Question

Question 4 (25 marks)

Option Pricing (10 marks)

The Webber Company is an international conglomerate with a real estate division that owns the right to erect an office building on a parcel of land in downtown Sacramento over the next year. This building would cost $17 million to construct. Due to low demand for office space in the downtown area, such a building is worth approximately $16 million today. If demand increases, the building would be worth $18.2 million a year from today. If demand decreases, the same office building would be worth only $15 million in a year. The company can borrow and lend at the risk-free annual effective rate of 7 percent. A local competitor in the real estate business has recently offered $624,000 for the right to build an office building on the land.

What is the value of the office building today? Use the two-state model to value the real option. (Do not round intermediate calculations and provide your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Hedging Risks (15 marks)

Part A. A year ago a bank entered into a $50 million five-year interest rate swap. It agreed to pay company A each year a fixed rate of 6% and to receive in return LIBOR. When the bank entered into this swap, LIBOR was 5%, but now interest rates have risen, so on a four-year interest rate swap the bank could expect to pay 6.5% and receive LIBOR.

(a) Is the swap showing a profit or loss to the bank? Explain.

(b) Suppose that at this point company A approaches the bank and asks to terminate the swap. If there are four annual payments still remaining, how much should the bank charge A to terminate?

Part B. For the following scenarios, describe a hedging strategy using futures contracts that might be considered.

1. Marshall Arts has just invested $1 million in long-term Treasury bonds. Marshall is concerned about increasing volatility in interest rates. He decides to hedge using bond futures contracts. Should he buy or sell such contracts?
2. The treasurer of Zeta Corporation plans to issue bonds in three months. She is also concerned about interest rate volatility and wants to lock in the price at which her company could sell 5% coupon bonds. How would she use bond futures contracts to hedge?

Answer 1

The Webber Company:

PART A:

a.     

Profit

b.     

If the bank took out a new 4-year swap, it would need to pay an extra $.25 million a year. At the new interest rate of 6.5%, the extra payment has a present value of $856,000. This is the amount that the bank should charge to -terminate.

PART B:

a. Sell

b. Sell 3-month bond futures.