Finance and Financial Management

ASSIGNMENT 2010-2011
Ahmed Kamal Pasha
Darshan Bhinde
Kaustubh Manohar
Pranal Rai
Rony George
Chiao-Wen Chang

MBA FULL-TIME
BHREAC
 TABLE OF CONTENTS

QUESTION 1............................................................................................................................... 3
PART A..................................................................................................................................................... 3
PART B..................................................................................................................................................... 5

QUESTION 2............................................................................................................................... 7
PART A..................................................................................................................................................... 7
PART B..................................................................................................................................................... 9

QUESTION 3............................................................................................................................. 11
PART A................................................................................................................................................... 11
PART B................................................................................................................................................... 11
PART C................................................................................................................................................... 12
PART D................................................................................................................................................... 13

QUESTION 4............................................................................................................................. 14
PART A................................................................................................................................................... 14
PART B................................................................................................................................................... 14
PART C................................................................................................................................................... 16
PART D................................................................................................................................................... 17
PART E................................................................................................................................................... 18

BIBLIOGRAPHY....................................................................................................................... 19
Question 1
Part A
Millions
Selling price per unit 16.00
Direct manufacturing cost per unit 3.50
Stock % of next year's sales anticipated 0.20
Overhead Charges (% of revenue) 0.10
R&D cost already incurred 1.50
R&D cost required 0.30
Cost of new production facilities 10.40
Tax % 0.30
Space Rent per month 0.10

PROFIT & LOSS ACCOUNT

Millions 0 1 2 3 4 5 6 7
Revenues 4.00 4.80 4.80 4.80 4.80 4.80 4.80
Fixed costs -0.14 -0.14 -0.14 -0.14 -0.14 -0.14 -0.14
Direct Manufacturing Cost -0.88 -1.05 -1.05 -1.05 -1.05 -1.05 -0.84
Capital Allowances -2.08 -2.08 -2.08 -2.08 -2.08
Overhead Charges -0.40 -0.48 -0.48 -0.48 -0.48 -0.48 -0.48
Cost of Stock -0.06 -0.06 -0.06 -0.06 -0.06 -0.06
Space Rent -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10
Capital Gain/Loss NEW 0.50
Capital Gain/Loss OLD -0.60 0.00

PBT -0.60 0.35 0.89 0.89 0.89 0.89 2.97 3.74

Tax(30%) 0.18 -0.10 -0.27 -0.27 -0.27 -0.27 -0.89 -1.12

Capital Gain/Loss -0.42 0.24 0.62 0.62 0.62 0.62 2.08 2.62

CASH FLOW STATEMENT

Millions 0 1 2 3 4 5 6 7
Outlay -10.40 0.50
Working Capital -0.30 0.30
Fixed costs -0.14 -0.14 -0.14 -0.14 -0.14 -0.14 -0.14
Direct Manufacturing Cost -0.88 -1.05 -1.05 -1.05 -1.05 -1.05 -0.84
Cost of Stock -0.06 -0.06 -0.06 -0.06 -0.06 -0.06
Capital Gain/Loss NEW 0.50
Opportunity cost for space rental to someone else -0.06 -0.06 -0.06 -0.06 -0.06 -0.06 -0.06
Opportunity cost for resale of old eqiupment -0.60

Revenues 4.00 4.80 4.80 4.80 4.80 4.80 4.80

PBT -11.30 2.87 3.49 3.49 3.49 3.49 3.49 5.06

Tax 0.18 -0.10 -0.27 -0.27 -0.27 -0.27 -0.89 -1.12
NCF -11.12 2.76 3.22 3.22 3.22 3.22 2.60 3.94
PVF(14%) 1.0000 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996
PV -11.12 2.42 2.48 2.18 1.91 1.67 1.18 1.57
NPV 2.30
IRR 0.22

Net Present Value 2.30

Internal Rate of Return 0.22
 Year Cummilative NCF Cummilative PV Cummilative DCF
0 -11.12 -11.12 -11.12
1 2.76 2.4223878 -8.6976
2 3.22 2.4800985 -6.2175
3 3.22 2.175525 -4.0420
4 3.22 1.9083383 -2.1337
5 3.22 1.6740262 -0.4596
6 2.60 1.1841044 0.7245
7 3.94 1.5736248 2.2981

Discounted Payback Period 5.1 years

Underlying Assumptions

 £1,500,000 is already spent on R&D and so it’s considered as sunk cost

 £300,000 further required in R&D is the working capital

 The new equipment bought for £10,400,000 will be sold at the end of project for
£500,000 i.e. capital gain

 The old equipment already under company ownership will be used as nothing is
mentioned regarding the efficiency / productivity of the old machines. However, as these
machines can be sold today at £600,000 therefore there is an opportunity cost attached
to this, hence will be considered as part of cash flow in year 0.

