Hedging with Options Contracts Carson Company would like to acquire Vinnet, Inc.

Question

Hedging with Options Contracts

Carson Company would like to acquire Vinnet, Inc., a publicly traded firm in the same industry. Vinnet’s stock price is currently much lower than the prices of other firms in the industry because it is inefficiently managed. Carson believes that it could restructure Vinnet’s operations and improve its performance. It is about to contact Vinnet to determine whether Vinnet will agree to an acquisition. Carson is somewhat concerned that investors may learn of its plans and buy Vinnet stock in anticipation that Carson will need to pay a high premium (perhaps a 30 percent premium above the prevailing stock price) in order to complete the acquisition. Carson decides to call a bank about its risk, as the bank has a brokerage subsidiary that can help it hedge with stock options.

a. How can Carson use stock options to reduce its exposure to this risk? Are there any limitations to this strategy, given that Carson will ultimately have to buy most or all of the Vinnet stock?

b. Describe the maximum possible loss that may be directly incurred by Carson as a result of engaging in this strategy.

c. Explain the results of the strategy you offered in the previous question if Vinnet plans to avoid the acquisition attempt by Carson.

Explanation / Answer

a. Carson can hedge its risk by going long on Vinnets' stock option. Call option provides the right but not the obligation to buy underlying asset. If investors come to know about the acquisition and start to buy the stock and cause the price to go up, although Carson will have to pay a higher price to acquire the stock but carson's payoff on call option will help offset the increased price.

Let price of stock be 30 at time of purchase of call.

by the time carson buys the stock price becomes 39 (30% higher)

pay off on call is max ( 0, excercise price - strike price) = max (0, 39 -30) = 9

thus call payoff will offset the increased price in share

b. Max loss incurred in this strategy will be the premium paid on call

if after purchasing the call if the price doesnot move then payoff will be max( 0 , 30 -30) = 0

but the cost of purchasing the call i.e. the premium is a cost that is not recovered.

c. Vinnet can avoid the aqcuisition in this either by increasing price of stock through buyback or through using other ways of anti takeover strategies. Increasing the buybacks will increase the cost, providing a payoff on call option for carson. If Vinnet uses other methods of preventing a takeover which doesnot increase the price of stock then carson is to lose the premium paid on the call option.

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.