consider a 35 year ord person wanting g250,000
of rife insurance
over.the next 30 years. Under a universh rife poricy,
tnat coverage
can be obtained for beginning of year premiums
of $1,600.00 per
year' At the end of.{?"f th; rump
_3o, sum cash varue of the poricy is
estimated to be $162,150.00. Assuming a lump .r, *itndrawal is
made at the end of year 80, taxes wourd
be owed on the difference
between the cash varue and the cumurative premium
pay-ments over
30 years (30 . $t,699 O0 g4g,00.). The atternative
= is to acquire
guaranteed renewabre term insurance
with premiums increasing
every ten years. with beginning of period premiurn
payments, tne
payments are estimated to be
$329.00 at years 0 through 9. At years
10 through 19 the payments are expecteO
to be $Ot6.00 p", y"ur.
and those premiums wiil increase to
91,346.00 at years 20 through
29. Assume a 3s.07o effective federar prus
state tax rate for an after-
taxcash flow analysis.
Chapter 12: Personal lnvestments and Hedoino
63s

Solution:
Whole Life:
-$1,600 -$1,600 -$1,600 -$1.600 -$t -$1,600 -$1,600 $1 62,1 50
1. 9 '10. . 19 20, ,29 30
'':- -. ,,.^ .
l:tt,t.

-$328 -$328 -$328 -DO lO -$61 6 -1,346 -$1,346 $o


'1. '10. . 19 20. 29 30
Vi;bole Life-Term:

-$1,272 -$1,272 -$1,272 -$984 -$eB4 -$254 -$254 +$162 150


.9 10. 10 2A 29 30
Before-tax, lncremental BOR = g.O{oio
,Assuming the cumuiative sum of the 30 universal life premiums
will
be deductible against the year 30 cash vaiue of $162,i50, the after-
tax cash flow at year S0 will be:
Year 30 CF - $162,1S0 - ($t62,150-g48,000)(C.35 tax rate)
= $122,'198
Tlris gives after-tax DCFROR of 7.21% on the incremental premium
investments. lf the z.T1% after-tax incremental investment is com-
petitive with other opportunities for investing capital now
and in the
iuture over the next s0 years, then acceptance of the incrementar
universai life policy investments is indicated.

12.7b Home Purchase Versus Renting


one of the most common major investment decisions that people face in
their working careers is deciding whether to rent or buy , ..rid"n.". Many
factors affect this decision. From an intangible viewpoint, most people
want
their o*'n home. on the other hand, if you travel a lot, not having to worry
about h.me maintenance may override the satisfaction of home ownership.
If you expect to move in a year or t$,o. renting and not having to worry
about selling your home to move may be perceived to be a big intangibrl
benelit regardless of economics. As discussed earlier in the text, a combina-
tion of intangible and financial factors along with economic considerations
usually impact investment decisions. Although the importance of intangible
and financial factors is recognized, a proper analysis of renting
versus buying a home should be done. ""ono*i"
636 Economic Evaluation and lnvestment Decision Methods

Economic parameters that need to be accounted for in a valid after-tax


rent versus buy analysis include, but are not limited to:
,; ,:,i
. Home purchase price, inclusive of all financing and closing fees,
points. etc.
. Projected ownership life
. Estimated future sale value
. Sale commission to be paid
. Initial equity required to purchase
. Loan amount*
. Loan interest rate and mortgage payments
. Cost of annual property taxes
. Cost of annual homeowners insurance
. Cost of annual maintenance and upkeep costs
. Annual rental expense for an equivalent prope(y
* Anrtual salary income times three is
a basic rule of thumb for determining
the maximum amount you can borrow on afirst home mortgage.

Tax savings from allowable deductions needs to be taken into account in


a proper after-tax analysis. However, atter selling, under year 2000 tax law,
if you have lived in a home for two of the past five years, a single person
may be able to exclude home sale gain up to $250,000 and a married couple
rnay be able to exclude $500,000 of gain. you cannot realize this tax benefit
more ofteii than every two years. If you sell for a loss, you may be able to
deduct the loss as business loss. check with a good tax accountant for pos-
sibilities in that regard.
If you buy a home and finance it at least partialry with a loan, the annual
borrowed money interest component of your mortgage payments is tax
deductible as an itemized deduction. Also your property taxes are
deductible as an itemized deduction so tax savings from these deductions
must be taken into account.
If you arg renting and not itemizing deductions, taxpayers take a standard
deduction ($7,350 for married couples in 2000) against income to determine
taxable income. Itemizing deductions after purchasing a home would result
in incremental benefits for those deductions in excess of the standard deduc-
tion. Rental payments are not tax deductible if you rent, so after-tax rent
costs equals the before-tax rent cost. A rent versus buy analysis is illustrated
in Example 12-18.
Chapter l2 Personal Investments and Hedging 637

