FIN4480 Resit Class Test Solutions 2018-19

Section A Solution

Part a)
Value of Investment =25,000 × 4.82=£ 120500

Risk is the share price falling, thereby reducing the value of the investment in Dean.

Part b)
Hedging a fall in Dean’s share price requires put options. The nearest to at-the-money is the
580p strike price. The delta-hedge derive N(d1).

S 482
X 480
t 0.1699
r 0.0075
Nd1 0.5415
C 16.97
P 14.22
Gamma 0.0101
Hedge ratio 2.1810
Delta Hedge
Contracts 55
Cost £7622

1
Hedge Ratio= =2.1810
1−0.5415
25000
Number of Put Options= ×2.1810 ≅ 55
1000
Total Cost of Options=55 × £ 142.22=£ 7622
Part c)
The share price falling from 482 to 443 is a loss of value for CI.
Loss on shares=25000 ( 4.43−4.82 )=−£ 9750
But the price fall means an increase in the put option premium. To determine the scale of the
increase use Black-Scholes and put-call parity.
S 443
X 480
t 0.1699
r 0.0075
Nd1 0.1766
C 3.37
P 39.62
−rt −0.0075 ×0.1726
P=C−S+ X e =3.37−443+ 480 ( 2.71828 ) =39.62
Per Share Gain=39.62−14.22=25.4 pence
Total Gain on Puts=55000 ×0.254=£ 13,970
 The gain on puts of £13970 exceeds the loss on the shares of £9750. There is an excess of £4220.
This is to be expected. As the share price declines the put option becomes more in the money
which means that the rate of increase in its premium accelerates. At the outset, the delta indicates
that the put option premium should rise by 0.4585 pence (i.e. 1-0.5415) for a 1 pence fall in the
share price. Hence the need just over two puts to hedge one share.

But with the share price at 543 pence the delta of 0.1766 indicates that the put option premium is
now growing at a rate of 0.8234 pence for a 1 pence share price fall. The upshot is that the gain
on the original hedge using 55 contracts will exceed the loss on the shares.
Part d)
The new delta is 0.1766. Therefore:
1
Put Hedge Ratio= =1.2046
1−0.1699

25000
Number of Put Options= ×1.2046 ≅ 30.115
1000

The delta hedge now requires 30 puts – 25 less than before. Hence 25 puts should be sold for
£396.20 each, generating:
25 × £ 396.20=£ 9905
Part e)
The gamma suggests that the delta of the option will change by 0.0101 for a small change in
the share price. Given the price at the outset of 582 pence, let’s assess the effect on the hedge
of a 1 pence price fall (a change of just 0.17%).
New delta=0.5415−0.0101=0.5314

1
Put Hedge Ratio= =2.1340
1−0.5314

25000
Delat Hedge= ×2.1340 ≅ 53
1000

This is two contracts less than the original hedge. Marginal changes in the asset price have
significant effects on the hedge. The gamma indicates that the hedge using at-the-money puts
is very sensitive to small changes in the price of Dean PLC shares.

Question 2:
Part A:
In this question the Brazilian business pay in USD which mean if the BRL depreciate, the
USD will automatically increase and the business has to pay more Brazilian Real to buy US
Dollar.
Part b)
The money market hedge:
a) Deposit present value of USD250,000
b) Buy the USD with BRL
c) Borrow BRL for one month
 250000
USD Deposit =USD
0.0 25 249480.2
1+( 12 )
Spot Cost of USD∈Brazilian Real=249480.2×3.7556=BRL936948

0.065 5
Opportunity Cost =937166 × 1+( 12 ) =BRL942062.2

942062.2
One−Month Forward Rate= =BRL3.768249
250000
Part C
Risk can measure as the depreciation of Brazilian Real Against USD. Brazilian business will
sell futures at spot rate of USD250000 which is equivalent to;
250000
BRL cost= =BRL 9015 50.7
0.2773
Part D
If Real depreciate which means that mean that amount the company need such USD250,000
needed to settle the invoice are more expensive. The cost of USD on spot rate on 25th August
is;
250000
Cost of USD= =BRL 1,000,8 01
0.2498
Considering the forward rate as the opportunity cost of the future hedge the increase in cost
of USD is;
Increase ∈Cost of USD=1,000,8 01−942062.2=BRL 5 8738.4

however, the company gains from future contracts will be;

Basis Point Gain=27 13−270 3=10
Cash ¿ Futures=10 ×9 × $ 10=$ 900
Given the spot rate on 25th August
BRL Cash¿ Futures=900 × BRL 4=BRL 3 600
Company cash market loss of BRL58738.4 thus the future hedge reduces the loss to
BRL55138 which mean that 98% cash market loss is covered by future position.
The small incapacity of the hedge is not surprising. Nine futures are priced at BRL 900,000.
The exhibition is worth BRL938,791 USD. So the company is a little lower - by 0.38791
equivalent to contracts. If a partial agreement was available, it would have the added benefit
of:
Gain ¿ Futures=157 × 0.38791× $ 10=$38.791
th
At the 25 August spot rate this is equal to BRL38.79 which more than cover the shortfall
from 9 contracts.