Stock or Call Option in the Case of General Electric (GE)

Stock or Call Option in the Case of General Electric (GE)
Student Name
Registration Number
Course
Date
Executive Summary
Financial trading is one of the common cash flow streams for many people, especially now that we are in the technology and internet era. Financial trading is the business of investing in a company’s stock, those that are listed in the Exchange market. Companies move to the stock market as a means to gain financial muscles. Investors on the hand gain access to cash flows in terms of dividends and from the sale of the shares. There are many theories that guide financial traders into making informed decisions. The trading market is run on the assumption that information is free-flowing and everybody can access it. Financial experts have come up with different theories and financial derivatives that aid in the decision making in order to reduce the risks of making loses and increase the chances of making profits. General Electric is one of such corporations that are listed in the stock exchange giving investors different channels to make investments and speculate on the profits they make. There are two fundamental approaches to the stock market. These are options and underlying stocks. These approaches have different factors that determine their viability to an investor. General Electric has been facing challenges in the stock market and investors are keener on how they invest in order to ensure that they do not make losses on their principal investments. The future of the company seems bright, giving investors the hope that they will continue making profits from informed trading with the company’s stock. Compared to other companies, GE may not be the best stock to invest in to make quick returns, but many investors depend on trading to make other type of investments including on the underlying stock to receive dividends.
Table of Contents TOC \o "1-3" \h \z \u Executive Summary PAGEREF _Toc526856308 \h 21.0 Introduction PAGEREF _Toc526856309 \h 42.0 Literature Review PAGEREF _Toc526856310 \h 42.1 Option Pricing Theory PAGEREF _Toc526856311 \h 52.2 Capital Asset Pricing Model PAGEREF _Toc526856312 \h 72.3 Stock valuation theories PAGEREF _Toc526856313 \h 93.0 Research Methodology PAGEREF _Toc526856314 \h 123.1 Case Study Method (General Electric) PAGEREF _Toc526856315 \h 123.2 Data collection PAGEREF _Toc526856316 \h 134.0 Presentation Findings PAGEREF _Toc526856317 \h 174.1 Analyzing the data PAGEREF _Toc526856318 \h 174.2 Reflection on the findings PAGEREF _Toc526856319 \h 185.0 Implications, Recommendations and Conclusion PAGEREF _Toc526856320 \h 19References PAGEREF _Toc526856321 \h 20
Stock or Call Option in the Case of General Electric (GE)
1.0 Introduction
General Electric (GE) is a multinational conglomerate headquartered in Boston, Massachusetts. The company, whose current Chairman and CEO is Mr. John L. Flannery, was founded in 1878 by Thomas A. Edison (GE, 2018). The company is involved in many markets with some of its major investments being in renewable energy, aviation, transport, healthcare, and oil and gas sectors employing more than 300,000 people. General Electric is listed in the New York Stock Exchange, creating the opportunities for millions of people to invest. This paper will discuss the financial derivatives at the company and conclude the best investment path to take as far as GE is concerned. Being listed in the New York Stock Exchange, General Electric provides investors with the opportunity to invest and make profits either from the sale of the shares or from receiving dividends at the end of a financial year. Every investor has to make a market analysis of the company they are looking to invest their money in so that they do not make losses on their investments. The analysis is aided by some financial derivatives that aim at making the right market projections. Some of the most common financial instruments being used by investors are call options and underlying stocks. Financial experts have, therefore, come up with theories that aid investors in making decisions on the best financial instruments to use so that they make profits on their investments.
2.0 Literature Review
When an investor is making decisions on their trading options, they ought to understand the different market factors. There are three major theories that financial experts have come up with to aid in the decision making in order to achieve profits in the market. These theories include the option pricing theory, capital asset pricing model and the stock valuation theory. Investors use these theories to evaluate the financial strategies and make informed decisions that will enhance the profits and minimize their risks.
2.1 Option Pricing Theory
This is one of the most common theories in use in the stock market globally. Options are financial instruments that are used by investors mainly for hedging purposes and speculating stock prices. Options are traded on the national options exchange. An example is the Chicago Board Options Exchange. Every option that is listed makes a representation of one hundred shares of the specific company stock (‘Options Basics,’ 2017). The option pricing theory refers to any financial model that thrives on acquiring the fair value of an option (‘Options Basics,’ 2017). Most of the times, the fair value of an option is based on the stock price in the exchange market. However, many factors affect the value of an option that an investor needs to take into consideration. These factors include the stock price, time of expiration of the option, volatility, interest rates, and cash dividends paid (‘Options Basics,’ 2017).
An option provides the holder with the right to buy or sell an already specified amount of the fundamental asset at a fixed price (Kallianpur & Karandikar, 2001). This price is referred to as the strike price, and the holder must exercise the right to either buy or sell on or before the specified expiry date of the option. There are two types of options; call options and put options. Call options give a buyer the right, but not the obligation to buy a certain amount of the underlying asset, mostly stock, at the specified strike price before the expiry of the option. A call option is said to be in the money when the share price it will fetch in the market is above the strike price. Put options, on the other hand, give the buyer of the option the right to sell the underlying asset at the strike price on or before the expiration of the option. A put option is said to be in the money when the share price is lower than the strike price.