EXAMPLE 12-18 Home Purchase Versus Rental


A five year life present worth cost of home service is to be made
by a married couple to compare purchase of a $150,000 home with
renting. The purchase cost would be covered with $30.000 cash
er:uity and a $120,000 thirty year loan at 10.0% interest per year.
Assurne yearly end-of-year mortgage payments for simplicity.
Assume the loan will be paid off at the end of year 5 when it is esti-
niated that the horne will be sold for $180,000. 47.0% real estale
saies commission is estimated to be paid on the sale value. Annual
property taxes are estimated to be $1,500 in year 1, escalating $50
per year through year'5. Annual house insurance is estimated to be
5500 with annual maintenance estrmated to be $1,000. Horne main-
tenance and insurance costs are not allowable itemized deductions,
but the home loan interest and pro.perty tax v''rill be taken as itern-
ized decjuctions for federal and state income tax calculation pur-
poses in iieu of using the married joint return standarci deduction of
57,350. Assume the individual ef{ective federai plus state tax rate is
30.0% Assurne that the year 5 sale value of $180,000 less real
estate sale commission is not taxable per current tax law. The cou-
ple assumes that other places exist to invest money at 10.0% per
year after-taxes and that the risk in those investments is equivalent
tc investing in the home. lf the couple rents, assume end-of-year
annual rent ccsts of $12,000 in years 1 and 2, $13,200 in years 3
and 4, and $14,000 in year 5.

Solution:
Home Purchase Cash Flow Analysis
Annural 30 year mortgage payments = $120,000(A/P1O,3O) =
$12,730. These annual mortgage payments break down into annual
interest and equity principal amounts each year shown in the cash
florry calculations.
638 Economic Evaluation and lnvestment Decision Methods

Year
4
-llor]9a,9e_tnterest _12,000 _11,927 _11,6a7-_17561651
- Property Tax -1,500 :llso_Looo _i:ffi _;:;;,
Taxable lnc.
vrvv
-Tax @ 30o/o 4,OSO 4,043 4,0g4 4,OZZ 4,00g
r I

*:]]::-"i" -e,4s0 _e,4s4 _e,41s _g,s86 _eJA


- lnsurance _500 _S00 _500 _500 _500
- Maintenance *1,000 _1,000 _1,000 _1,000 _1,000
- Principal -rc} _803 _gg3 _g72 _1,069
+ Loan Amount 120,000
- Purchase price -15o,ooo -114'543
+ Sale Value
180,000
- Commission
-12,600
CashFlow 30,000 _11,680-1 ,tgt _11.296 _11,8;B ;0Sg5---
Purchase Present Worth Cost @ 1O.0"/":
30,000 + 11,680(P/F1 g,1) + 11,ZSZ(plF
p,2) + 11,796(piFt0,g)
+ 1 1,858(P lF p,4) - 4O,9gS(p/F1
9,5)
= $41,862

Hental Cash Ftow Analysis


Year
Annual Rent = CF 0 -12,000 -12,000 _13,200 _1azOO _14lOO
Rental Present Worth Cost @ 10.0./":
1 2,000 (P / A p/A g,2) / F
1 O,Z) + 1 3, 200 ( 1 e 1 O,Z) + 1 4, 400 ( p/F g, 5 )
1
= $48,700

Th9 smaller present worth cost of 5 years of


..
"purchase,"
housing service is
so purchasing is the economic choice. That"concrusion,
however, negrects the facl that itemizing tax
deductions causes ross
of the married joint return standard ded-uction
of $7,350 fin zOOO;. tt
deductions are itemized, in addition to home roan
interesi ano prop_
erty tax, several other costs can be deducted
such as annual auto
ownership taxes, state income tax and charitable
contributions.
Assume the ricense taxes and state income
tax and charitabre deduc_
Chapter 12: Personal lnvestments ano Hedging 639

tions would be $2,200 per year. so the dtfference in the $7,350 stan-
ijard deduction and $2,200 is a foregone $5,150 deduction if a home
is bought and deductions are itemized. A $5,150 deduction in each
o{ years 1 through 5 would save $5,150(0.30 tax rate) or $1,545 per
5iear in tax savings. The present worth of these tax savings is
$i,545(P/A10,5) = $5,858. lf the present worth home purchase cost
is increased hy the 55,858 opportunity cost from foregone tax sav-
ings due to itemized versus standard deduction, the adjusted present
v,,orth purchase cost is $47,720, which is closer to the $48,700 rent
nresent worth cost. Carefully accounting for all costs, revenues and
tar effects along with the proper timing of these items is very impor-
tant to all analyses, including home purchase versus rent analyses.