 The old equipment will have no worth at the end of 7 years

 The space being used for manufacturing has an opportunity cost of £60,000

 Overhead charges are not included in the cash flow statement as these charges are an
internal transaction and there is no real cash flow.

 Similarly the space charges are not included in the cash flow statement as there is no
real or incremental cash flow in or out of the company.

 The stock level maintenance is considered as a working capital

Interpretation of NPV, IRR & Discounted Payback Period

Net Present Value [NPV] is a measure of the profitability of an investment, expressed in

current pound terms. Since the NPV is positive in this case, it is feasible for the company to go
ahead with the project because a positive NPV interprets into the venture being successful and
bringing in surplus profits after covering all project related costs. The outcome of this venture
can bring about growth for the company in the medium and possibly the long term. Such news if
made public can have a positive effect on share price of the company.

Internal Rate of Return [IRR] is the rate at which the NPV is zero. If the IRR is greater than the
required rate of return, the project can be implemented as planned. In this case, the IRR (22%)
is greater than the required rate of return (14%), implying that the investment can be accepted.
The Discounted Payback Period is the number of years if takes to recover the initial
investment into the project keeping in view the time value of money. In our case, the life of the
project is seven years and the payback is happening in a little over 5 years, which is again a
positive sign in favour of accepting the investment.

Part B

We have performed sensitivity analysis for this investment proposal by changing each
determinant variable, keeping all others constant. These variations allow us to identify the key
factors that drive the NPV upwards or downwards. Sensitivity analyses involve estimating a
range of inputs for each of the factors and noting the resulting changes on the NPV.
The factors we used to perform our sensitivity analysis are as follows.

 Unit sale price

 Quantity of sales
 Discount Rate
 Initial outlay

From the graphs below, it is evident that the NPV increases if the unit price of the product is
increased and vice versa. Also, as the discount rate increases, NPV decreases and the cut off
discount rate below which the NPV will become 0 wherein the project must not be undertaken
has been identified.

NPV vs PRICE

18

17
Price (million)

16

15

14

13

12
-1.000 -0.500 0.000 0.500 1.000 1.500 2.000 2.500 3.000 3.500 4.000

NPV

NPV vs QUANTITY

2.4000
2.2000
Quantity (million)

2.0000
1.8000
1.6000
1.4000
1.2000
1.0000
-2.0000 -1.0000 0.0000 1.0000 2.0000 3.0000 4.0000 5.0000

NPV
 NPV vs DISCOUNT RATE

22%

20%
Discount Rate

18%

16%

14%

12%

10%
-2.000 -1.000 0.000 1.000 2.000 3.000 4.000 5.000

NPV

NPV vs INITIAL OUTLAY

14
13.5
Initial Outlay (millions)

13
12.5
12
11.5
11
10.5
10
9.5
9
-1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4

NPV

That being said, there are also certain limitations while considering undergoing a sensitivity
analysis. A notable limitation would be the correlation of underlying variables being considered.
For example, the increase in unit sales price would be a result of increase in manufacturing
costs or inflation. In such scenarios, a prudent judgement needs to be taken and under such
circumstances, break even analysis might be an alternate solution that can help identify break
even discount rates, unit prices or outlays more effectively.
Question 2

Part A
i. Assumptions behind using various dividend models and fair value of share

1) From the data listing earnings and dividends, we see that the growth in earnings
and dividends is not spread evenly over the five years. Hence there has been
change in the dividend policy and the payout ratio over the five years with the
discretion of the management. This implies that the growth rate of dividends is
not constant till 2015 and the fair value of Trebanos’ shares would have to be
calculated using the ‘Specified Holding Period model’ rather than the just the
‘Constant Rate of Growth model’ mentioned below.
2) It also mentioned that the company is anticipated to maintain a constant growth
rate of 6% at the end of five years for the foreseeable future. Since the company
definitely plans to hold the shares for more than a year after 2015, we can
assume the dividends and earnings will grow at a constant rate into the future
post this year, calculate the expected dividend for year 2016 using the
‘Constant Rate of Growth model’ and further use this dividend to calculate the
price of the stock at the end of year 2015.
3) Finally, this price will be used in the ‘Specified Holding Period model’ to get the
present value of Trebanos’ shares.
4) The two models being used are illustrated below.

