Download Share options

21 DERIVATIVES
OHT 21.‹#›
LEARNING OBJECTIVES
• Explain the nature of options and the
distinction between different kinds of
options, and demonstrate their application
in a wide variety of areas
• Show the value of the forwards, futures,
FRAs, swaps, caps and floors markets by
demonstrating transactions which manage
and transfer risk
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
DERIVATIVES
• A derivative instrument is an asset whose
performance is based on (derived from)
the behaviour of the value of an
underlying asset
•
“Underlyings”
–
–
–
–
–
–
Commodities
Shares
Bonds
Share indices
Currencies
Interest rates
Derivatives are contracts that give the
holder the right, and sometimes the
obligation, to buy or sell a quantity of
the underlying, …
…. or benefit in another way from a rise
or fall in the value of the underlying.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
It is the legal right that becomes an asset,
with its own value.
It is the right that is purchased or sold.
Derivative instruments include the
following:
–
–
–
–
–
Futures
Options
Swaps
Forward rate agreements
Forwards
Derivatives can be used to:
– Speculate
– Hedge
– Arbitrage
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
OPTIONS
An option is a contract giving one party the
right, but not the obligation, to buy or sell a
financial instrument, commodity or some
other underlying asset at a given price, at or
before a specified date.
For example, property development options
Share options
• A call option gives the purchaser a right, but
•
•
•
•
not the obligation, to buy a fixed number of
shares at a specified price at some time in
the future
On LIFFE, one option contract relates to a
quantity of 1,000 shares
The seller of the option, who receives the
premium, is referred to as the writer
American-style options can be exercised by
the buyer at any time up to the expiry date
European-style options can only be
exercised on a predetermined future date
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
CALL OPTION HOLDER (CALL
OPTION BUYER)
Cadbury Schweppes
Intrinsic value – the payoff that would be received if
the underlying is at its current level when the option
expires
Time value – the amount by which option premium
exceeds the intrinsic value
In-the-money-option – an option with intrinsic value
Out-of-the-money-option – an option with no
intrinsic value
At-the-money-option – market price equal to option
exercise price
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
CALL OPTION WRITERS
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
OHT 21.‹#›
PUT OPTIONS
A put option gives the holder the right, but not the
obligation, to sell a specific quantity of shares on or
before a specified date at a fixed exercise price.
Cadbury Schweppes
Purchase, for a premium of 19.5p per share (£195 in total),
the right to sell 1,000 shares on or before late January 2002 at
460p.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
USING SHARE OPTIONS TO REDUCE
RISK: HEDGING
Options can give protection against
unfavourable movements in the underlying
while permitting the possibility of
benefiting from favourable movements
Example:
You hold 1,000 shares in Cadbury
Schweppes on 13 Aug. 2001, worth £4,820
(482p per share)
Possible takeover bid
Or dramatic price fall
Sell shares? - loss of possible upside
Alternative: Buy put option - a 460 April
put purchased, premium £280
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
If share price falls to 380p in late April:
Loss on underlying shares £1,020
Intrinsic value of put option £800
((460-380) x 1000)
Below 460p for every 1p lost in share price
1p is gained on the put option.
Maximum loss is £500 (£220 intrinsic value
+ £280 option premium)
Hedging reduces the dispersion of possible
outcomes. There is a floor below which
losses cannot increase, while on the upside
the benefit is reduced due to premium.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
OHT 21.‹#›
INDEX OPTIONS
• Options on whole share indices can be purchased
• Index options are cash settled
• The index is regarded as a price and each one-point
movement on the index represents £10
HEDGING AGAINST A DECLINE IN
THE MARKET
A fund manager controlling a £30m portfolio of shares.
Concerned the market might fall.
Number of options needed to hedge:
With the index at 5431 on 13 August 2001 and each
point of that index settled at £10, one contract has a
value of 5431  £10 = £54,310
To cover a £30m portfolio:
£30m
£54,310 = 552 contracts
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
Buy 552 December 5425 puts for 229 points per
contract.
Premium:
229 points £10  552 = £1,264,080
(4.2% premium)
The index falls 15% to 4616, and the loss on the
portfolio is:
£30m  0.15 = £4,500,000
Gain on options:
(5425 – 4616)  552  £10 =
Less option premium paid
£4,465,680
£1,264,080
£3,201,600
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
CORPORATE USES OF OPTIONS
1 Share options schemes
2 Warrants
3 Convertible bonds
4 Rights issues
5 Share underwriting
6 Commodities
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
OPERATIONAL AND STRATEGIC
DECISIONS WITH OPTIONS (REAL
OPTIONS)
• The expansion option
• The option to abandon
• Option on timing
True NPV
True NPV takes into account the value of
options.
