Industrial Products Corp. (IPC), a publically held company, is considering going private. It is extremely important to IPC’s management that the pension fund’s present surplus level be preserved pending completion of buyout financing. For the next three months (until September 1, 1990), management’s goal is to sustain no loss of value in the pension fund portfolio,. Today (June 1, 1190), this value is $300 million. Of this totall, $150 million is invested in equities in the form of an S&P 500 Index fund, producing an annual dividend yield of 4 percent: the balance is invested in a single U.S. government bond issue, having a coupon of 8 percent and a maturity 6/01/2005. Since the “no-loss strategy” has only a three-month time horizon, management does not wish to sell any of the present security holdings.
Assume that sufficient cash is available to satisfy margin requirements, transaction costs, and so on, and tha the following market conditions exist as of June 1, 1990:
– The S&P 500 Index is at the 350 level, with a yield of 4.0 percent.
– The U.S. government 8.0 percent bonds due 6/1/2005 are selling at 100.
– U.S. Treasury bills due on 9/1/90 are priced to yield 1.5 percent for the three-month period (i.e., 6 percent annually).
Available investment instruments are the following:
Current Contract Strike Contract Strike Contract
Contract Expiration Price Price Size
S&P 500 Index future 9/1/1990 355.00 175,000
Future on U.S. government 8% bonds due 6/1/05 9/1/1990 101.00 100,000
S&P 500 call option 9/1/1990 8.00 350 35,000
S&P 500 put option 9/1/1990 7.00 350 35,000
U.S. government 8% due 6/1/2005 call option 9/1/1990 2.50 100 100,000
U.S. government 8% due 6/1/2005 put option 9/1/1990 4.50 100 100,000
a. Assume that the management wished to protect the portfolio against any losses (Ignoring the costs of purchasing options or futures contracts) but wishes also to participate in any stock or bond market advances over the next three months. Using the preceding instruments, design two strategies to accomplish this goal, and calculate the number of contracts needed to implement each strategy.
b. Using the put-call parity relationship and the fair value formula for futures (both follow), recommend which one of the two strategies designed in Part a should be implemented. Justify your choice.
Put Price = Call Price Minus Security Price Plus Present Value of (Exercise Price Plus Income on the Underlying Security)
Futures Price = Underlying Security Price Plus (Treasury Bill Income Minus Income on the Underlying Security)
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