Question

In: Finance

​As the CFO of Dragon Airways (ticker symbol: DRAG) you decide to sell 100,000 shares in...

​As the CFO of Dragon Airways (ticker symbol: DRAG) you decide to sell 100,000 shares in a ​secondary offering to raise additional capital for an expansion. Your shares currently trade ​at $100/share and have a beta of 1.25. It will take several weeks to complete the ​registration process through the SEC and you are concerned that the overall stock market ​will fall in the interim. So you decide to hedge the stock sale by selling short the shares of ​another airline, LAND. Its shares trade at $75/share and have a beta of 0.95.

​These are the relevant prices today:

​​DRAG: ​Beta: 1.25; share price $100/share.

​​LAND:​Beta: 0.95; share price $75/share​

​Five weeks later, you issue the shares and simultaneously cover your hedge position. Prices ​then are:

​​DRAG:​Share price $107.50/share

​​LAND:​Share price $79.50/share​​

​a.​What is the anticipated transaction?

​b. ​What can be done to hedge this risk? (i.e. buy/sell? what? how many shares, how ​​​much in value?)

​c.​How much does the firm pay/receive when it carries out the anticipated transaction?

​d.​What does the firm do to cover the hedge position? Did the hedge transaction produce ​​a profit or a loss, and how much?

​e.​Combining the results of the anticipated transaction and the hedge, what is the ​​​effective price of the overall transaction?

Solutions

Expert Solution

1- The anticipated Transaction is focused on gaining the price differential that may arise between the Anticipated Sale Date and the Actual Sale date. The CFO is anticipating the price to fall and eventually he will have to sell the Shares at a Loss. So in order to have an Added profit and make as much as he is expecting to make now he will sell shares of LAND to cover the Loss.

2- To hedge the risk we will sell short shares of LAND. So we will Sell Shares of Land that would match up the anticipated Loss in the Shares of DRAG.

So Total Value of Drag today to sell = 100,000 * $100 = $10 Million at a beta of 1.25

So to cover the whole value with Shares of LAND we will have to sell more, since beta of DRAG is more than beta of LAND so its share price will react much more than LAND

So Shares to Sell Short = (1,00,00,000*1.25) / (0.95*75) = 175439 Shares of LAND

3- The Firm receives = 175439 Shares of Land Valued at 175439*75 = $13157925

4- The firm will Buy the Shares of Land eventually in the future. Share price of Land in Future is $79.5

So total Value of Shares in the future of Land = 175439*79.5 = $13947400

Since we have to Buy these shares in the future at a higher price, it is a loss for us.

Loss Amount = 13947400 - 13157925 = 789475$

5- In the future we will sell 100,000 shares of DRAG at 107.5

So we will get = 100,000 * 107.5 = 10750,000

We had a loss of 790,000

So total Value at the end = 96,00,000 (10750000 - 790,000)

So effective price is 96.


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