12.7c Personal Auto Purchase versus Lease


Inciividuals do not get depreciation tax deductions or lease payrnent
expense deductions on personai automobile costs. Interest pzrid on money
borrr-rrved to finance personal autos is not tax dcductible under current tlx
larv in i993. Therelbre. the after-tax cost of providing automobile service is
the same as the before-tax cost for purchasing with cash, purchasing with
bonowed money, or leasing. This is very difl-erent than the business analysis
c'f auto lease versus purchase analysis presented in Exampie 10-2 where the
t,rr savings fiom depreciation and operating lease payments were taken into
,rccount as allowable tax deductions. The following example illustrates sev-
elal decision criteria that can be used to evaluate the leasing versus purchase
ol a personal automobile. These techniques are the same for all types of
vehicles.

EXAMPLE 12-19 Personal Aulo Purchase Versus Lease


Three alternatives are being considered for the personal use of a
luxury automobile over the next 36 months based on actuai lease
cost and purchase cost data. The manufacturer's suggested retail
price (MSRP) is $71,850.00. When applicable, the year 3 salvage is
estimated at $0.50 on the dollar, or $35,925.00 for the base cases A
& B (realized at the end of the 36th month). The alternatives follow:

(A) Purchase the car with cash now, at time zero, for $71,850.00.
640 Economic Evaluation and Investment Decision Methods

(B) Purchase the car by putting 20% down at time zero and
bor-
rowing the remaining g0% of the,MSRP at an annuat
interest
rate of 10% compounded monthry. The roan wiil be paid
off in
36 end-of-month payments, starting in month one.
For both (A) and (B) the sarvage varue is as stated
earrier.
(C) Lease the car with beginning-of_month payments of g977.g1
and an additionar 10% of the MSRp when you pick up the
vehicle at time zero.
The minimum rate of return is 12h annuar interest compounded
monthly. Assume all insurance and operating costs
will be the same
for each method of financing, so they can be omitted
in the anarysis.
use present worth cost and incremental rate of return or Npv
to
determine which alternative of financing is the economic
choice.
lhen, since few peopre pay the MSRP-*n"n acquiring a vehicre,
determine the break-even purchase price for arternativel
would make you indifferent between purchasing or teasing.
t & 2 that
All other
criteria remain the same.

Solution:
(1) Present Worth Cost
A) Cash C=971,850
Salvage = $3S,g2S
0. . .. .. .36
0.69892
PWC = 71,850 - 35,925(p lFft",SA) = g46,741.12

B) Borrow 80% at 10o/o par annum compounded rnonthly.


20% Equity c=$1a,!Zg--c=$'t,854.72. . . . c=$1r8-54.r2
s^ru.=$35,92s
0 t .......36
where: 0.43227
Loan Payment = [0.8(71,8S0)](A/p0.8333%,30)
= $t ,BS4.7Z

30.1075 0.69892
PWC = 14,370 + 1 ,854(P/A1 g5,925(p lF
%,36) - fl.536) = g45,1 02.28
t
I
I
Chaoter i2: Personal lnvestments and Hedging 641

I C) Lea:e
LP=$977.81
I
I
I C=$7,185 LP=$977.81 .

