Victor and Maria Consider Hedging an Investment with Puts Victor and Maria Hernandez invested in 200 shares of Pharmacia Corporation common stock at $93 per share. They purchased the stock because the...

Victor and Maria Consider Hedging an Investment with Puts

Victor and Maria Hernandez invested in 200 shares of Pharmacia Corporation common stock at $93 per share. They purchased the stock because the company is testing a new drug that may represent a significant medical breakthrough. The stock’s value has already risen $8 in three months, in anticipation of the U.S. Food and Drug Administration’s approval of the new drug. Many observers believe that the price of the stock could reach $120 if the drug is successful. If it does not prove to be the breakthrough anticipated, the price of the stock could drop back to the $85 range, or even lower. The Hernandezes are optimistic but feel that they should hedge their position a bit. As a result, they have decided to purchase two nine month Pharmacia 100-share puts for $3 per share at a striking price of $93 per share. Ignore commissions when answering the following questions.

(a) What price would the Pharmacia stock need to reach for the Hernandezes to break even on their investment?

(b) How much would the Hernandezes gain if they sold the stock for $102 six months from now?

(c) How much would the return be as a percentage on an annualized basis?

(d) If the price of the stock dropped to $85 in six months, how much would the Hernandezes lose?