Pricing Wesfarmers Partially Protected Shares

Katherine Uylangco and Steve Easton

The University of Newcastle, Callaghan, NSW, 2308, AUSTRALIA
Katherine.Uylangco@newcastle.edu.au, Steve.Easton@newcastle.edu.au

Abstract In April 2007, Wesfarmers announced a proposal to acquire the entire issued capital of Coles. Part of the eventual offer included Coles shareholders being given Wesfarmers shares with partial price protection (WESN shares). This paper provides a theoretical valuation for WESN shares and compares these prices with those observed over the first year of trading. It shows that the modelled price of WESN shares was generally higher than the observed prices. Model assumptions regarding the risk free rate of return, expected dividends, expected volatility and the correlation between Wesfarmers shares and the S&P/ASX 200 All Industrials Index do account for some of this difference, in particular the volatility assumption. An alternative explanation of the difference is that there are several features of the WESN share offer that cannot be incorporated into the model that detract from the value of WESN shares, thus creating a lower market value than would otherwise be expected. Keywords: option pricing, monte carlo simulation, barrier options, rainbow options

1. Introduction On the 7th of November 2007 Coles Group Ltd (Coles), was taken over by Wesfarmers Ltd (Wesfarmers). The combination of the two companies resulted in Wesfarmers becoming Australias 11th largest company. The takeover proposal was such that Coles shareholders received Wesfarmers shares with partial price protection in exchange for Coles shares. The Wesfarmers partially protected shares were listed with the Australian Securities Exchange (ASX) on the 12th of November 2007 with the code WESN as distinct from Wesfarmers ordinary shares, which are listed with the ASX code of WES. The features of the Wesfarmers partially protected (WESN) shares are complex but the central details are as follows. WESN shares offer protection to the shareholder if the Wesfarmers ordinary (WES) share price is below $45.00 at the so-called lapse date. The lapse date is four years after the issue date of WESN shares (12 November 2007) unless this period is extended. A one-year extension will occur if the S&P/ASX 200 Industrials Price Index is below 6500 at the lapse date and this extension may be applied for a maximum of four years. Provided the WES share price
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is above $36.00 at the lapse date, the holder of a WESN share will receive WES shares to the value of $45.00. Where the WES share price is below $36.00, the holder of a WESN share will receive 1.25 WES shares per WESN share. WESN shares will automatically be converted into WES shares with no bonus issue if the WES share price is greater than $45.00 over any consecutive 20-day period between the date of the issue of shares and the lapse date. WESN share therefore comprises a WES share, together with embedded complex options with barrier and rainbow features. This paper provides a theoretical value of WESN shares and provides some empirical evidence on the pricing of these shares.

2. Methodology As discussed, WESN shares can be expressed as the equivalent of a long position in the underlying WES shares, a long put option on WES shares with an exercise price of $45 and a short position in 1.25 put options on WES shares with an exercise price of $36. If all additional features were to be ignored the binomial option pricing model could be applied to
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determine the theoretical value of WESN shares. However, there are two additional features that significantly affect the share value. Firstly, the options have a barrier of $45.00, whereby the option is worthless if the WES share price is greater than $45.00 over 20 consecutive days. Second, Wesfarmers can extend the lapse date if the value of the S&P/ASX 200 All Industrials Index is less than 6500 for two months prior to the lapse date. There can be a maximum of four extensions. Due to the additional features a closed form solution cannot be derived, therefore, Monte Carlo simulations are used to create the share prices. A formula provided in Boyle (1977) is used for simulating share prices, namely:

