Finance Forward Options, Hedging
| Black-Scholes Option Pricing Model | ||
| Inputs: | ||
| Stock Price (S) | $35.78 | |
| Strike Price (X) | $32.50 | |
| Volatility () | 25.00% | |
| Risk-free Rate | 5.00% | |
| Time to expiration (T) | 7 | |
| Dividend Yield | 0.00% | |
| # of Options (000) | 10,000 | |
| # Shares Outstanding (000) | 100,000 | |
| Tax Rate | 40.00% | |
| Output: | ||
| D1 | 1.00523 | |
| D2 | 0.34379 | |
| N(D1) | 0.84261 | |
| N(D2) | 0.63450 | |
| Call Price | $15.61696 | |
| Put Price | $2.73932 | |
| Value of Call Options (000) | $156,170 | |
| After-tax Option Value (000) | $93,702 | |
This model implies an annual volatility for Microsoft bonds at 25%.
- The transactions can be hedged using the hedge in the options market. A currency option is an agreement between the buyer and seller where the buyer (call) has the ability though not obligation to buy the currency at a precise price or before a certain date.
In this form of hedging, calls are applied if the threat to the dollar in precise is that the dollar/euro exchange goes below the breakeven point so the dollar would buy puts to hedge this threat.
In regard to all of the market hedges available, I am able to use the option hedge.
- Forward market hedge: since we are hedging A/R we have to sell forward the receivables of Euro 100,000 @ $ 1.36/Euro to get 136,000.
While for four months the value is $ 1.46/Euro to get 146,000. Hence the forward market hedge is 136000 – 146000 = -$10,000.
Money Market Hedge: since we are hedging A/R we have to create a liability in Euro to match in value.
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt
Weight of Equity = 75 %
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 7.5% + 1.5 * 5% = 15%
Weight of Debt = 25%
Cost of Debt = after tax cost of debt* (1- Tax rate) = 88% * (1-0.2) = 87.2%
Hence WACC = 75% * 15% + 25% * 87.2% = 33.05%
Reference
Madura, J. (2012). International Financial Management, Abridged Edition. Connecticut: Cengage Learning.
