Download Intermediate Financial Management, 5th Ed.

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CHAPTER 18
Derivatives and Risk Management
Derivative securities
Fundamentals of risk management
Using derivatives to reduce interest
rate risk
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Why might stockholders be indifferent
to whether or not a firm reduces the
volatility of its cash flows?
If volatility is due to systematic risk, it
can be eliminated by diversifying
investors’ portfolios.
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Reasons Risk Management Might
Increase the Value of a Corporation
Increase their use of debt.
Maintain their optimal capital budget.
Avoid financial distress costs.
Utilize their comparative advantages
in hedging, compared to investors.
Reduce the risks and costs of
borrowing.
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Reduce the higher taxes that result
from fluctuating earnings.
Initiate compensation programs to
reward managers for achieving stable
earnings.
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What is an option?
An option is a contract that gives its
holder the right, but not the
obligation, to buy (or sell) an asset at
some predetermined price within a
specified period of time.
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What is the single most important
characteristic of an option?
It does not obligate its owner to
take any action. It merely gives the
owner the right to buy or sell an
asset.
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Option Terminology
Call option: An option to buy a
specified number of shares of a
security within some future period.
Put option: An option to sell a
specified number of shares of a
security within some future period.
Exercise (or strike) price: The price
stated in the option contract at which
the security can be bought or sold.
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Option price: The market price of
the option contract.
Expiration date: The date the
option matures.
Exercise value: The value of a call
option if it were exercised today =
Current stock price - Strike price.
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Covered option: A call option
written against stock held in an
investor’s portfolio.
Naked (uncovered) option: An
option sold without the stock to
back it up.
In-the-money call: A call option
whose exercise price is less than
the current price of the underlying stock.
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Out-of-the-money call: A call
option whose exercise price
exceeds the current stock
price.
LEAPS: Long-term Equity
AnticiPation Securities are
similar to conventional options
except that they are long-term
options with maturities of up to
2 1/2 years.
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Consider the following data:
Stock Price
$25
30
35
40
45
50
Call Option Price
$ 3.00
7.50
12.00
16.50
21.00
25.50
Exercise price = $25.
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Create a table which shows (a) stock
price, (b) strike price, (c) exercise
value, (d) option price, and (e) premium
of option price over the exercise value.
Price of Strike
Stock (a) Price (b)
$25.00
$25.00
30.00
25.00
35.00
25.00
40.00
25.00
45.00
25.00
50.00
25.00
Exercise Value
of Option (a) – (b)
$0.00
5.00
10.00
15.00
20.00
25.00
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Table (Continued)
Exercise Value
of Option (c)
$ 0.00
5.00
10.00
15.00
20.00
25.00
Mkt. Price
of Option (d)
$ 3.00
7.50
12.00
16.50
21.00
25.50
Premium
(d) – (c)
$ 3.00
2.50
2.00
1.50
1.00
0.50
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What happens to the premium of the
option price over the exercise
value as the stock price rises?
The premium of the option price over
the exercise value declines as the
stock price increases.
This is due to the declining degree of
leverage provided by options as the
underlying stock price increases, and
the greater loss potential of options at
higher option prices.
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Call Premium Diagram
Option
value
30
25
20
15
Market price
10
5
Exercise value
5
10
15
20
25
30
35
40
45
50
Stock Price
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What are the assumptions of the
Black-Scholes Option Pricing Model?
The stock underlying the call option
provides no dividends during the call
option’s life.
There are no transactions costs for
the sale/purchase of either the stock
or the option.
kRF is known and constant during the
option’s life.
(More...)
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Security buyers may borrow any
fraction of the purchase price at the
short-term, risk-free rate.
No penalty for short selling and sellers
receive immediately full cash proceeds
at today’s price.
Call option can be exercised only on its
expiration date.
 Security trading takes place in
continuous time, and stock prices
move randomly in continuous time.
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What are the three equations that
make up the OPM?
V = P[N(d1)] – Xe -k t[N(d2)].
RF
d1 =
ln(P/X) + [kRF +
(s2s/2)]t
t
d2 = d1 – s t.
.