{ 0 1 .......35 36
,!
29.4086
FWC = B,'tO2.B1 +9ZZ.B1(p1A1"7",g5) = $Qgr9lg,Bl

Sensitivity of PWC Results to Discount Rate Changes:


Nominal Cash Borrow Lease
Discount Rate PW Cost PW Cost PW Cost
0% $35,295 $45,2'15 $42,386
4% 39,981 45,322 40,415
J/O 40,9'19 4s,323 39,946
6% 41,829 45,316 39,487
10/
l/o 42,712 45,300 39,039
8% 43,568 45,275 38,597
9% 44,399 45,243 38,165
10% 45,203 45,203 37,741
11% 45,984 45,156 37,326
12"/" 46,741 45,102 36,919
I OO/
tJ /o 47,476 45,A42 36,520
14% 48,189 44,975 36,1 28
15% 48,879 44,903 35,745
20% 52,036 44,463 33,934

(2) lncremental Analysis


Borrow-Lease:
AC=$6,207 AC=$876:91 AC=$876.91 . . . AC=$1 ,854.72 L=$35,925
0 1 35............36
AROR = -4.6ok, therefore reject borrowing al 10"/o
Cash-Lease:
AC=$63,687.19 5=$977.81......5=$977.81 L=$3s,9zs
0 'l .......35 -
36
AROR = 4.31"/" < 12/" so leasing is economically preferable
642 Economic Evaluation and lnvestment Decision
Methods

.9i1." leasing is preferred to both forms of purchasing:


what is the break-even cash purchase price it otn"er
opportunities
exist to invest your money at 12% before taxes?
PW Cost of leasing = $36,919. Let X the
= break-even cash purchase
price.

0.69892
X - 0.5X(P lF 1%,e6) = $36,91 9

X =$!9191 This break-even price is Z9o/o otthe MSRp.

Leveraged Break-even:
0.03227 30.1075 0.69892
o.2X + 0.8X(A/P0.833s%,s6) (PtA1y",s6)
- O.sx(p/rit;) = 36,e1e
0.6285X=36,919; X=$gql11
lf the dealer wanted a 15/" return on his or her
investment, based on
the given one time front-end payment, the monthry
r"are payments
and the finar salvage value, whai is the dealer
cost basis in the vehi_
cle?

28.2079 0.6394
7, 1 85. 00 + 977 .81 + 977 .81 (p I A
1 .25%, 35) + 35, 925.00( p /F l .ZS"7",SA)
= $qel1g.2?

Section 12.8 Summary of Selected Investment


Terminology
American-style options: an option that may be exercised
at any time from
the date of purchase until the eipiration
date.
At-the-money: an option whosi strike price equals
the market price of the
underlying security.
Bearer bonds: (also known as coupon bonds) were
not registered. These
made grandparents famous for "cripping coupons.,,
Pol9r SJ, the owner or
holder of a bearer bond had inrerest (frorn the -"oupor.
d"p;;irc; at a bank)
income not easily traced by the Internal Revenue
Service. Bearer bonds are
no longer issued today.
rriapter 12: Personai lnvestments and Hedging
643

ltonds: are promissory notes of a corporation or government enlity.


uall option: an oprion con[acr that gives the holder the right to buy a speci-
fied iimount cf an underlying security (stock, commodity. iia"*. interest
rate,
elc. ) at a specitied price istrike price) for a specified period
of time (expira-
il:'l t;;lte':.
f-lall privileges: are insiruments incluciecl in most colporate
and municipal
ilr-riid.. This gives the issuer ol'the debt the riglit to .uil th. bond
before the
ricirruirl maturity date. If execured, call privileges usuallv reduce
the yield rrn
ir L',i'iid Ierurri ibr it-s holder.
conimon stock: represents an ownership interest in a corporation or business.
common stock index: is a measure of value for a group of stocks. Some of
the nrore notable indexes would include the Dow Jonei Industrials (DJIA),
Nlsciaq, Nasdaq 100, S&p 500, Fortune 500, NYSE Composite,
Russell
lOixi and the list goes orr. Indexes are traded in the markets today much like
an\' ,)titer stock and may offer some trading advantages.
corrrertible debentu.cs: may be exchanged by the holder for common
sl.ouk or another security of rhe.same company in accordance
with the terms
i'f the issue.
cunrulati'e preferred stock: includes a provision that states if one or more
dividends are omitted, the omitted dividends must be paid bcfore any
divi-
,-iends may'be paid on the company's
common str:ck.
current assets: :re convertibie into cash within a year in normal operations.
Llebcntures: :rre simiiar to bonds with tire exceprion that they are backed
onli' by the general credit and name of the issuing company und nut by any
specific assets of the company. As such, clebentures .ur.y *o." financial
risk than bonds and as a result, generally offer slightiy higher yierds
depending on the issuer.
Deep discount bonds: see ,,zero coupon bond."
Derivative: a security whose value is derived in part from the value and
characteristics of an underlying security. put and call options and futures
contracts are examples of financial derivatives.
Dol'ntick: is a term used to designate a trlrsaction made at a price less
tlran the preceding trade.
European Style options: an option with a limited exercise window during
a specified period just prior to expiration.
Equity options: put or call options related to an individual common stock.
Even-tick: is a term used to designate a transaction made at a price equal to
the preceding trade.
Exercise: to execute the right entitled to the holder of an option.
644 Economic Evaluation and lnvestment Decision Methods