‘Specified Holding Period model’ to calculate fair price of Trebanos’ shares:

P = D + D + D + D + D .+ P
0
1
1
2
2
3
3
4
4
5
5
5
5
(1+r ) (1+r ) (1+r ) (1+r ) (1+r ) (1+r )
Where Dn = dividend for year n
r = required rate of return
P5 = Share price at end of year 2015

‘Constant Rate of Growth model’ to calculate price of share at end of year 2015:

P 5 =
D6
r −g
Where D6 = dividend for year 2016
r = required rate of return
g = constant growth rate (6% in this case)
5) The required rate of return can be calculated by using the Capital Asset Pricing
Model (CAPM) shown below.
ER= R+ß( ER-R)
ER= 5%+ 1.2(13%-5%)
ER= 5%+ 8.4%
ER= 13.4%
 Calculations:
Based on the above assumptions, we start by calculating the expected dividend
for year 2016 and use that to calculate the share price at the end of year 2015.

D6 = D5 (1+g)
= 3.50(1+0.06)
= 3.71

P5 = 3.71/ (0.134-0.06)
= 50.135
Substituting these values in the ‘Specified Holding Period model’, we get the fair
value of Trebanos’ shares.
∴ P=0
0 . 60
1
+
0 . 90
2
.+
1. 80
3
+
3. 0
4
+
3 . 50
5
+
53
5
(1+0. 13) (1+0.13 ) (1+0 .13) (1+0 .13) (1+0 .13) (1+0 .13)
Value of Trebanos’ shares
 Po = 32.88

ii. Discussion on required information to suggest appropriate share price

Share prices can be determined using various methods.

Earnings based valuation: As evident from the above calculations, the dividend
model will help determine the price of the stock. Also Earnings per share can help
determine the price of the shares. With the earnings provided and price calculated,
we can identify the PE multiple. But the PE multiple by itself would not be sufficient
to make a calculated decision. The PE ratio of another company in same industry, if
provided, would help to make appropriate comparisons.
Beta & CAPM method: The risk free rate, market rate and beta are provided. Beta
is over 1 and indicates that this is an aggressive stock. It basically suggests the
sensitivity of the stock as compared with the market. Using the Capital Asset Pricing
Model (CAPM), we can calculate the expected rate and determine if it is higher as
compared to required rate of return and determine the share prices.
NPV methods or Cash Flow methods: share prices can also depend on the NPV
of the companies. Using the NPV method share prices can be determined. EBITDA
is a measure that gives the free cash flows or actual profitability. It can be a good
measure to determine the share price
Demand and supply: At any given point in time, the value of the share can also be
determined by the supply and demand of the stock.
Stock splits, Rights issue, and Bonus shares: Additional information like stock
splits or rights issues would definitely impact stock prices and could be included in
the analysis to determine the appropriate price of the shares.
Financial Leverage/Gearing: It has been mentioned that the company is completely
financed by equity, but there is no mention if in the future the company intends to
issue debt. Issuing debt will also increase financial leverage and have an impact on
the price of the shares.
Part B
Discussion on PE Ratios

The P/E gives an idea of what the market is willing to pay for the company’s earnings. The
higher the P/E the more the market is willing to pay for the company’s earnings. Some investors
read a high P/E as an overpriced stock and that may be the reason for the high value. However
it can also indicate the market has high hopes for this stock’s future and has bid up the price (for
example, a massively high P/E is sometimes the result of a rumoured acquisition). It may also
reflect an industry in bad shape, where the share price is being supported by small shareholders
reluctant to face reality - retaining their holdings in the hope of better times. The PE ratio has
units of years, which can be interpreted as the number of years of earnings to pay back
purchase price. 

Each PE ratio when analysed independently is meaningless. P/E ratios must be viewed in
relation to comparable companies, the overall market and historical data. It would not make
sense if we compare PE ratios of companies in different industries as the earning power of
these companies may differ due to different natures of their businesses. Also the perception of
the market to pay the prices for stocks in different industries differs as risk involved in different
sectors may vary. Hence for our analysis, we decided to choose each of the four companies
from different industries.

