Please prepare a written report in a form of a pdf file, that will include your individual solution to the following problem. Attach also a separate file with all necessary calculations.
Problem to be solved:
The absolute return investment fund is considering completing the portfolio with one company in three months from 20th April 2020. The manager ask you to choose preferred company on your own. The the value of the entire contract includes
- cost of buying stock shares at the market in three months,
- cost of hedging against market risk of the price of an underlying to go up within three months,
- cost of hedging against interest rate risk
You are authorized to pay for the whole contract maximum 1000000USD (or its equivalent in foreign currency given spot exchange rates from 20thApril 2020). Please explain the details of a deal, and calculate its. cost separately for stock, hedging against market risk, hedginf against interest rate risk considering the following assumptions:
- Justify the choice of a company – what it is potential to generate positive rate of return? How many stocks of this company can you buy using authorized amount of money ?
- Given the speculative (stochastic) nature of the investment, you are recommended you to buy a three month OTC European ATM call option on this stock.Calculate option premium for each stock and the total value of an option contract. Calibrate option parameters to market conditions. If the considered stock will pay dividends in next three months, adjust your valuation accordingly. Justify the choice of volatility and risk-free rate.
- The contract will be financed via credit with a 3-year maturity and interest paid on an annual basis. You are recommended to use an interest rate LIBOR swap or a CAP contract, to protect your payments against unforeseen changes of interest rates. Which one will you use – justify your choice by explaining difference in mechanisms of the two contract types and cost of the two. Assume, that a notational principal of the interest rate contract should cover both the value of shares to be bought and the value of an opton. Calibrate swap parameters to real interest rates conditions and justify your estimations.