Acquisition Target

1.A corporate takeover bid is often pursued in stages as the acquiring firm seeks a controlling interest in the acquisition.A company, company A, has identified company B as an acquisition target.B’s stock is currently trading at $73 per share.If word leaks, then the stock price will likely be driven up, increasing the cost of the acquisition.The firm therefore wants to hedge against this possibility.

  • The company wants to buy 100,000 shares on December 17.Company B’s stock currently has a beta of 2.March contracts on the S&P 500 are trading at 2807, with a multiplier of $250 times the index price. Based on this, construct an optimal hedge using the March S&P contract.
  • On December 17, B’s stock is trading at $76.50 and the March futures price is 2842.Calculate the additional cost of the shares as well as the gain/loss on the futures position.Was the hedge successful?Explain.

2.Another way to write a duration-based hedge ratio is as follows:

Hedge Ratio = CFctd X (Pb X Db) (1+YTMctd)where

(Pf X Df )(1+YTMb)

CF = conversion factor for CTD bond

Pb = price of bond portfolio as percentage of par

Db = duration of bond portfolio

Pf = price of futures contract as percentage of 100%

Df = duration of CTD bond for futures contract

YTMctd = Yield to Maturity of CTD bond

YTMb = Yield to Maturity of the portfolio (average)

A bond portfolio manager holds a government bond portfolio with a face value of $10 million that is currently worth a market value of $9.7 million.The manager is concerned about future rising interest rates and so decides to hedge with a T-Bond futures contract.The cheapest to deliver bonds have a projected duration at maturity of 11.14 years.Their conversion factor is 1.1529 and at their current price the futures price is 90-22.The projected average duration of the bond portfolio is 9.0 years.Current Yield to Maturity is 7.8% on the portfolio and 7.1% on the CTD bond.

a.Based on the above data, compute the optimal hedge ratio.

b.Based on the interest rate expectations, should they take a short or long position?

c.The optimal number of contracts to hedge with is given by:

Number of contracts = HR X (Portfolio par value/value of futures contract)

Where each futures contract is for $100,000 of bonds.

Based on this, compute the optimal number of futures contracts to hold.

d.The closing futures contract price is 89-16.Based on this, how did the futures position perform?

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