• Author / Uploaded
• Ashlesh Mangrulkar

Citation preview

The Galaxy Dividend Income Growth Fund’s Option Investment Strategies

FM1 Assignment

Ashlesh Mangrulkar B18014 (Section A) 08-OCTOBER-2018

Name : Ashlesh Mangrulkar

SID: B18014

Section A

Introduction The Galaxy Dividend Income Growth Fund is a closed end mutual fund (funds listed on the stock exchange and traded throughout the day) offering investment opportunities to different institutions in the US. The fund has traditionally generated income through 2 primary routes : a.) Investing at least 75% of its total assets in the equities of firms that paid dividends to its existing shareholders, planned to increase the dividend payout and had the capability to undergo capital appreciation. b.) Invest in equities that at present were not paying dividends to their shareholders, but near term growth potential was bright and would eventually pay out dividends in the long run. The Fund has paid dividends of $0.40 annually per share even when returns have been negative. To meet this, it has even recommended cash distributions that exceeded income generated through some return of capital. The management has proposed that the Fund can engage in options trading. The directors have requested for a pilot study of potential profit and losses from selective options trading. Two stocks in the fund’s portfolio : JPMorgan Chase & Co. and Facebook, Inc. have been selected for the study.

Name : Ashlesh Mangrulkar

SID: B18014

Section A

Financial Problems 1. Low Yield financial environment since the 2008 financial crisis has affected the traditional investment returns for the Fund. The Fund has found it increasing difficult to meet its level cash dividend policy of $0.40 per share annually. It has even recommended payouts that have exceeded its net investment income resulting in return of capital. The Fund has to decide on an options strategy to boost its incomes by buying options or by earning premiums by selling or writing options. The Fund is already being traded at a discount of 12% from its NAV. It has $1.25 billion in assets and 117 million shares, resulting in NAV of $10.68. 2. Analyzing volatility of underlying asset and rigid dividend policy The Fund has a policy of giving out dividend of $0.40 annually since its inception. Despite factoring market volatilities and fluctuations it hasn’t historically deviated from its performance. This creates a stress on asset value and fund managers are pressurized to generate high returns which can be difficult in bearish market. The Fund had to resort to using its capital to sustain the policy. An alternative to exploring new investment channels can be to make dividends a function of market movement. Through derivatives trading, the Fund is increasing its exposure to the volatility of the stock prices. In volatile markets, writing an option becomes more attractive than buying options.

3. Calculating risk/reward payoff which is dependent on risk appetite. Each options strategy has an associated payoff. Conservative investors, for example, do not invest in naked calls ( writing call options without owning the underlying security) and invest in covered calls. Depending on the stock biases we might go bullish, bearish or neutral. The Fund traditionally has shown a preference in companies that pay dividends to shareholders. In the case, we have 2 companies, JPMorgan Chase & Co. that has historically paid dividends and Facebook, Inc. that has a higher P/E ratio.

Name : Ashlesh Mangrulkar

SID: B18014

Section A

4. Deciding on an options strategy for the Fund for generating higher risk adjusted returns through returns and premiums. There are 2 key aspects when trading options on stocks : strike price and maturity time period. To be able to calculate future payoffs the Fund should be able to predict with reasonable accuracy the share price on maturity of JPMorgan Chase & Co. and Facebook, Inc. The options premium will be decided by the maturity period. There is also an opportunity to generate returns through any arbitrage opportunity due to a mismatch in put-call parity that may exist in the market. The Fund can also earn income through premiums by writing call options that are worthless at time of maturity. Options are useful to hedge risk if the Fund should want to protect its investment, for example by investing in call options to hedge risk against bearish market trends.

5. Information on market ‘Events’ that can affect the short term and long term outlook An event can significantly affect the volatility of stock price and its value. Market events such as regulations announced by the Govt. or change in treasury rates ( esp. in case of banks) or company events such as new product launches, annual/quarterly earnings report or sector -specific regulation need to be studied. Past financial performance might be soft indicator of future performance but any analysis on predicted maturity price should take events into account. For example, higher dividend in one quarter might affect the stock price bullishly but also result in increased volatility of asset value. Events can be categorized as marketwide or stock-price events.