Exercise price: the price at which the option is to be


executed. Also known
as a strike price.
Expiration date: the date at which an option contract becomes
null and
void or a futures contract is to be exercised.
Fixed assets: are assets that in the normal course of business
will not be
converted to cash within one year.
Futures contracts: are legal contracts to buy or sell a
specified amount of
some commodity at a specified price for delivery at
a future conffact expira_
tion date.
Hedging: a strategy to limit the loss or capture a gain from
movement in
the value of a security, currency, index, interest rate
or commodity.
Holder: the buyer or purchaser of an option.
rndex options: options related to an index representing group
a of
common stocks such as the Dow Jones Industrials
Average. oltions rerated
to the Dow are known as DJX options many other
well.
- ind-ex option, exist as

Indenture: is a written agreement under which bonds,


debentures and pre-
ferred stock are issued, setting forth the interest
or dividend rates, maturity
dates, call dates and other conditions such as
conversion terms, sinking fund
requirements and so forth.
In-the-money: is a term^rerated to the option premium.
A car option pre-
mium is in-the-money if the strike price is less than
the current market
price of the underlying sec-urity. a put option premium
is in the money if
the strike price is greater than the .u.."rt .r*.t price
for the u,derrying
security.
Intrinsic value: the actual physicat value of an option if
exercised. AIso
defined as the amount by which an option premium
is said to be ..in-the-
money."
Junk bonds: are issued by highry reveraged corporations that may have
questionable assets backing them as collateral.
Leaps: Long-term equity anticipation securities
are options with a rife of 2
to 3 years or basically, long-term options.
Long position: an investment whoie holder believes
the underlying security
is likely to move higher in the future. In options, the
number of contracts
bought would exceed the number of contracts
sold.
i\rargin: the cash an investor must deposit in a reveraged
account, the actual
1lount is typically compured daily by the brokerl Margin can also be
defined as the equity capitar that, when ctmbined
with the b-orrowed money,
will cover the cost of an investment.
L;rrapter' 12: Personal Investments and Hedging 645

llrrnicipal tronds: are issued bv a state, city or county * the interest is


eirher wholly or partially exempt from t'ederal and or state income tax.
l*rked call option: is a call option for which the writer does not own an
rurrir.,alent position in the underlying security for the options he or she has
\':rilall.
(iptiorr bul'er: is also knou,n as the holder. The buyer is the person obtain-
irrg tiic rights conveyed by the call option for a fee c:rlled a premium.
r:t {)xlers:
1. I :i ;'i..

.\li-or-none: is an order to be executed in its entirety, or not at all.


l)ay: is an order to buy or sell a stated amount of a security that, if not
executed, will expire at the end of the trading day.
Fill-or-till: is a market or limit order that is to be erecuted in its entirety
as soon as it is represented to the trading crorvd, or not at all.
Good-tilt-Canceled: is au order to buy or seli wirich remains in effect
urrtri either executcd or canceled
Limit: is an order to buy or sell a stated amour)t of a security at a speci-
fied irrice, or at a better price after the order is presented to the trading
crowd.
[Iarket: is an order to buy or sell a stated amount of a security at the
most advantageous price obtainable when presente-d to the trading
crorvd.
Stop: is an order to buy ar or above a specified price (the "stop" plice), or
to sell at or below a specified price (the "stop'' price). Once the stop
price level is realized, the order becornes a market order.
Out-of-the-money: is a term related to an option prenritrm. For a call
option, the premium is out-of-the-money if the strike price is greater than
the market price of the underlying security. For a put option, the premium is
said to be out-of-the-money if the strike price is less than the market price
of the underlying security,.
Participating preferred stock: holders of this stock are entitled to any
stated dividend and also to additional dividends on a spccified basis upon
plrl: lrlent of dividends on the comrnon stock of the company.
Pre{'erred stock: represents a special class of stock that does not represent
an orvnership interest in the company. Preferred stock dividends are t1'pi-
cally paid at a specified rate.
Premium: is usually described as the price per unit of an option contract.
For equity options, the premium is expressed per share. Each option con-
tract controls 100 shares, so, 100 times the premium gives the value of one
equ i1"1, option contract.
646 Economic Evaluation and lnvestment Decision Methods

