CHAPTER 18

Derivatives and Risk

Management

Derivative securities
Fundamentals of risk
management
Using derivatives
18-1

Are stockholders concerned about

whether or not a firm reduces the
volatility of its cash flows?

Not necessarily.
If cash flow volatility is due to
systematic risk, it can be
eliminated by diversifying
investors portfolios.

18-2

Reasons that corporations

engage in risk
management
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.
Reduce the higher taxes that result from
fluctuating earnings.
Initiate compensation programs to reward
managers for achieving stable earnings.
18-3

What is an option?

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.
Most important characteristic of
an option:

It does not obligate its owner to take

action.
It merely gives the owner the right to
18-4
buy or sell an asset.

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.
Option price the market price of the option
contract.
18-5

Option terminology

Expiration date the date the option

matures.

Exercise value the value of an option if it

were exercised today (Current stock price Strike price).

Covered option an option written against

stock held in an investors portfolio.

Naked (uncovered) option an option

written without the stock to back it up.
18-6

Option terminology

In-the-money call a call option whose

exercise price is less than the current price of
the underlying stock.

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.
18-7

Option example

A call option with an exercise price of

$25, has the following values at these
prices:
Stock price
$25
30
35
40
45
50

Call option price

$3.00
7.50
12.00
16.50
21.00
25.50
18-8

Determining option
exercise value and option
premium
Stock Strike Exercise
Option
Option
price
price
$25.00 $25.00
30.00 25.00
35.00 25.00
40.00 25.00
45.00 25.00
50.00 25.00

value
$0.00
5.00
10.00
15.00
20.00
25.00

price premium
$3.00
$3.00
7.50
2.50
12.00
2.00
16.50
1.50
21.00
1.00
25.50
0.50
18-9

How does the option premium

change as the stock price
increases?

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.
18-10

Call premium diagram

Option value

30
25
20

Market price

15

Stock
Exercise value

10

Price

5
5

10

15

20

25

30

35

40

45

50
18-11

What are the assumptions of the

Black-Scholes Option Pricing
Model?

The stock underlying the call option

provides no dividends during the call
options life.
There are no transactions costs for the
sale/purchase of either the stock or the
option.
kRF is known and constant during the
options life.
Security buyers may borrow any fraction
of the purchase price at the short-term,
risk-free rate.
18-12

What are the assumptions of the

Black-Scholes Option Pricing
Model?

No penalty for short selling and

sellers receive immediately full
cash proceeds at todays 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.
18-13

Which equations must be solved

to find the Black-Scholes option
price?

ln(P/X) [kRF
t]
2

d1
t
d2 d1 - t
2

V P[N(d1 )] - Xe [N(d2 )]
-kRFt

18-14

Use the B-S OPM to find the option

value of a call option with P = $27, X
= $25,
kRF = 6%, t = 0.5 years, and 2 =
ln($27/$25
) [(0.06 0.11 )] (0.5)
0.11.
2

d1

0.5736

(0.3317)(0
.7071)
d2 0.5736- (0.3317)(0
.7071) 0.3391

From Table A - 5 in the textbook

N(d1 ) N(0.5736) 0.5000 0.2168 0.7168
N(d2 ) N(0.3391) 0.5000 0.1327 0.6327

18-15

Solving for option value

V P[N(d1)] - Xe

-kRFt

[N(d2 )]

V $27[0.7168
] - $25e

-(0.06)(0.5
)

[0.6327]

V $4.0036

18-16

How do the factors of the B-S

OPM affect a call options
value?
As the factor increases Option value
Current stock price
Increases
Exercise price
Decreases
Time to expiration
Increases
Risk-free rate
Increases
Stock return variance
Increases

18-17

What is corporate risk

management, and why is it
important to all firms?

Corporate risk management relates to

the management of unpredictable
events that would have adverse
consequences for the firm.
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.
18-18

Definitions of different
types of risk

Speculative risks offer the chance of a gain

as well as a loss.

Pure risks offer only the prospect of a loss.

Demand risks risks associated with the

demand for a firms products or services.

Input risks risks associated with a firms

input costs.
Financial risks result from financial
transactions.

18-19

Definitions of different
types of risk

Property risks risks associated with

loss of a firms productive assets.
Personnel risk result from human
actions.
Environmental risk risk associated
with polluting the environment.
Liability risks connected with
product, service, or employee liability.
Insurable risks risks that typically
can be covered by insurance.
18-20

What are the three steps

of corporate risk
management?

Identify the risks faced by the

firm.
2. Measure the potential impact of
the identified risks.
3. Decide how each relevant risk
should be handled.
1.

18-21

What can companies do 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.

Take actions to reduce the probability of

occurrence of adverse events and the
magnitude associated with such adverse
events.

Avoid the activities that give rise to risk.

18-22

What is 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 bond portfolio
falls.

18-23

Financial Risk
Management Concepts

Derivative a security whose value 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 or to hedge and
thus reduce risk.
18-24

Financial Risk
Management Concepts

Hedging usually used when a price change

could negatively affect a firms 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.

Swaps the exchange of cash payment

obligations between two parties, usually
because each party prefers the terms of the
others debt contract. Swaps can reduce
each partys financial risk.
18-25

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 todays price, even if
the market price on the item has
risen substantially in the interim.

18-26