- 20 Marks
FM – May 2019 – L3 – Q5 – Portfolio Management
Evaluate whether an option price is fair for hedging Yaro Plc. shares, and explain how changes in volatility and the risk-free rate affect the value of a call option.
Question
You are the portfolio manager of an asset management company based in Kano. Your company has in its portfolio 27,750,000 shares of Yaro Plc., a company listed on the Nigerian Stock Exchange. The shares are currently trading at N3.60 per share.
Your company plans to sell the shares in six months’ time to pay dividends, and you plan to hedge the risk of Yaro’s shares falling by more than 5% from their current market value. A decision has therefore been taken to buy an over-the-counter option to protect the shares. A merchant bank has offered to sell an appropriate six-month option to your company for N1,250,000.
Yaro’s share price has an annual standard deviation of 13%, and the risk-free rate is 4% per year.
Required:
a. Evaluate whether or not the price at which the merchant bank is willing to sell the option is a fair price.
b. Explain briefly (without any calculations) how a decrease in the value of each of the following variables is likely to change the value of a call option:
i. Volatility of the stock price
ii. Risk-free rate
(Total: 15 Marks)
Find Related Questions by Tags, levels, etc.