Homework Eight

Show your work and/or explain your answers!

1.      (10 points) King Julien has a lot of money and is considering investing in one of two business ventures:

a.       Sock It To Me – a high-tech gadget that points in the direction of the nearest sock and beeps frantically when in close proximity to one.  This technology is patented and no other firm is close to completing their own design.

b.      Warm Glow – recently NASA scientists have discovered that neon light increases vegetative growth when placed next to plants.  They have shared this discovery with the world.  Warm Glow is a firm that has approached you with the idea of selling long thin tubes of neon lighting to plant nurseries.

Suppose you happen to know, magically, that the total amount of profit earned by the Sock It To Me, and the total amount of profit earned by all people selling neon lighting to nurseries, is exactly $100 million.  King Julien wants to invest in Warm Glow but you know that, all else equal, he should pick Sock It To Me.  Why is the sock finder a better choice?  Convince King Julien that he would not make as much money if he picks Warm Glow.[1]

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.      Most people are familiar with the concept of buying low and selling high, but King Julien is a different kind of cat – he wants to sell high and buy low.  He wants to ‘short’ a commodity.  You explain to King Julien that, while it may seem impossible, or at least dishonest, to sell something one does not have, this is exactly the type of transaction made possible by financial derivatives.  Specifically, we are going to buy a put option – a contract wherein we agree sell a commodity at some point in the future at a price to be specified today, called a ‘strike price’. We are selling short, or ‘shorting’ this commodity.  Our counter party who wrote the put option, i.e. they wrote the contract we bought, are said to be ‘going long’.

 

If the strike price is the same as today’s price, then it’s as simple as this:  we are betting the price will fall and our counter party is betting it will rise.  If the price falls, we can buy the commodity at the new, lower price then turn around and sell it at our higher strike price.  The difference in prices, minus some fees and taxes, is our profit margin.  If the price rises, then we must still fulfill our obligation by purchasing the commodity at the new price.  But in this case, since the new price is higher, we will lose money and our counter party will gain.  This time the difference in prices is their profit margin.  So all this really just boils down to a bet about whether the price of some commodity will rise or fall.

Suppose the following three commodities[2] have all experienced a recent sharp increase in prices.  King Julien thinks these are “bubbles” – he thinks their prices are unsustainably high and that the bubble will soon burst and the prices fall.

I.       Green Pearls of Tahiti.  Pearl divers are very competitive but Tahiti is remote and there are relatively few people with the stamina and skill to collect pearls.

II.    Computer Memory.  New developments in information technology are expected to reduce the cost of producing data storage in the near future.

III. Gold.  There is no reason to expect the supply or gold, or the cost of finding and extracting it will change in the foreseeable future.

 

a.       (8 points) Assuming all else is held constant, which of these should King Julien short and why?  That is, as the bubble bursts and we transition to a new long-run equilibrium, which of these commodities do you think will experience the greater decrease in price?  Hint: based on the information given above, what would the long-run supply curves look like for these commodities

b.      (4 points) Which of these commodities is likely to see the smallest decrease in price and why?

 

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• 1504614520-micro_hw8 Tutor File.docx