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The treasury division of Marengo Co, a large quoted company, holds equity investments in various companies around
the world. One of the investments is in Arion Co, in which Marengo holds 200,000 shares, which is around 2% of the total number of Arion Co’s shares traded on the stock market. Over the past year, due to the general strength in the equity markets following optimistic predictions of the performance of world economies, Marengo’s investments have performed well. However, there is some concern that the share price of Arion Co may fall in the coming two months due to uncertainty in its markets. It is expected that any fall in share prices will be reversed following this period of uncertainty. The treasury division managers in Marengo, Wenyu, Lola and Sam, held a meeting to discuss what to do with the investment in Arion Co and they each made a different suggestion as follows: 1. Wenyu was of the opinion that Marengo’s shareholders would benefit most if no action were taken. He argued that the courses of action proposed by Lola and Sam, below, would result in extra costs and possibly increase the risk to Marengo Co. 2. Lola proposed that Arion Co’s shares should be sold in order to eliminate the risk of a fall in the share price. 3. Sam suggested that the investment should be hedged using an appropriate derivative product. Although no exchange-traded derivative products exist on Arion Co’s shares, a bank has offered over-the-counter (OTC) option contracts at an exercise price of 350 cents per share in a contract size of 1,000 shares each, for the appropriate time period. Arion Co’s current share price is 340 cents per share, although the volatility of the share prices could be as high as 40%. It can be assumed that Arion Co will not pay any dividends in the coming few months and that the appropriate inter-bank lending rate will be 4% over that period. Required: (a) Estimate the number of OTC put option contracts that Marengo Co will need to hedge against any adverse movement in Arion Co’s share price. Provide a brief explanation of your answer. Note: You may assume that the delta of a put option is equivalent to N(–d1) (7 marks) (b) Discuss possible reasons for the suggestions made by each of the three managers. |
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