S&P/ASX 200 All Industrials Index have been determined, the value of WESN shares can be determined for each simulation. The expiry date will differ under each simulation, depending on the values of WES shares and the S&P/ASX 200 All Industrials Index with potential exit points at 4.5 years, 5.5 years, 6.5 years, 7.5 years and 8.5 years. The average of the 10,000 simulated values is used to determine a value for WESN shares. The study period is from 12 November 2007 when WESN shares were listed to 12 November 2008. Inputs required for the model are the risk free rate of interest, dividends, volatility and covariance of the returns of WES shares and the S&P/ASX 200 All Industrials Index. The risk free rate of return varies over the period for which data exists. The risk free rate of return is St+1 = St exp [r 2/2 + x] (1)1) estimated using the 5 and 10 year Treasury Bonds. An implied rate is then interpolated for a rate that is the where: furthest possible expiry 12th May 2016 less the date of St = the current stock price at time t, the share price. Expected dividends are assumed to be r = the risk free rate of return $2.00 per annum, therefore the dividend rate 2 = the variance rate (dividend/share price) varies depending on the WES x = a normally distributed random variable with zero share price. This figure is based on the current dividend mean and unit variance for WES shares and expected future dividends as In addition, the antithetic variate method, as described in reported by JB Were in the September 2007 economic Boyle (1977), is used as a variance reduction technique report. Future expected dividends as estimated by JB to reduce simulation error. Were were $2.00 in 2008, $2.07 in 2009 and $2.10 in Five thousand simulated pathways are derived for WES 2010. Expected volatility is estimated using the implied share prices from the 13th of November 2007 to the 12th volatility rates from the ASX and is different for WES of May 2016, followed by 5000 simulated pathways shares and the S&P/ASX 200 All Industrials Index. where the random numbers generated are the negative of These estimates are based on the implied theoretical the first 5000 random numbers. Another 5000 random values of WES shares and S&P/ASX 200 Accumulation numbers are then simulated that are correlated with the Index options. The correlation of the returns for WES first 5000 random numbers to simulate the values of the shares and the S&P/ASX 200 All Industrials Index is S&P/ASX 200 All Industrials Index. This is followed 0.59, based on the historical return correlations for WES by another 5000 simulated pathways where the random shares and the S&P/ASX 200 All Industrials Index from numbers generated are the negative of the 5000 random March 31, 2000 to November 12, 2007. numbers. The end of day share prices for WES shares, WESN An adjustment factor is included because random shares and the end of day values for S&P/ASX 200 All numbers are produced with a certain correlation, Industrials Index were collected from Datastream for the whereas the model requires that the return series for period 12 November 2007 to 12 November 2008. The WES shares and the S&P/ASX 200 All Industrials Index risk free rate of return is obtained from the Reserve Bank values have a particular correlation. An adaptation of of Australia website listed as Interest Rates & Yields: Stuart and Ord (1994) Section 10.5 page 350 results in Money Market & Commonwealth Government the following equation. Securities. The volatility for WES shares and the S&P/ASX 200 All Industrials Index is obtained from the cov(xS,xI)=cov[g(x),h(x)]/{Sexp(r-S2)*I exp(r-2I2)} (2)1) ASX website listed as Volatility and Dividend Parameters under Futures and Options. where : The minimum (maximum) end of day share price for S relates to WES shares WES shares over this period was 18.75 (42.39) with the I relates to the S&P/ASX 200 All Industrials Index average price of 34.66. The minimum (maximum) Equation 2 is then used to estimate the required actual price of WESN shares over this period was 18.65 covariance of the random numbers such that the (42.35) with the average price of 34.83. The minimum covariance of the return series is equal to an assumed (maximum) value of the S&P/ASX 200 All Industrials value. Index over this period was 3,500 (7,066) with the Once the 10,000 8.5 year simulated prices for WES average value of 5,230. shares and 10,000 8.5 year simulated values for the

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3. Results This section provides results of the model used to value WESN shares for the first year following their listing. The results of the price of WES shares are compared with the actual price of WESN shares and the theoretical or modelled value of WESN shares. This section also examines the model sensitivity to the risk free rate of return, expected dividends, expected volatility and the correlation between Wesfarmers and the S&P/ASX 200 All Industrials Index. Lastly, the difference between the actual and modelled value of WESN shares are discussed. The model follows WESN share prices, but observed WESN share prices are closer to WES share prices than anticipated. The modelled values of WESN shares are consistently higher than the observed price of WESN shares by about fifty cents. A closer examination of the difference between observed and modelled WESN share prices is provided in Figure 1. It shows that the difference between the modelled and observed price for WESN shares ranges from zero to just over $1.50. The price difference does not follow any particular trends however, it does appear to be at its highest around midSeptember when the market was exhibiting extreme volatility due to the global financial crisis.
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The price difference between modelled and observed valuations of WESN suggests that either the model assumptions are not those assumed by the market or that the qualitative features of the share offer were not well accepted by the market. A discussion of the effect of the model assumptions is provided next. A discussion of the effect of qualitative features of the share issues are also discussed in more detail. The sensitivity of the model to assumptions about the risk free rate of return, expected dividends, expected volatility and the correlation between WES and the S&P/ASX 200 All Industrials Index were examined. The effect of changing the risk free rate of return assumption in the model over the potential 8.5 years to expiry is examined. The risk free rate of return is
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changed from the bond rate interpolated from Reserve Bank data (bond rate) to the bond rate minus 3% pa to the bond rate plus 3% pa and to a flat rate of 10% pa. As the risk free rate of return is decreased by 3% pa, the difference between the modelled and observed prices of WESN shares generally increases. As the risk free rate of return is increased by 3% pa, the difference between the modelled and observed prices of WESN shares generally decreases. When the risk free rate of return has an assumed fixed rate of 10%, the difference between the modelled and observed prices of WESN shares decreases further. Next, the effect of changing the expected dividend assumption in the model over the potential 8.5 years to expiry is examined. The expected dividend rate is changed from $2.00 per annum (resulting in a varying dividend rate equal to $2.00 divided by the share price) to the dividend rate plus 2% pa to the dividend rate minus 2% pa and then to a constant dividend rate of 5% pa. As the expected dividend rate is decreased by 2% pa, the difference between the modelled and observed prices of WESN shares generally decreases. As the expected dividend rate is increased by 2% pa, the difference between the modelled and observed prices of WESN shares generally increases. Applying the constant dividend rate of 5% provides results close to the varying dividend rate based on a dividend of $2.00 per annum. Next, the effect of changing the expected volatility assumption in the model over the potential 8.5 years to expiry is examined. The expected volatility is changed from the variable volatility rates provided by the ASX to the variable volatility rates provided by the ASX minus 10% pa and to the variable volatility rates provided by the ASX plus 10% pa for WES shares and the S&P/ASX 200 All Industrials Index to test for sensitivity. The expected volatility is changed from the variable volatility rates provided by the ASX to the variable volatility rates provided by the ASX minus 10% pa and to the variable volatility rates provided by the ASX plus 10% pa for WES shares and the S&P/ASX 200 All Industrials Index. Figure 2 shows that as the expected volatility is decreased for WES shares and the S&P/ASX 200 All Industrials Index, the difference between the modelled and observed prices of WESN shares increases significantly. As the expected volatility is increased for WES shares and the S&P/ASX 200 All Industrials Index, the difference between the modelled and observed prices of WESN shares decreases. Lastly, the effect of changing the correlation between WES and the S&P/ASX 200 All Industrials Index is examined. The correlation between WES and the S&P/ASX 200 All Industrials Index is changed from 59% to 90% and to 30%. As the correlation between WES and the S&P/ASX 200 All Industrials Index is decreased, the difference between the modelled and observed prices of WESN shares slightly increases. As the correlation between WES and the S&P/ASX 200 All

