3 you are considering a collar plus a loan or pvsf to

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3) You are considering a collar plus a loan or PVSF to raise cash for Doug’s potential investments. What is the borrowing cost of either transaction? Answer: One year LIBOR plus 25 bps or 1.15% 4) Please provide a specific strategy for Doug to follow over the next year. Include specific pricing in the presentation and your assumptions on interest rates, volatility, and stock price in your written answer. Answer: To hedge QLGC, Doug would consider the following strategies: Advantages Considerations Collar plus loan or PVSF The floor /cap mirror client’s objectives. Client back lock in Reinvestment risk: Unless the client believes that the
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favorable long-term rate in low rate environment reinvestment rate will exceed his cost of capital, the addition of a loan or a PVSF does not make sense. Collar The floor /cap mirror client’s view on the stock and tax deferral objective. By itself, does not provide for monetization. Covered call Disciplined exit strategy. Client receives relatively high premium due to implied volatility. Client is only protected to the extent of the premium received. Would not meet client’s objective of substantial downside protection. Outright put Offers principal protection of various degrees, depending on put strike. Requires upfront premium paid. Unlikely that client would want to pay premium given his limited liquidity source. Our overall recommendation is to hedge Doug’s entire position with a zero premium collar and raise $21 million through a margin loan. Since Doug feels there is 20% upside in QLGC, we should strike the call $21.49 ($17.91 x 1.2). We can then price the option using the following parameters: Stock Price = $17.27 (Due to 3.59% dealer discount.) In order to determine the dealer discount, we need to establish the aggregate number of shares that the dealer has to short in order to establish the initial hedge. By pricing a 1-year, zero premium collar, we find that the delta is .54. The dealer therefore incurs an execution shortfall of 3.59% on 2.592 million shares (.54 x 4.8 million shares). Call Strike = 21.49 Term = 1 year Interest Rate = 0.4% (Rebate rate, 0.9% - 0.5%) Dividend Yield = 0 Delta = .32
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Call Volatility = 33.3 which is calculated 39.7% - [(.50-.32) /.25] x .5 x4. 34.7 is a 12 month interpolation of 5 and 14 month 50 delta volatility, skew is 4 points Call Price = 1.00
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