(All PE ratios are in USD terms)

P&G – 16.81
A PE Ratio of 16.81 implies that investors are ready to pay $16.81 for each dollar of the
company earnings. This seems to be overvalued as it is greater than its peers in the consumer
goods industry (Johnson & Johnson – 12.63). Unilever (competitor to P&G) has a PE ratio of
15.42. So P&G seems to be a good buy as compared to Johnson & Johnson but Unilever may
be a better option. A low PE ratio is considered a good sign but it is also necessary to analyse
other factors that may be driving the price of the company.

Amazon- 65.7
Amazon also enjoys relatively high PE ratio as compared to Apple (19.4) & EBay (22.9). The
high PE ratio implies that investors expect better future growth & earnings for the company.
Currently Amazon still has a very small slice of retail market. It has fairly how competition and
has good growth opportunities in the E-commerce sector.

CITI Group- 13.00

The current PE Ratio of CITI Group suggests that investors do not value this stock as much as
HSBC since for every dollar earned, they are willing to pay $13 whereas for HSBC, investors
are willing to pay $31. Also looking at the historical trend of the PE ratios, we see that the 5 year
high PE ratio for CITI was 48. Investors probably bought it when the PE multiple was 48 but are
currently sitting at losses.
Wynn Resorts, Ltd – 96.2 (Resorts & Casino Industry)
Currently the PE ratio of 96.2 may seem much higher than regional standards. PE ratios of
average US companies range between 12- 18. But when compared to PE ratios of its
competitors like Las Vegas sands, which has a PE ratio of 78.2 it may seem overvalued. If we
compare the current PE ratio with the PE ratio 52 weeks ago (420.4) it seems that PE ratio have
drastically dropped. There could various reasons that may drive the PE. In this case reasons
could be that since the share prices were relatively low 52 weeks ago, it might have been
viewed by some as undervalued stock and hence people were willing to pay more for the stock
resulting in the high PE ratio. The casino and entertainment industry are usually highly growth
oriented and hence we see higher PE ratios in this industry.

To conclude, PE may have varied interpretations. The factors that may drive PE ratios are
discussed below.

 Earnings calculation: The earnings considered in the PE calculations may be different

for different companies. Certain companies consider future earnings to calculate PE
while others consider current or past earnings.
 Accounting Methods: Earnings of companies may depend on various factors including
different accounting policies and the depreciation method used by the companies.
 Market Price of the Stock: Price of the stock can variably change due to many reasons
like market news or change in dividend policies or major announcements by the
companies.
 Sector: PE ratios also vary as per the sector or industry a company belongs to. Like PE
ratios of the casino industry is relatively higher and PE ratios in oil companies are much
lower.
 Growth Stage: PE ratios also vary depending on the different growth stages of the
organisation. PE ratios of new companies may be low in general when compared to
growth oriented companies.
Question 3
Part A
Analysis of terms of rights issue for Lloyds Banking Group

Number of shares issues by company before rights issue (N0) = 27.161 billion
Initial price per share (P0) = 91.50p
Initial value of the firm (V0) = £24.85 billion

Funds expected to be raised by the rights issue (F) = £13.51 billion

Subscription price for right (Ps) = 37p
Ps
Discount percentage = ×100
P0
= (37/91.50)*100
= 40.44%

Funds Required F
Number of new shares to be issued ( ΔN ) = =
Subscription Price Ps
= 13.51 billion/0.37
= 36.51 billion shares

Number of shares outstanding N0

Number of shares to acquire a right N ( R) = =
Number of new shares ΔN
= 27.161/36.51
= 0.74 old shares

Number of new shares ΔN

Terms of the rights issue = =
Number of shares outstanding N0
= 36.51/27.161
= 1.34 new shares

Initial Value + New Funds V0 + F

Ex-rights price ( Px )= =
Old Shares + New Shares N 0+ΔN
= (24.85 + 13.51)/ (27.161 + 36.51)
= £0.6025 or 60.25p

Theoretical Value of right = Ex rights price - Subscription price

= 60.25 – 37
= 23.25p

Part B
Illustration of neutral impact on wealth

Number of shares held by the investor = 720 shares

i) Exercise rights
Initial investment = 720 * 0.9150
= £658.8
 Number of new shares as rights = 720* 1.34
= 965 shares
Exercise of rights at 37p = 965 * 0.37
= £357.05
Total investment ≈ £1015
Value of new investment = (720 + 965) * Px≈ £1015
 Change in wealth =0

ii) Sell rights

Initial investment = 720 * 0.9150
= £658.8
Value of 720 shares following rights issue = 720 * 0.6025
= £433.8
Decline in value = £225
Proceeds from sale of rights at 23.25p = 965 * 0.2325
≈ £225
 Change in wealth =0

Part C
The possible reasons for employing three important perspectives of rights issues are discussed
below.