Name : Ashlesh Mangrulkar

SID: B18014

Section A

Analysis and Interpretations 1. Analysis of JPMorgan Chase & Co. and Facebook Inc. a) JPMorgan Chase & Co. Since 2009, JP has shown stable operating and net incomes. It has paid regular dividends to its shareholders. In 2014, it is projected to pay an annual dividend of $1.52 per share, in line with existing trends. The stock price hasn’t shown significant variability and returns per day is between -$0.04 to $0.04. The Price to Earnings ratio had shown a decrease in 2012 but has bounced back since then. The financial firm has strong fundamentals and is not highly volatile. The stock has performed well in 2013 ( lowest stock price ~ highest stock price in 2012) and investors will prefer to go bullish on this stock. b) Facebook, Inc Facebook went public with its IPO in 2012. It hasn’t paid any dividends to its shareholders and is not projected to pay any in the foreseeable future. The stock is subject to high volatility, by analyzing the daily stock price returns. One particular instance had a return of 29.61% return. The business model of Facebook is fairly robust and is globally poised to be the next big thing, but since it’s a fairly new company its stock price is subject to misinformation and conjecture. Its P/E ratio should stabilize in a few years, as should its net income and revenue, because it leads to significant unpredictability for investors. Most investors would prefer to hold Facebook’s stock and go long, with a call option to hedge their investment.

Options Strategy The Fund has conventionally favored higher investment in dividend paying firms. The same will be followed here. The aim is to increase risk adjusted performance of the fund, and increase income through call writing to support its cash dividend payout policy.

Name : Ashlesh Mangrulkar

SID: B18014

Section A

Facebook, Inc. Covered Call : A covered call strategy is useful to generate steady income from a stock that is already owned, while safeguarding the investment. It also limits the amount of gains that can be made. Through covered calls we sell a call option at a strike price above the current stock price. The following situations may occur hence :

Profit/Loss

a) The stock price increases above the strike price : In that case the buyer of the call will exercise his right to the option and purchase the stocks from us. At maturity, our income will be limited by Profit = Amount made by writing call + (Strike price of Call - purchase price of stock)*no. of shares b) The stock price remains neutral or falls below the current traded price: The buyer of the call will not exercise his right to buy shares and it will become worthless. Our income will be restricted to the premium earned from selling the call. However, the capital has depreciated in this case on our investment in the stock. Profit = Premium made by writing call

Stock Price Strike Price

Profit/Loss Bull Buy Write Spread Strike 1 Strike 2 Stock Price 60 65 50 -0.15 55 -0.15 57.74 -0.15 60 -0.15 62.5 2.35 65 4.85 68 4.85

Name : Ashlesh Mangrulkar

SID: B18014

Section A

JPMorgan Chase & Co. Bull Call Spread In case of this stock, we expect a moderate increase in the price of the stock, hence we will purchase a call option at a strike price and write the same number of calls at a higher strike price. The following cases may occur: a) The price of the stock falls below the 1st strike price : The maximum loss is made and is equal to the price of premium paid for the 2 calls. b) The price of stock is between the 2 strike prices : The total payoff is equal to difference of the 2 calls and the profit made from selling the stock at a higher value c) The price of stock exceeds the 2nd strike price : The total payoff is maximized at the 2nd strike price. Any movement above the 2nd strike price is forfeited.

Profit/Loss

Strike Price 2

Strike Price 1

Stock Price

The profit/loss for this analysis is given below Bull Spread Stock Price 50 55 57.74 60 62.5 65 68

Name : Ashlesh Mangrulkar

Profit/Loss Buy Write Strike 1 Strike 2 60 65 -0.15 -0.15 -0.15 -0.15 2.35 4.85 4.85

SID: B18014

Section A

Recommendations The Fund is operating on some rigid criteria which have been set by its board of directors. It seeks to supplement its income by trading in options. The recommendations are : 1. The Fund doesn’t have significant expertise when it comes to options trading, and hence for different stocks under its portfolio it will have to devise a separate strategy for each stock based on its business fundamentals. It will have to invest in developing the intellectual capital to develop some level of expertise in this regard. In case of Facebook, Inc. it is a volatile stock compared to JPMorgan Chase & Co. which was offering dividends regularly to its shareholders. 2. To prevent return of capital, the Fund can effectively change its dividend payout criteria, w.r.t market performance. Rather than forcible sticking to a fixed payout plan, it can tie it with market performance, thus rewarding shareholders when markets perform above expectations. 3. Since the stock price is trading below NAV, the Fund is inclined to take bold steps to improve its performance, but such a knee-jerk reaction is undesirable. It could try to improve its performance by changing its investment model of 75%-25%. In case of IPOs though no dividend is paid, the Fund can take advantage of the market movements in its favor. 4. The Fund can benchmark its performance with other closed end Mutual Funds that are operating in the same market and compare the returns it offers w.r.t to them. It can adopt their best practices.

Name : Ashlesh Mangrulkar

SID: B18014

Section A