True NPV = Crude NPV + NPV of
expansion
option
+
NPV + NPV of + NPV of
of the
timing
other
option to
option
option
abandon
possibilities
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
FORWARDS AND FUTURES
CONTRACTS
Forwards
A forward contract is an agreement between
two parties to undertake an exchange at an
agreed future date at a price agreed now.
Example: potato crisp manufacturer
Futures
• Agreements between two parties to
undertake a transaction at an agreed price on
a specified future date
• Exchange-based instruments traded on a
regulated exchange
• The clearing house becomes the formal
counterparty to every transaction
• Standardised legal agreements traded in
highly liquid markets
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
FORWARDS AND FUTURES
CONTRACTS
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
OHT 21.‹#›
21 DERIVATIVES
MARKING TO MARKET AND
MARGINS
•
•
•
•
•
Daily marking to market
Member’s margin account
Initial margin
Maintenance margin
Variation margin
Day
£
Value of futur e
(based on daily closing price)
Buyers’ position
Initial margin
Variation margin (+ credited)
(– debited)
Accumulated profit (loss)
Sellers’ position
Initial margin
Variation margin (+ credited)
(– debited)
Accumulated profit (loss)
Monday
Tuesday
Wednesday
Thursday
Friday
50,000
49,000
44,000
50,000
55,000
5,000
0
–1,000
–5,000
+6,000
+5,000
0
–1,000
–6,000
0
+5,000
5,000
0
+1,000
+5,000
–6,000
–5,000
0
+1,000
+6,000
0
–5,000
Exhibit 21.16 Example of initial margin and marking to market
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
• Leverage
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
• Settlement:
Physical delivery
Cash
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
OHT 21.‹#›
SHORT-TERM INTEREST RATE
FUTURES
Notional fixed-term deposits, usually for three-month periods starting at a specific time in
the future.
• The buyer of one contract is buying the right to deposit money at a particular rate of
interest for three months at least notionally.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
SHORT-TERM INTEREST RATE
FUTURES
The unit of trading for a three-month sterling time deposit is £500,000.
Cash delivery is the means of settlement. Delivery defines the date and time of the expiry of the
contact – September, December, March and June.
Price is defined as:
P = 100 – i
where:
P = price index;
i = the future interest rate in percentage terms.
Tick
A tick is the minimum price movement on a future.
On a three-month sterling interest rate contract a tick is a movement of 0.01 per cent on a trading
unit of £500,000.
£12.50 is the value of a tick movement in a three-month sterling interest rate futures contract.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
FORWARD RATE AGREEMENTS
(FRAs)
Agreements about the future level of interest
rates.
The rate of interest at some point in the future
is compared with the level agreed when the
FRA was established and compensation is
paid by one party to the other based on the
difference.
Certainty over the effective interest cost of
borrowing is generated in the future if an FRA
is bought.
The sale of an FRA by a company protects
against a fall in interest rates.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
FRA Example:
A company needs to borrow £6m in six
months’ time for a period of one year
• It arranges this with bank X
• The current rate of interest is 7%
• Concern: interest rates will be higher when
the loan is drawn down
• Purchase FRA at 7% from bank Y to take
effect 6 months from now and relate to 12
month loan
• Six months later:
Spot interest rates for 1 year borrowing = 8.5%
Payment to bank X: £6m  0.085 = £510,000
(£90,000 more than if rate is 7%)
Bank Y pays (0.085-0.07)  £6m = £90,000
If rates fall below 7% company compensates Bank Y.
A “sale” of an FRA: protects against a fall in rates.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
A comparison of options, futures and
forward rate agreements
Exhibit 21.22
Options
Futures
FRAs
Downside risk is limited but
the buyer is able to participate
in favourable movements.
Specific rates are locked in.
No right to let the contract
lapse, as with options.
No margins or premiums payable.
Available on or off exchanges.
Exchange regulation and clearing
house reduce counterparty
default risk for those options
traded on exchanges.
No premium is payable. (However
margin payments are required.)
Tailor-made, not standardised as
to size, duration and terms.
Usually highly liquid markets.
Very liquid markets. Able to
reverse transactions quickly
and cheaply.
Can create certainty. Locks in
specific effective interest rate.
May be useful if no strong view
is held on direction of underlying.
Exchange regulation and clearing
house reduce counterparty
default risk.
Advantages
Disadvantages
Premium payable reduces returns.
If the underlying transaction does
not materialise, potential loss is
unlimited.
Benefits from favourable
movements in rates are forgone.
Margin r equired on written
options.
