Bruce Honniball - 1613 Words

BRUCE HONIBALL’S INVENTION Principles of Corporate Finance 7th Edition Richard A. Brealey and Stewart C. Myers MEMORANDUM To: Bruce Honiball From: Sheila Cox Re: Gibb River Bank Equity-Linked Deposits Bruce, thank you for your memo. I think you may be onto a winner with the equity-linked deposits, though my calculations suggest that we can’t afford to be quite as generous as you propose. Spotting the option. Think of it this way. Whatever happens to Australian share prices, depositors under your scheme get back their initial investment of $A100 at the end of the year. If share prices rise by y percent, they also receive a bonus of .5y ( $A100. For example, if prices rise by 10 percent, the bonus†¦show more content†¦That would guarantee that we could also pay any bonus. We would then have a completely hedged, risk-free position. What if equity-linked deposits sell like hot cakes and it becomes difficult or expensive to buy sufficient call options on the index? There is another way to hedge our risks. Black and Scholes showed that a call option can be replicated by a mixture of delta shares and borrowing. In my example, delta works out at .6256. So to replicate one call, the bank would need to invest .6256 ( $A100 in the market index[3] and borrow $A50.28.[4] The net cost of replicating one call would be 62.56 - 50.28 = $A12.28. Of course, to replicate .3 calls, the bank would need to invest only .3 ( 62.56 = $A18.77 in the market index and borrow .3 ( 50.28 = $A15.09.[5] So, if necessary, we can hedge the equity-linked deposits by borrowing to buy the market.[6] As time passes and share prices change, we would need to adjust the amounts that the bank borrows and invests in the market index. Bear Market Deposits. I have also looked briefly at your idea of bear market deposits. Again it is useful to break the payoffs into a fixed payment and a bonus element. Suppose we stick with your suggestion to pay a bonus of $A5 for each 10 percent fall in the index. Then the payoffs from a bear market deposit are as follows: Share prices fall by y% Share prices rise Repayment of deposit $A100 $A100 Bonus .5y (Show MoreRelatedBruce Honniball1604 Words   |  7 PagesBRUCE HONIBALL’S INVENTION Principles of Corporate Finance 7th Edition Richard A. Brealey and Stewart C. Myers MEMORANDUM To: Bruce Honiball From: Sheila Cox Re: Gibb River Bank Equity-Linked Deposits Bruce, thank you for your memo. I think you may be onto a winner with the equity-linked deposits, though my calculations suggest that we can’t afford to be quite as generous as you propose. Spotting the option. Think of it this way. Whatever happens to Australian share prices