Price Earnings Ratio: financial measure of performance


based on the fol-
lowing formula:
P/E Ratio = Price of Common stock / Earnings per
share of common Stock
Earnings refer to the frnancial "net income; generated
for a given period.
some analysts base earnings on the most recently reporteJ
+ quarters,
while others look forward at the forecasted next + quari"r,
of antlcipated
earnings.
Put option: an option contract that gives the holder the right to
sell a speci_
fied amount of an underlying r".uiity or asset at a specified price
(strike
price) for a specified period of time (expiration date).
Registered bonds: are uniquely different from bearer bonds
in that the bond
is registered by the issuing corporation or government in
the name of the
owner or holder. This information is then provided to
the Internal Revenue
Service. All bonds issued today are registered.
short position: the number of common stock shares sord short at given
a
time. Although short se[ers usualry are negative concerning
prospects for
ltock price, analysts often consider a high short position in'a stock to be
bullish for stock prices because shares ,old ,ho.t must eventuaily
be repur-
r.-hased which may drive rhe price higher.
short sale: invorves selling a stock that an investor may not own,
with the
expectation of being able to buy it back later at a lower price.
sinking fund: holds money set aside regularly by a company or govern-
ment entity to redeem bonds, debentures or preferred
sto& in accordance
with the indenture.
Speculative value: see time value.
spread: involves the simultaneous purchase and writing of options
on the
same underlying security. These options may have difierent
strike prices
and or expiration dates. The purpose of a spread is
to minimize risk and also
create the possibility for increased profits above that possible
by simply
owning the underlying security.
Straddle: involves the simultaneous purchase and sale of the
same number
of calls and puts with identical strike prices and expiration
dates.
Strips: see "zero coupon bond.,'
T"rr.I.:ylance: a pure form of life insurance in rhe sense that the poricy
provides life insurance only over a limited number
of years into the future
and is not in any way a savings plan.
Time value: the portion of an option's premium that is speculative
and
related to the amount of time remaining before an option
expires. Time
value will diminish to zero as an option approaches
its e;piration orr".
Chapter 12: Personal lnvestments and Hedoing 647

'freasury bills (T-hills): are securities issued by the U.S. government with
lives ranging from three to six months. In the past, one-year t-bills have also
been avaiiirble but they are scheduled to be phased out in early 2001 due to
ine declining U.S. debt.
1'reasurl'notes: are secr:rities issued by the U.S. government with lives
tl:;. rii.i ii ;.il ()lt j t., fit e vj.lfs.
'lrtlasurl bonds: are securities issued by the U S. governrne::t with lives
r:rrgine 1i'trn fir'e to thirti,' yeilrs.
i.,'rriversal Iille insurance: see whole life insurance.
[lp-tick: is a tenn used to designate a transaction made at a price higher
than the preceding trade.
\Yhole life insurance: (also known as universal life) this involves a combi-
nation of term life insurance and savings plan that has a separate after-tax
vahre.
ll'r-iting a covered call: a strategv by which a perion writes (or sells) call
opliclns while simultnneously orvning the undcrlying secr,rrit';. The rvriter
receil'es the premiu:n frorn the buyer of the cell.
lVriting a covered put: a strategy by rvhich a person sells put options and
simuitaneor,rsly creates a short sale position in an equi'ralent ntlmber of
shares in the underlying security. The u,riter receive-q the premiurrr from tlie
b,.r-ver of the puts.
Yield: the compound interest equivalent of stock dividends per share
dir idecl b1' the prurchase pricc of the stock (aiso i:rrown as a dii'id'-'rtd yielJ)
or. in the bond market, the annual interest divided by the purchase price
(commonly known as current yield).
Yield to maturity: is the bond markets definition of the nominal com-
pound interest rate of return being received on a bond investment if held to
maturity with or without call privileges.
Zero coupon bonds: also known as "deep discount bonds" or "strips,"
these bonds pay the owner a single lump sutn of money called "maturity
villue" at a future time referred to as the bond "maturity date." Zero coupolt
hilrriis do n()t pay interest atrnually or semi-annuelly like norinal registered
bonds and therefore, are sold at a discount to the bond maturity value
(maturity'i,alue may also be referred to as "face value").

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