Many exchange restrictions
on size, duration, trading times.
Greater risk of counterparty
default – not exchange traded.
Margin calls require daily work
for ‘back office’.
More difficult to liquidate.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
CAPS
An interest cap is a contract that gives the purchaser the
right to effectively set maximum level for interest rates
payable.
Compensation is paid to the purchaser of a cap if
interest rates rise above an agreed level.
Example:
• Oakham borrows £20m for 5 years from Bank A at
variable interest rate Libor + 1.5%
(interest reset every 3 months – currently 7%)
• Concern: interest rates rise
Buys an interest rate cap set at Libor of 8.5%
• Cost, say 2.3% payable now for 5 year cover
(£20m x 0.023=£460,000)
• 3rd Year: Libor = 9.5%
• Oakham pays to Bank A 9.5+1.5%
Receives 1% from cap seller
If rates fall Oakham benefits
Floors and collars
If the interest rate falls below an agreed level, the seller
(the floor writer) makes compensatory payments to the
floor buyer.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
SWAPS
A swap is an exchange of cash payment
obligations.
Cat plc and Dog plc
• Cat plc and Dog plc both want to borrow
£150m for eight years
• Cat would like to borrow on a fixed-rate
basis because this would better match its
asset position
• Dog prefers to borrow at floating rates
because of optimism about future interestrate falls
• Cat could obtain fixed-rate borrowing at
10 per cent and floating rate at Libor +2 per
cent
• Dog is able to borrow at 8 per cent fixed
and Libor +1 per cent floating:
Fixed Floating
Cat can borrow at
10% Libor +2%
Dog can borrow at
8% Libor +1%
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
SWAPS CAT AND DOG
Fixed 9.5%
Cat
Dog
Libor +2%
Libor +2%
Bank A
Fixed 8%
Bank B
Exhibit 21.23 An interest rate swap
Cat:
Pays
Receives
Pays
Net payment
Libor +2%
Libor +2%
Fixed 9.5%
Fixed 9.5%
Dog:
Pays
Fixed 8%
Receives
Fixed 9.5%
Pays
Libor +2%
Net payment Libor +0.5%
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
DERIVATIVES USERS
• Hedgers
To hedge is to enter into transactions which
protect a business or assets against changes in
some underlying
• Speculators
Speculators take a position in financial
instruments and other assets with a view to
obtaining a profit on changes in value.
• Arbitrageurs
The act of arbitrage is to exploit price
differences on the same instrument or similar
assets
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
OVER-THE-COUNTER (OTC) AND
EXCHANGE-TRADED DERIVATIVES
Advantages
OTC derivative
Contracts can be tailor -made, which allows perfect hedging and permits hedges of
more unusual underlyings.
Disadvantages
Ther e is a risk (credit risk) that the counterparty will fail to honour the transaction.
Low level of market regulation with resultant loss of transparency and price dissemination.
Often difficult to reverse a hedge once the agreement has been made.
Higher transaction costs.
Advantages
Exchange-traded derivative
Credit risk is reduced because the clearing house is counterparty.
High regulation encourages transparency and openness on the price of recent trades.
Liquidity is usually much higher than for OTC – large orders can be cleared quickly
due to high daily volume of trade.
Positions can be reversed by closing quickly – an equal and opposite transaction is
completed in minutes.
Disadvantages
Standardisation may be restrictive, e.g. standardised terms for quality of underlying,
quantity, delivery dates.
The limited trading hours and margin requirements may be inconvenient.
Exhibit 21.25 OTC and exchange-traded derivatives
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
21 DERIVATIVES
OHT 21.‹#›
OPTION PRICING
Notation to be used:
C = value of call option
S = current market price of share
X = future exercise price
Rf = risk-free interest rate (per annum)
T = time to expiry (in years)
 = standard deviation of the share price
E = mathematical fixed constants: 2.718....
• Options have a minimum value of zero
C0
• The market value of an option will be greater than the
intrinsic value at any time prior to expiry
Market value = intrinsic value + time value
• Intrinsic value (S – X) rises as share price increases or
exercise price falls
X
Intrinsic value = S –
(1 + rf)t
• The higher the risk-free rate of return the higher will be
intrinsic value
• The maximum value of an option is the price of the share
C<S
• A major influence boosting the time value is the volatility
of the underlying share price
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 21.‹#›
21 DERIVATIVES
BLACK AND SCHOLES’ OPTION
PRICING MODEL
C = SN(d1) – X N (d )
2
erf t
where:
N (.) = cumulative normal distribution
function of d1 and d2;
d1 =
ln(S/X) + (rf + 2/2)t
t
ln = natural log
d2 = d1 – t
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002