Options are only exercised when the investor is making profits from the strike price. When a person exercises their right to sell or buy the underlying asset, in this case, stock, they can then resell them at a higher price making profits. The profit from options is commonly referred to as the intrinsic value (Staff, 2018). Options have to have two sides, the buyer and the seller who come into an option contract that can be exercised at or before the expiry date. This paper will dwell mostly on call options as a financial tool for investors. When a buyer shows their interest in buying an underlying asset, then they come into a contract with the seller. This contract gives the buyer the right to exercise their right, and they have to pay a premium in order to acquire this right (Staff, 2018).
When an investor buys a call option, they usually have made speculations that the value of the asset will appreciate before the expiry of the option. When the price of the asset increases, the buyer can then buy the asset at the lower strike price and resell it at the higher price that they will fetch in the market. This means that an investor has to consider all the factors that affect the prices of the option before they commit in the contract (Sebastian, 2017). When the value of the asset decreases, the contract is dismissed, and the buyer loses the premium they had paid to the seller, and this means that they make a loss in the long run. The sellers of the call options, therefore, count on the price of the asset going down so that they can keep the premium and make their profits from them, this is because the right by the buyer was not exercised.
Financial analysts use call options in their portfolio to reduce the amount of risk. This is because if something happened and the price of the underlying asset falls below the strike price, they will only make a loss on their premium. If the price goes up, which is what they count on, the will make profits since they will exercise the contract at the strike price. The financial tool is also used for hedging. When the right analysis is done, call options are used by traders to hedge their resources. The amount of profit that one can make when the price of the asset goes up within the expiry of the option is immense. American options are the best when it comes to hedging since the buyer can exercise their right at any time on or before the expiry date.
2.2 Capital Asset Pricing Model
This is another financial model that is used by investors especially in the stock market. According to an article by the Harvard Business Review (1982), Capital Asset Pricing Model (CAPM) is an idealized portrayal of how financial markets attach prices on securities determining the expected returns on capital investments. According to the article, the model provides investors with a methodology of quantifying risk. Investors then turn the risk into reasonable estimates of expected return on equity (Mullins, 1982). This method is used by traders to make estimates on costs that aid them in making judgments on the kind of investments that they will partake.
The Capital Asset Pricing Model was initially developed in the year 1952 by Harry Markowitz and later incorporated by financial experts including William Sharpe (Mullins, 1982). It is a financial model that works around the relationship between risk and return of the investor. In most instances, the model is used to determine risks in high-risk scenarios. In essence, the theory argues that the returns from an investment should be equal to the rate on the risk taken including a premium. If an investment does not match the expected return or higher than the expected return, then it is not a worthwhile investment. An investment that an investor should put their money into ought to exceed the expected return or at least match it otherwise the investor will be making a loss.
The theory can be summed up in a formula (ACCA, n.d)
E(ri) = Rf + βi(E(rm) – Rf) where:
E(ri) is the required return on a financial asset
Rf is the risk-free rate of return
 βi refers to the beta value of the financial asset
E(rm) refers to the average return on the capital market,
According to the above formula, the required return on a financial asset is equal to the sum of the risk-free rate of return and a risk premium as earlier discussed. A risk premium is a premium that an investor is entitled to as a result of taking the risk of investment. In this case, where shares are the financial assets in question, the average return on the capital market is the required return of equity investors. Equity investors are the investors who invest in shares expecting to earn a dividend at the end of a financial year. When an investor buys equity, they are entitled to own a part of the company, and as such get a piece of the returns, the company gets from its day to day running, at the end of a financial year.
The theory puts into consideration that an investor needs to get compensation on the time value of money and the risk (Abonongo & Ackora-Prah, 2011). With time, the value of money increases. This is because we put into consideration that the money could be invested somewhere else and attract some interest. This is why the investor ought to get compensated for the period that they have decided to make their investment. This makes the investment worthwhile. Risk, on the other hand, means that the investor ought to get compensated for putting their investment under the risk. The risk-free rate is defined using the yields on items such as government bonds, such as the US Treasury bonds.
In applying the CAPM theory, the beta value is readily found in financial sites. Beta value is an indirect measure which compares the systematic risk associated with a company’s shares with the systematic risk of the capital market as a whole (ACAA global). This means that beta is the comparison between the return rates of a certain investment, shares, compared to the returns of the whole stock market. An example is, if a particular stock has a beta value of 1, then the return on the stock will increase by a margin equal to 10%. This only works when the capital market as a whole makes a 10% increment.
2.3 Stock valuation theories
Stock valuation theories are theories that are used in the financial markets with the sole purpose of finding the “current worth of an asset.” This kind of financial analysis dwells on finding the intrinsic value of an asset, in this case, stock, by discounting the future cash flows to the present (Trainer, 2011). In the analyses, the future growth and earnings of a company are compared to the current price of the stock to determine whether investing in the company is worthwhile or not.
Stock valuation theories put into consideration a company’s future growth projections since the projections are factored into the stock price during trades. It is imperative that an investor analyzes the financial derivatives to determine what stock to invest in. There can be two scenarios in this kind of analysis. A stock of a certain company can either be undervalued or overvalued in the stock market, severely at times. Making the wrong decision, or investing without making the...