Use of deep discounts

1. Deep discounts (40.44% in Lloyds’ case) help ensure that market price of shares never go
below the subscription price of rights being issued. Ensuring this difference is a key
determinant in the success of the rights issue.
2. Since the capital to be raised is almost 55% of the initial value of the firm (£24.85 billion),
issuing rights at a conventional discount of 20% (resulting in a subscription price of 18.3p)
would result in the terms being 0.67 new shares. This would not be an attractive offering for
the current shareholders and so, a deeper discount is definitely required.

Use of underwriting
1. Deep discounting leads to a larger number of total shares with claims on the firm’s earnings,
dividends and assets leading to adverse reactions from investors who seldom differentiate
between real and nominal changes. Thus the presence of underwriters is necessary to
absorb such risks.
2. Also, deep discounting may be viewed by investors as a failure to arrange underwriting and
so, associations with large investment banks would help eliminate this fear.
3. From the underwriters’ perspective, this would be a golden opportunity to own a part of a
large banking firm like Lloyds and would be highly profitable in the long term.

High cost of underwriting

1. Underwriters normally charge a nominal fee of 2% of the proceeds of the issue. In Lloyds’
case, the price of issues was discounted by 40.44% and a fee of 2% would not be attractive
for underwriters to take on the risk of absorbing unsold rights. This clearly justifies the use of
higher than average fees.
Part D
The possible reasons for a positive market reaction and an increase in the price of the shares
over the period between the announcement of the issue and the release of the issue over are
discussed below.
1. If the share market foresees higher returns and thus higher profitability on the new capital
being raised by Lloyds due to prior information about investment proposals tied to this
capital, the share prices would increase as soon as the rights issue is announced.
2. Share prices fluctuate on demand and supply. If Lloyds’ shares were in high demand prior to
the announcement, the share prices would inevitably increase.
3. It could be argued that insider trading or leakage of information would spark speculation of a
possible increase in share prices. Also, the involvement of high profile underwriters in the
rights issue might stir public interests in favour of the company. These factors would lead to
increased trading and a proportional increase in share prices.
4. Share prices increase proportionally to an increase in the dividend payout ratio. A possible
step of this nature by Lloyds before the announcement of the rights issue would cause a
definite increase in share prices.
Question 4

Part A
Reasons why November calls trade at higher prices than September calls

In the normal market scenario, share prices rarely change drastically and would take time to
increase or decrease. Investors spend in buying option premiums considering that share prices
would change and profits can be booked. During the short span of an option’s life, there are
fewer chances that at the maturity date, the share price would change to such an extent that it
would trespass the sum of the option execution and option premium price. The longer the time
that a call has to run to maturity, the greater would be the scope for the price to drift above the
exercise price. Obviously a longer maturity period would give more time for prices to fall below
the exercise price; however potential gains and losses are not symmetrically distributed. There
are limits to losses but not to the gains. This suggests that the option premium is directly related
to market volatility and hence related to the time left to option maturity. The longer the maturity
date available, the more likely for investors to invest in options as there are higher chances of
making profit in long term options. Because of this reason, the premium prices attached to long
maturity options are generally higher than the short maturity options and hence the November
calls are trading on higher prices than the September calls.

Value of Call

Time Value

ST

Value of call premium α Time to option maturity

Part B

Comparison between Call, Put and Straddle Options

From the question,

Share Exercise Price X = 190

November Expiring Call Premium C0 = 50
November Expiring Put Premium P0 = 22

Call Option
 ST = X + C0
ST = 190 + 50 = 240

Profit/Loss

C0 = 50

240

X=190 Share Price

- 50

Put Option
ST = X - P0
ST = 190 – 22 = 168

Profit/Loss
+

P0 = 22

168

X=190 share Price

Straddle Option

For a profitable straddle:

ST – X > C0 + P0 OR X – ST > C0 + P0
ST > X + C0 + P0 ST < X – C0 – P0
ST > 190 + 50 + 22 ST < 190 – 50 - 22
ST > 262 ST < 118

When investing in the call option, the investor would receive gains only if the share price at
maturity will go higher than 240p.Consequently in the put option, gains would be attained only if
the share price goes below 168p. Investing in a straddle option, the investor will face a loss
when the share price is between 118p and 262p, else profits would be realized.

