Question

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 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?

                  Sell 100,000 shares in several weeks

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

                  Selling short the shares of another airline, LAND

         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?

Answer 1

Effective Price is $99.60