Consider a stock (XYZ Corporation) currently trading at $50, with annualized volatility of 65%. The continuously compounded annualized interest rate…


Suppose Nova virus is a tropical disease carried by Nova mosquitoes, bugs which are otherwise harmless. XYZ Corporation is developing an environmentally safe pesticide that kills Nova mosquitoes. ABC Corporation is developing a vaccine for Nova virus. ABC management is nervous about the terms on which they will be able to raise equity and is considering hedges based on XYZ corporation stock.

b.    How do you expect XYZ stock price movements to be correlated with ABC’s business prospects? Explain why.

c.     Discuss ways ABC can hedge its risk using instruments tied to XYZ, given your assumption about how XYZ stock price movements are correlated with ABC’s business prospects. Specifically, how can ABC hedge using an XYZ call? An XYZ put? An XYZ forward? XYZ stock? In each case, discuss how ABC would use that instrument ALONE—not in combination with other derivatives.  

d.    The CEO of ABC has heard about spread positions and wants to use one. Would you recommend a bull spread or a bear spread on XYZ stock? 

e.    Based on your recommendation in (c), construct a spread of that type using the options from (a). Graph the profit in 1 year as a function of the price of XYZ in one year. Be sure to label the maximum profit, the minimum profit, and the breakeven point(s).

f.     Does this strategy fully solve ABC’s risk management problem? Explain why or why not.

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