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CMA Part 2
Financial Decision Making
Study Unit 5 - Financial Instruments and Cost of
Capital
Ronald Schmidt, CMA, CFM
5.4 Derivatives
• Derivative Instrument
– Investment in which gain or loss is derived from some
other economic event.
– One party speculates (incur risk) and the other hedges
(avoid risk).
– Are not claims on business assets such as equity
securities.
• Hedging
– Using offsetting commitments to minimize impact of
adverse price movements.
– Long Position: would like to sell an asset in the future to
benefit from the rise in value. (participate in short hedge)
– Short Position: would like to buy an asset in the future to
benefit from fall in value. (participate in long hedge)
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5.4 Derivatives
• Options
– Buyer has the right to demand some action from seller.
But is not obligated!
– Exercise is always at the discretion of the option holder.
– Expiration Dates
• European
• American
– Exercise Price (strike price): price at which the option
holder can purchase or sell the asset.
– Option Price: amount the buyer pays to acquire the
option.
– Covered Option: seller already has possession of asset
– Naked (uncovered) Option: does not have possession of
asset. Speculative.
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5.4 Derivatives
• Call Options
– Right to purchase the underlying asset at a fixed
price.
– Price > Exercise Price, in the money.
– Price < Exercise Price, out of the money.
– Price = Exercise Price, at the money
– Buyer has a long position and the seller has a short
position.
– Buyer’s Gain/Loss =
– Seller’s Gain/Loss =
– Examples p.186 (d & e)
– Graph p.187 (f)
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5.4 Derivatives
• Call Options
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5.4 Derivatives
• Call Options
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5.4 Derivatives
• Put Options
–
–
–
–
–
–
–
–
–
Right to sell the underlying asset at a fixed price.
Price < Exercise Price, in the money.
Price > Exercise Price, out of the money.
Price = Exercise Price, at the money
Holder has a short position and the seller has a
long position.
Buyer’s Gain/Loss =
Seller’s Gain/Loss =
Examples p.187-188 (d & e)
Graph p.188 (f)
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5.4 Derivatives
• Put Options
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5.4 Derivatives
• Put Options
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5.4 Derivatives
• Put Call Parity
– Depicts the combinations of investment
strategies that can be devised using Euro
options.
• 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑙𝑙 + 𝑃𝑉 𝑥𝑃 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑢𝑡 +
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
– Restated to provide a risk-free return:
• 𝑃𝑉 𝑥𝑃 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑢𝑡 + 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 −
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑙𝑙
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5.4 Derivatives
• Valuing an Option
• Black Scholes
• Binomial
– Exercise Price
• xP increase causes decrease in value of call and increase in
value of put.
– Price of Underlying Asset
• Price increase causes call value to increase
– Interest Rates
• Rise in interest rates results in rise in value of call
– Time until Expiration
• Increase in time causes options value to increase
– Table on p.189
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5.4 Derivatives
• Forward Contracts
– Two parties agree that, at a future date, one
will perform and the other will pay a specified
amount.
– Retailer / Wholesaler example
– Buyer has taken a long position while the
seller has taken a short position.
– Both parties are contractually obligated to
perform
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5.4 Derivatives
• Futures Contracts
– Trading of commodities
– Commitment to buy or sell an asset at a fixed
price during a specific future month.
• Counterparty unknown
– Delivery during a given month, no exact date.
Flexibility
– Active trading results in a liquid market where
participants can net out their positions. Hedging
– Contract prices are marked to market everyday.
Daily settlement.
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5.4 Derivatives
• Swaps
– Contracts by which the parties exchange cash
flows.
– Interest Rate Swaps: agreements to exchange
interest payments based on one interest
structure for payments based on another
structure.
– Currency Swaps: agreements to exchange cash
flows denominated in one currency for cash
flows denominated in another.
– Credit Default Swaps
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SU 5.4 – Practice Question 1
An automobile company that uses the futures market to set the price of
steel to protect a profit against price increases is an example of
A.
B.
C.
D.
A short hedge.
A long hedge.
Selling futures to protect the company from
loss.
Selling futures to protect against price
declines.
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SU 5.4 – Practice Question 1 Answer
Correct Answer: B
A change in prices can be minimized or avoided by hedging.
Hedging is the process of using offsetting commitments to
minimize or avoid the impact of adverse price movements. The
automobile company desires to stabilize the price of steel so that
its cost to the company will not rise and cut into profits.
Accordingly, the automobile company uses the futures market to
create a long hedge, which is a futures contract that is purchased
to protect against price increases.
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SU 5.4 – Practice Question 2
The use of derivatives to either hedge or speculate results in
A.
Increased risk regardless of motive.
B.
Decreased risk regardless of motive.
C.
Offsetting risk when hedging and increased
risk when speculating.
D.
Offsetting risk when speculating and
increased risk when hedging.
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SU 5.4 – Practice Question 2 Answer
Correct Answer: C
Derivatives, including options and futures, are contracts between
the parties who contract. Unlike stocks and bonds, they are not
claims on business assets. A futures contract is entered into as
either a speculation or a hedge. Speculation involves the
assumption of risk in the hope of gaining from price movements.
Hedging is the process of using offsetting commitments to
minimize or avoid the impact of adverse price movements.
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SU 5.4 – Practice Question 3
A forward contract involves a commitment today to purchase a product
A.
On a specific future date at a price to be
determined some time in the future.
B.
At some time during the current day at its
present price.
C.
On a specific future date at a price
determined today.
D.
Only when its price increases above its
current exercise price.
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SU 5.4 – Practice Question 1 Answer
Correct Answer: C
A forward contract is an executory contract in which the parties
involved agree to the terms of a purchase and a sale, but
performance is deferred. Accordingly, a forward contract involves
a commitment today to purchase a product on a specific future
date at a price determined today.
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