Jaguar plc–1984 Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Part 2

Q1.) Consider a stock that is worth 4 today and in one period will be worth either 6 or 3, each with probability ½. The risk-free rate is zero.

a. What is the value today of a European put option on this stock, expiring in one period, with strike price 5?

b. What is the value today of a European call option on this stock, expiring in one period, with strike price 5?

Answer 02

Value of European Put Option = $11.58 (Exhibit-F)

Value of European Call Option = $10.58 (Exhibit-F)

Q2.) Clipped from an editorial in the September 2nd Traders Magazine:

The problem with so much volume migrating off-exchange is that displayed market makers constantly find that, despite the stock trading at their limit price, their limit orders often remain unexecuted. This is because a large number of market orders, which would have normally interacted with the market maker's limit orders, are now routed to over-the-counter market makers that trade directly against that order flow. They simply match or slightly beat the displayed quotation, without having to display any quotes of their own.

With so many orders being executed off-exchange, many liquidity providers feel like they are simply setting the price, taking the risk and not reaping the rewards of getting the execution. Couple that with the increased adverse selection risk and you have a market in which many participants are hesitant to quote.

What is the adverse selection risk faced by liquidity providers, and why would the practice described here make it worse?

Answer 02

The adverse selection risk is one caused by information asymmetry. Information asymmetry occurs when the broker or the liquidity provider as in this case has more information on the stock-trading versus the investors in the market. When there is over load of orders, it limits the ability of the liquidity provider to go for a MAXIMAX approach, which means choosing the best out of the best stock available for trading. As a consequence, the liquidity providers, in pressure of executing orders, execute such orders which are free of arbitrage profit. Furthermore, the situation worsens up when liquidity providers feel reluctant to quote the price, fearing they might incur loss on the deal. Therefore adverse selection risk is a major obstacle in the efficient flow of the stock market.

Q3.) You are an entrepreneur with two potential projects, A and B, which each cost 100, and which have the following payoffs in Depression (D) and Prosperity (P), each of which has probability ½:

D P

A 60 140

B 80 130

You want to raise money toward the cost of 100 by issuing a bond with face value 100, to be paid out of the project’s payoffs. Whatever the bond issue doesn’t raise, you will pay in yourself, and you get the equity claim on the project. You cannot commit to which project you will choose after issuing the bond. You are considering adding a clause to the bond contract which allows the bondholders to liquidate the project immediately after you choose it, and pay themselves off out of the proceeds. Would such a clause help? What considerations are important? Be precise.

Answer 03

A clause to recall the bond investment by bond holders will help enterprise raise confidence of investor regarding the safety of their investment, moreover, the two project show very volatile payoffs and investment in such projects might lose the investors’ fund, therefore, a clause to reclaim their investment will help enterprise in raising required funds.

Additionally, the enterprise should consider the committed cost of investment, and its ability and cost to abandon the project in case bond holders withdraw their investment.

Q4.) In a year, Kepler Motorcars will be worth either 100 or 40, each with probability ½. Kepler has a bond outstanding, with principal amount 100, maturing in a year. The bond is held by 100 investors, each holding principal amount 1. The bond has a covenant making it senior to all other Kepler debt, and this covenant can be amended by a majority vote of bondholders (i.e. at least 51). To bondholders, Kepler offers an exchange: bondholders can tender their bonds while voting to remove the covenant, and if the vote passes, those who tendered get a new bond with principal amount 0.9, senior to the old bond. If you are a bondholder, are you better off tendering your bond? Why or why not? What considerations are important?

Answer 04

I will chose to tender my bond because Kepler Motors value is not going to be more than the value of bonds payable by Kepler Motors and if its value decrease below 100, as it will fall to 40 with ½ probability, moreover, if Kepler Motors goes into liquidation, the value would be divided among 100 bond holders and on the other hand if 51% bond holder vote for removal of covenant and become senior to old bond holders, they will be ranked first in order of repayment of their debt and will get more than old bond holders. Additionally........................................

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