Profit/Loss

Put Call

168 240

118 190 262 Share Price

Exercise Put Cost = 50 + 22 Exercise Call

In an ideal world, predicting the direction of share prices is not easy; however it is much simpler
to anticipate whether the market will be stable or volatile depending on important market driving
factors. In this situation, investing money in either a call or a put is dangerous since the market
is unpredictable and might oppose the direction of investment with the investor ending up losing
the whole premium amount. When investors sense future volatility in stocks, they can adopt the
straddle technique to avoid losses and make profits. In a straddle investment, the investor
spends money in both the call and put options. Although more premiums are spent in a straddle,
it is much safer since if share prices shoot up, call options generate profits and when share
prices plummet, put options mitigate losses. However, investing in a straddle option is
questionable when the share price is predicted to be stable for a long period.

Part C
Reasons why options are considers are zero sum games

Options are considered as zero sum games in which one participant’s (writer/Investor) gain
result only from another participant’s (writer/investor) equivalent losses. The net change in total
wealth among both the participants will be zero, only the wealth shifts from one to another.
Profit

Investor’s Position

+C0

X ST

-C0

Loss Writer’s Position

The possibility of profits for both the investors and writers in a call option trading would be as
follows:

Share Price Investor Writer

If ST < X -C +C
If ST > X ST-(X+C) (X+C) - ST

From the above figure and profit/loss illustrations associated with call options for investors and
writers, it can be inferred that while investors attain profits through high share price at expiration
time (ST), writers would have losses in the same proportion. On the other hand, when writers
attain profit through low share prices at expiration time, investors will have the same losses
(premium amount paid to buy the call). It proves that the profit of one is the same as the loss of
the other and balances each other out. This justifies that options are zero sum games for
investors and writers.

Part D
Analysis for covered call using call option

Covered call is a method in which the writer of a call invests in the underlying asset to control
risk exposure. In this method, the risk for large losses is mitigated by the chances of high gains
on the shares being held. However the combined profits in a covered call is less than that
generated by investing in shares whose prices exceeds the exercise price plus the value of call.

Exercise Price X = 230

October Call Premium C0 = 18

Call Liability of Profit/Loss

Share Price of Net profit Profit/Loss
Exercise a Call at on covered
Price Call on call on share
Price expiry date call

210 230 18 0 18 -20 -2

In the above example, there is a net loss of 2p, considering that money has only been invested
in buying the call at an exercise price of 230p plus call premium of 18p.

Before applying the concept of the covered call, the writer would lose 20p in the transaction.
When the maturity share price is 210p, the total loss incurred would be of 18p. From the writer’s
perspective, the investor would lose the call premium, however the writer would have to pay 20p
as the current market price is 210p and as per the obligation, the writer has to pay 230p to the
investor, thus ending up in a 20p difference per share.

Using a covered call, the writer’s loss is decreased to 2p from 20p by capturing the profit from
the call premium, thus reducing exposure to apparent risk.
Part E

Reasons why buying and selling of options involves a high degree of risk exposure

Both buying and selling of options involve high degrees of risk exposure, though selling is riskier
than buying options. The risk involved in selling can also be compared to the risk involved in
futures trading where risks are seen even on high profit percentages.

As the seller of the options, the writer collects the premium from the buyer in exchange for
bearing the risk of either buying or selling the underlying commodity. As a buyer, the maximum
loss an investor can incur is the loss of premium if the share price at maturity period is less than
the execution price. However, losses for the option seller can be unlimited when the market
climbs sky high. The writer of a call option can lose more money than a short seller of that stock
on the same rise of stock price. This exemplifies how leverage in options can work against the
option traders.

Some of the major risks pertaining to buying options are:

 Risk of losing the entire investment in a relatively short period of time
 Risk created by specific exercise provisions of a specific option contract
 Regulatory agencies may impose exercise restrictions, which stops investor from
realising potential value

The risks pertaining to selling options are:

 Options sold may be exercised at any time before expiration
 Covered call traders forgo the right to profit when the underlying stock rises above the
strike price of the call options sold and continue to risk a loss due to a decline in the
underlying stock
 Call options can be exercised outside of market hours such that effective remedy actions
cannot be performed by the writer of those options
 Writers of stock options are obligated under the options that they sold even if a trading
market is not available or if they are unable to perform a closing transaction
 The value of the underlying stock may surge or ditch unexpectedly, leading to automatic
exercises
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