Hedging with Options Contracts

Carson Company would like to acquire Vinnet, Inc., a publicly traded firm in the same industry. Vinnets stock price is currently much lower than the prices of other firms in the industry because it is inefficiently managed. Carson believes that it could restructure Vinnets operations and improve its performance. It is about to contact Vinnet to determine whether Vinnet will agree to an acquisition. Carson is somewhat concerned that investors may learn of its plans and buy Vinnet stock in anticipation that Carson will need to pay a high premium (perhaps a 30 percent premium above the prevailing stock price) in order to complete the acquisition. Carson decides to call a bank about its risk, as the bank has a brokerage subsidiary that can help it hedge with stock options.

a. How can Carson use stock options to reduce its exposure to this risk? Are there any limitations to this strategy, given that Carson will ultimately have to buy most or all of the Vinnet stock?

b. Describe the maximum possible loss that may be directly incurred by Carson as a result of engaging in this strategy.

c. Explain the results of the strategy you offered in the previous question if Vinnet plans to avoid the acquisition attempt by Carson.