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Industrials Index is increased, the difference between the modelled and observed prices of WESN shares slightly decreases. In summary, increasing the risk free rate of return, decreasing expected dividends and increasing expected volatility and the correlation between Wesfarmers and the S&P/ASX 200 All Industrials Index would all provide model valuations that were closer to (and at times lower than) the observed price of WESN shares. In particular, volatility assumptions appear to have a major impact on the model valuations. The difference between the observed and modelled prices of WESN shares may be attributed to either model assumptions for the expected risk free interest rate, expected dividends, expected volatility and the correlation between Wesfarmers and the S&P/ASX 200 All Industrials Index that are different to those of the market or qualitative features of the share offer. However, other factors may also be influencing the model valuations. This section discusses the impact of qualitative features of the share offer that are not able to be included in the model. Features that could not be incorporated into the model, but which may explain the difference between the observed and modelled values include: - Section 10 of the Terms of Issue which states that if a takeover bid is made for WES shares, the Directors will use reasonable endeavours to procure that equivalent takeover offers are made to WESN shareholders or that they participate in the scheme of arrangement; - in the event of a company default by Wesfarmers, WESN shareholders have the same rights as WES shareholders (not superior rights) to participate in surplus assets and profits on a winding up. Lower prices of WES shares will increase the risk of takeover or default. Therefore it is expected that these factors will have a greater impact, resulting in actual prices increasingly lower than theoretical values as the share price falls; - Section 4 of the Terms of Issue which states that the holder of a WESN share may elect to have their WESN shares reclassified as WES shares at any time. This feature ensures that in the absence of transaction costs and with short selling allowed, WESN shares

may not be priced below WES shares. However, transaction costs do exist and are higher for WESN than WES and short selling was not permitted over part of the study period; - Section 11 of the Terms of Issue which states that where events such as bonus issues or rights issues occur the directors may make adjustments the floor or cap price for WESN shares; and - Section 8 of the Terms of Issue which states that the directors at their sole discretion may decide not to effect the bonus issue. Each of these factors contributes to a market uncertainty regarding WESN shares which will reduce the observed price of WESN shares compared to the modelled value. This uncertainty will become increasingly important as the price of WES shares falls as the possibility of takeover or default increases and as limited liquidity continues to increase transaction costs. This will result in WESN share prices that are closer to (and potentially even less than) WES share prices than would be expected using a theoretical model.

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4. Conclusions This paper provides a theoretical valuation for WESN shares and compares these prices with those observed over the first year of trading. It shows that the modelled price of WESN shares was generally higher than the observed prices. Model assumptions regarding the risk free rate of return, expected dividends, expected volatility and the correlation between WES shares and the S&P/ASX 200 All Industrials Index do account for some of this difference, in particular the volatility assumption. An alternative explanation of the difference is that there are several features of the WESN share offer that cannot be incorporated into the model that detract from the value of WESN shares, thus creating a lower market value than would otherwise be expected.

References
[1] P. Boyle. Options: A Monte Carlo Approach, Journal of Financial Economics, 4 323338, 1997. [2] A. Sturt, J. Ord. Kendalls Advanced Theory of Statistics, Edward Arnold, London, 1994.

Third Annual ASEARC Conference Figure 2. Model Sensitivity to a Change in Volatility.

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