Case Background

 Owned by Galaxy Inc., this is a close-end mutual fund with an objective to generate
regular passive income for the investors. The fund distributed a quarterly dividend of
$0.10 per share in line with it objectives

 75% of the companies’ assets are invested in equities that pay dividends as well
potential for dividend growth and capital appreciation overtime. Remaining assets
were invested in equities with high short-term growth potential as well as possibility
of dividend payoffs in the long run.

 In the end of FY13, there was approximately $1.25 billion in assets-under-

management with 117 million outstanding shares. Thus the net asset value is $10.68
per share.

 In order to maintain a constant stream of dividend distribution, the fund routinely

disburses in excess of its quarterly investment income. This became difficult in the
recent years due to the low-yield environment prevailing post-2008 financial crisis.

 By the end of 2013, the shares of the fund were sold in the stock market at $9.40,
which is at a 12% discount on NAV.
 Challenges Faced by the Investment Fund

 Rigid nature of commitment- Most of the people who invest in the fund do it for
the sake of stable passive income. As such the focus of the organization is to ensure
regular level of cash flow to the investors regardless of market conditions.
Distributions in excess of investment income (as is evident in certain cases) can
jeopardize the long-term sustainability of business.

 Diminishing returns from stock markets – The market yield has been lukewarm
post 2008 subprime mortgage crisis. Most of companies whose equity is there in
the fund’s portfolio have faced drastic decline in revenues as well as liquidity crisis
due to past debts and loss of profits to service the debts. As such, all the companies
who previously paid handsome dividend in regular intervals cannot afford to
maintain the same level of payments sustainably. However, 75% of the fund’s
portfolio consists of equities which give regular dividends. Clearly, this strategy is
not playing out well post the crisis situation.

 Erosion of Net Asset Value of shares- As mentioned above, the fund is struggling to
earn quarterly returns to the tune of $ 0.1 per share for the investors. Furthermore,
the returns are paid on a quarterly basis (i.e. $0.1 per share per quarter) and not
annually ($0.4 per share). This implies that if the firm fails to earn the requisite
return of $0.1 per share from stock market, it will have to pay back part of the
capital to maintain the level of disbursement. This leads to erosion of assets under
management and consequently the Net Asset Value too. Furthermore, since the
assets under management decreases every quarter the company fails to earn the
requisite return, maintaining the level of return becomes even more difficult in the
subsequent quarter (due the decrease in funds).
 Slump in share prices in the stock market- The fund is increasingly finding it difficult
to maintain the desired level of performance. Coupled with the issue of erosion of
Net Asset Value, the shares of the company are increasingly losing its shine among
the investors in stock market. The crisis is at its helm in 2013, when the shares are
being traded at a 12% discount on its Net Asset Value. This reduction in market
capitalization manifests into two major problems. First, whenever the company will
be issuing new shares, they will be sold at a discounted value. This will result in
reduced cash inflow for the fund. Second, there will be credibility issues whenever
the fund house approaches a lender. Poor performance in the stock market will
prevent the organization from obtaining debt at a competitive interest rate as well
as terms.

 Lack of flexibility for fund managers- As of 2014, the fund managers do not have
the authority to either use financial leverage or to venture in the derivatives
market. By using financial leverage (e.g. issuing bonds), the fund can gain additional
funds to maximize the returns for the shareholders. Financial leverage has the
added advantage of tax shields as per US corporate income laws. However, it should
be noted that this strategy will pay off only when the return from the equity market
exceeds the interest rate and other costs incurred in obtaining the capital.
Venturing into options market can also potentially increase returns as discussed in
the case but they are also subject to market risks.
 Analysis and Interpretation

There are 117 million outstanding shares. According to company policy, our target is
to disburse $0.1 per share quarterly.

117 million shares X $0.1 per share = $11.7 million quarterly disbursement post
expenses and profits.

Annual payment target is 4 X $11.7 million = $46.8 million post expenses and profit.

If we buy call or put options, there can be two strategies: -

1. Exercise them at or before maturity only if the profit, not the payoff is positive
2. Sell those options if the market price goes above purchase price (of the option).

Exercising call options

If we buy call options (with a maturity date on March 22) on JP Morgan Chase
stocks on January 14, we will have to incur a cost of $790 per contract for a strike
price of $50 per share. Now if the traded price of the share rises above $57.90 we
can gain either by buying the stock at the exercise price or by selling the call option
before expiry.

