The managers of Daylon plc are reviewing the companys investment portfolio. About 15% of the portfolio is represented by a holding of 5,550,000 ordinary shares of Mondglobe plc. The managers are concerned about the effect on portfolio value if the price of Mondglobes shares should fall, and are considering selling the shares. Daylons

investment bank has suggested that the risk of Mondglobes shares falling by more than 5% from their current value could be protected against by buying an over the counter option. The investment bank is prepared to sell an appropriate six month option to Daylon for 250,000.

Other information:

(i) The current market price of Mondglobes ordinary shares is 360 pence.

(ii) The annual volatility (variance) of Mondglobes shares for the last year was 169%.

(iii) The risk free rate is 4% per year.

(iv) No dividend is expected to be paid by Mondglobe during the next six months.

Required:

(a) Evaluate whether or not the price at which the investment bank is willing to sell the option is a fair price.(8 marks)

(b) Discuss what factors Daylon should consider before deciding whether or not to purchase the option. (4 marks)