Question

BFS Limited has agreed to underwrite a forthcoming equity issue (at $6.15 per share which is equal to the current market price) by Australian Foundation Limited (AFI), a Listed Investment Company on the ASX. Any shares acquired by BFS must be held by them for at least 28 days before they can be disposed of. It is currently the start of April and BFS expects that they will have to purchase around 1m shares of AFI in mid-April but will dispose of the shares on market as soon as they are permitted under the underwriting agreement

Explain how BFS can hedge, using futures contracts, the risk associated with any equity it acquires through the underwriting agreement. Include a worked example in your explanation

Answer 1

First of all, we need to understand what is hedging.In order to safeguard ourself from price fluctuations,company often tends to hedge.

In the given scenario, BFS Limited needs to sell 1mn shares of AFI in mid april.So in order to do so, BFS limited will enter into an agreement with prospective investor to sell these shares after 1 month at a predtermined price.

To illustrate with an example,

Current MP : $ 6.15

Total shares: 1mn

Therefore, total exposure= 1mn * $ 6.15 = $61,50,000/-

Suppose 1 month future is trading at $ 6.30

then in that scenario Underwriter will enter into 1 month future and afteer a span of 1 month it will sell the shares at a predetermined price of $ 6.30/share irrespective of the market price at that point of time and hence perfectly hedge itself.

Company usually enters into underwriting agreements in order to safeguard its interest against minimum subscription of shares by paying commission for the same.However in cxase of underwriting, majority of stake is with one entity only.So there is a risk of coup in the management.