Now, if we exercise the option we will have to incur a cost of $ 5790 per contract.
The company has declared a dividend of $ 0.38 per share payable on April 2, 2014.

Therefore, dividend income per contract = $0.38 per share X 100 shares = $ 38

Now let’s assume the Net Asset Value of the fund’s share remain constant i.e.
$10.68. Let us also assume we need to earn $0.13 per fund’s share. The additional
$0.03 per share is on account of the Galaxy’s profits and other expenses incurred.
No. of fund’s shares utilized per contract = $5790/10.68 = 542 shares (approx.)

Target investment income per share= 542 shares X $0.13 per share = $70.46

Gain required in excess of dividend income= $70.46- $38 = $32.46

Required capital appreciation per call contract= 5790+32.46= $5822.46

Therefore, if the market price of the share is above $58.22 we can achievement our
payment distribution target profitably.

Therefore, for the call exercise to be profitable the market price of the JP Morgan
Chase share needs to increase by 0.83% from January 14 to March 22, 2014.

If we take the same period in 2013 the value of the share increased around 7%. So,
exercising this option is not a bad decision. Similar returns can be gained by
exercising calls with a strike price of $40 and $45.

If the market price of the share is below the exercise price and we still choose to
exercise the option we will have a dividend income of $38 per contract. To have a
no profit – no loss situation the share price should not skid below $57.90-$0.38 =
$57.52.

Similarly, if we buy call options maturing at June 21 at a strike price of $50, we can
get the requisite return of $0.13 per investor’s share if the market price of the JP
Morgan Chase share is $58.46 on or before maturity. This implies a 1.25% increase
over January 14 prices. In the same period previous year, the stock witnessed
around 15% increase in market price. On the downside, to have a no profit –no loss
situation the price should not dip below $58.30-$0.38 = $57.92.

Similarly, we can take the same assumptions in case of Facebook call options. To
achieve the target gains the share price needs to be above $59.97 (for March 22
maturity) and $61.64 (for June 21 maturity). This translates to an increase of 3.86%
and 6.75% increase over January 14 closing prices respectively. The percentage
decrease in market prices in 2013 were around -18% and -24% respectively.
However, there were peaks before the maturity period. Hence the options can be
exercised before maturity as well (American options).

Exercising put options

Going by 2013 trends the volatility on JP Morgan Chase stocks is low. There has
been a consistent increase in the market price over the year. So, in this case buying
and exercising put option may not be a wise decision.

On the other hand, the market price of Facebook shares is highly volatile and were
declining till mid- July, after which the price increased somewhat consistently. If
similar trends continue buying a put option may or may not pay off depending on
the original purchase price of the shares.

Buying and selling options instead of exercising them

Let us assume that the market price of options increase/ decrease proportionately
with the change in the market prices of the underlying asset (since the options in
question are American type).

Let us take put option on Facebook shares with a strike price of $65 with maturity
on June 21. If we are to sell the option just a couple of days before June 21, we
have to ensure that the value is at least above $ 720 per contract. Furthermore, in
order to meet Galaxy’s target investment gain, the market price of the put option
should be $729 per contract.
 Recommendations

Based on the analysis of case facts, it can be safely concluded that venturing into
options can be a profitable venture for Galaxy. By analysing the JP Morgan Chase
call options, it is seen that the target investment gains can be achieved and even
exceeded, provided the stock prices show similar volatility. Although, the viability of
exercising couldn’t be shown in the analysis due to lack of purchase price data of
the stocks, they too are viable sources of revenue. Similarly, the fund can also trade
options of companies without actually exercising them.

However, it should be kept in mind that short term returns are necessary if the firm
were to increase the confidence of its investors. This will help Galaxy to improve the
stock prices and subsequently its market capitalization.

With a higher market capitalization, Galaxy could obtain loans at favourable interest
rates from financial institutions. These loans can be leveraged to further enhance
the returns for its investors.

On the question of issuing options, the fund should ideally wait-and-watch for the
time being. By becoming an issuer, the firm is exposing itself to additional risk. Since
the options are American options, they can be exercised before maturity. So, even if
the prices surge for a day (for calls) or drop drastically momentarily (for puts), the
investors may exercise the options and cause considerable losses to the fund.
The Galaxy Dividend Income Growth Fund’s
Option Investment Strategies

FM1 Assignment

Kaustav Dey

B18088

08-10-2018