Just as Times Mirror is about to agree to the PEPS transaction, Congress passes a sweeping tax reform of the rules on constructive sales, and Morgan Stanley must return to the drawing board to design a new security that will enable Times Mirror to exit its position in Netscape without incurring capital gains taxes. Morgan Stanley proposes a new security, PEPS II, which obligates Times Mirror to deliver cash equal to the price of one share of Netscape in two years if the price of Netscape is between 45 and 85. If the price is greater than 85, Times Mirror must deliver cash equal to $85. If the price is less than $45, Times Mirror must deliver $45. In addition, Times Mirror must pay a $5 coupon at the end of one year and at maturity (at the end of two years). Assume the current price of Netscape is $60, ignore any credit risk of Times Mirror, assume that Netscape will not pay dividends, assume that the continuously compounded interest rate is 5%, and volatility is 95%
a. First, consider other ways that TM might consider hedging its Netscape exposure (ignore taxes and regulations in answering this question). Specifically, describe what positions Times Mirror could take in 1) a Netscape call, 2) a Netscape put, 3) a Netscape forward in order to hedge their exposure. (Answer each of those subparts separately—i.e., I am asking how you would use a call alone; a put alone; and a forward alone, as opposed to in combination with other derivatives.)
b. From the perspective of the investor, fully describe the PEPS II in terms of “building blocks” such as calls, puts, forwards, etc.,
c. From the perspective of the investor, what is the value of the PEPS II (ignore transaction costs and assume Black-Scholes for any option valuations)?
d. Suppose the offering is brought to market priced at $58. You have access to the offering and sense an arbitrage. Describe exactly the positions you would take to execute the arbitrage, assuming you can trade in calls, puts, forwards, and the underlying shares; you can also borrow and lend at the prevailing interest rate.