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What is the value of the following
call option according to the OPM?
Assume: P = $27; X = $25; kRF = 6%;
t = 0.5 years: s2 = 0.11
V = $27[N(d1)] – $25e-(0.06)(0.5)[N(d2)].
ln($27/$25) + [(0.06 + 0.11/2)](0.5)
d1 =
(0.3317)(0.7071)
= 0.5736.
d2 = d1 – (0.3317)(0.7071) = d1 – 0.2345
= 0.5736 – 0.2345 = 0.3391.
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N(d1) = N(0.5736) = 0.5000 + 0.2168
= 0.7168.
N(d2) = N(0.3391) = 0.5000 + 0.1327
= 0.6327.
Note: Values obtained from Table A-5 in text.
V = $27(0.7168) – $25e-0.03(0.6327)
= $19.3536 – $25(0.97045)(0.6327)
= $4.0036.
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What impact do the following parameters have on a call option’s value?
Current stock price: Call option
value increases as the current
stock price increases.
Exercise price: As the exercise
price increases, a call option’s
value decreases.
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Option period: As the expiration date
is lengthened, a call option’s value
increases (more chance of becoming in
the money.)
Risk-free rate: Call option’s value
tends to increase as kRF increases
(reduces the PV of the exercise price).
Stock return variance: Option value
increases with variance of the
underlying stock (more chance of
becoming in the money).
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What is corporate risk management?
Corporate risk management relates
to the management of unpredictable
events that would have adverse
consequences for the firm.
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Why is corporate risk management
important to all firms?
All firms face risks, but the lower
those risks can be made, the more
valuable the firm, other things held
constant. Of course, risk reduction
has a cost.
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Definitions of Different Types of Risk
Speculative risks: Those that offer the
chance of a gain as well as a loss.
Pure risks: Those that offer only the
prospect of a loss.
Demand risks: Those associated with
the demand for a firm’s products or
services.
Input risks: Those associated with a
firm’s input costs.
(More...)
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Financial risks: Those that result from
financial transactions.
Property risks: Those associated with loss
of a firm’s productive assets.
Personnel risk: Risks that result from
human actions.
Environmental risk: Risk associated with
polluting the environment.
Liability risks: Connected with product,
service, or employee liability.
Insurable risks: Those that typically can
be covered by insurance.
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What are the three steps of
corporate risk management?
Step 1. Identify the risks faced by the
firm.
Step 2. Measure the potential impact
of the identified risks.
Step 3. Decide how each relevant risk
should be handled.
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What are some actions that
companies can take to minimize
or reduce risk exposure?
Transfer risk to an insurance
company by paying periodic
premiums.
Transfer functions that produce
risk to third parties.
Purchase derivative contracts to
reduce input and financial risks. (More...)
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Take actions to reduce the
probability of occurrence of
adverse events.
Take actions to reduce the
magnitude of the loss associated
with adverse events.
Avoid the activities that give rise
to risk.
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What is a financial risk exposure?
Financial risk exposure refers to
the risk inherent in the financial
markets due to price fluctuations.
Example: A firm holds a portfolio
of bonds, interest rates rise, and
the value of the bonds falls.
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Financial Risk Management Concepts
Derivative: Security whose value stems or
is derived from the values of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.
Futures: Contracts that call for the
purchase or sale of a financial (or real) asset
at some future date, but at a price determined
today. Futures (and other derivatives) can be
used either as highly leveraged speculations
(More...)
or to hedge and thus reduce risk.
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Hedging: Generally conducted where
a price change could negatively affect a
firm’s profits.
Long hedge: involves the purchase
of a futures contract to guard against
a price increase.
Short hedge: involves the sale of a
futures contract to protect against a
price decline in commodities or
financial securities.
(More...)
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Swaps: Involve the exchange of cash
payment obligations between two
parties, usually because each party
prefers the terms of the other’s debt
contract. Swaps can reduce each
party’s financial risk.
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How can commodity futures markets
be used to reduce input price risk?
The purchase of a commodity futures
contract will allow a firm to make a
future purchase of the input at
today’s price, even if the market price
on the item has risen substantially in
the interim.