Case Study - financial risk analysis and hedging strategy A pension fund manager expects to receive an inflow of funds in 90 days time and would like to invest some of the funds in a certain stock. The stoc price today is $25. The fund manager would be very happy if in 90 days' time the stock was selling for $25. But he is worried about the possible stock price rising in the period, so he decided to hedge the risk with futures or option markets. He asks you as a financial consultant to help him to mal the decision. The maximum price the manager would pay for the stock is $30. An innovative financial institution offers you the following type of contract. If the stock price is above $30, you can buy the stock at $30. If the stock price is below the $X, you buy the stock at a price of $X. If the stock price is between X and 30, you will pay the spot price. The lower bound, X, is set by the financial institution such that the value of the contract is zero. Current market information provides you with the following information: Volatility of the stock (0) 27.25 percent Discount Rate (rc) 6.00 percent (continuous interest rate Assuming a 365-day year for both volatility and risk free rate. For the contract provided by the financial institution, can you identify the two implicit options? (Hint: Buying Call and Writing Put). Explain why with their net values associated with different stock prices. Since the lower bound X, is such that the value of the overall contract is zero, determine the lower bound X for the contract. (Hint: you need to pay a premium for buying a call option and you will receive a premium for writing a put option. The X value is determined by the condition that the call premium paid equals the put premium received. You need to us Black-Scholes model and the trial-and-error method to find the X value)
