Chapter 18

DERIVATIVES AND RISK MANAGEMENT

Learning Objectives

After reading this chapter, students should be able to:
1. Identify the circumstances in which it makes sense for companies to
manage risk.
2. Describe the various types of derivatives and explain how they can be
used to manage risk.
3. Value options using the Binomial and Black-Scholes Option Pricing
Models.
4. Discuss the various elements of risk management and the different
processes that firms use to manage risks.

Overview
Risk management can mean many things, but in business it involves
identifying events that could have adverse financial consequences for the
firm and then undertaking actions to prevent and/or minimize the damage
caused by these events. Years ago, corporate risk managers dealt primarily
with insurance—they made sure the firm was adequately insured against
fire, theft, and other casualties and that it had adequate liability coverage.
More recently, however, the scope of risk management has been broadened
to include such things as controlling the costs of key inputs or protecting
against changes in interest rates or exchange rates. In addition, risk
managers try to ensure that actions designed to hedge against risks are not
actually increasing risks.

Outline

I. Although there is no proof that risk management adds value,
there are several good reasons for companies to manage risk.
Corporate managers frequently hedge risk even though it does
little to increase corporate value. Perhaps a more likely
explanation is that hedging creates other benefits that
ultimately lead to either higher cash flows and/or a lower
WACC.
A. Debt capacity. Risk management can reduce the volatility of cash
flows, and this decreases the probability of bankruptcy. Firms with
lower operating risks can use more debt, and this can lead to higher
stock prices due to the interest tax savings.

through the use of swaps. hence of financial distress. our tax system encourages risk management to stabilize earnings. Hedging with futures lowered aggregate risk in the economy. Financial distress is associated with having cash flows fall below expected levels. 1. especially the interest rate on debt. Effective risk management requires specialized skills and knowledge that firms are more likely to have than individual investors. . Companies with volatile earnings pay more taxes than more stable companies due to the treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. a manager’s bonus is higher if earnings are stable. The earliest futures dealings were between two parties who arranged transactions between themselves. middlemen came into the picture. C. A historical perspective is useful when studying derivatives. G. One of the first formal markets for derivatives was the futures market for wheat. B. and trading in futures was established. Managers know more about the firm’s risk exposure than outside investors. B. E. F. By smoothing out the cash flows. D. Financial distress. Compensation systems. though. Perhaps the most important aspect of risk management involves derivative securities. Maintaining the optimal capital budget over time. it may still be beneficial to managers. Therefore. risk management can alleviate the possibility that internal cash flows will be too low to support the optimal capital budget. Soon. Typically. Borrowing costs. Any such cost reduction adds value to the firm. Firms have lower transactions costs due to a larger volume of hedging activities. 3. Comparative advantages in hedging. Firms can sometimes reduce input costs. 2. II. Many compensation systems establish “floors” and “ceilings” on bonuses or else reward managers for meeting targets. Tax effects. hence managers can create more effective hedges. A. Many investors cannot implement a homemade hedging program as efficiently as a firm can. Risk management can reduce the likelihood of low cash flows. even if hedging does not add much value for stockholders. So.

Speculators then entered the scene. Derivatives markets are inherently volatile due to the leverage involved. a. foreign currencies. a. C. F. 1. The Chicago Board of Trade was an early marketplace for this dealing. These exist for many commodities. Insurance is an obvious example of this type of hedge. Even in these instances. and having a better basis for pricing hedges makes the counterparties more comfortable with deals. . Natural hedges are situations in which aggregate risk can be reduced by derivatives transactions between two parties known as counterparties. and this stabilizes the market.” E. 2. 1. 2. 1. insurance companies can reduce certain types of risk through diversification. 3. With nonsymmetric hedges. Speculators bearing that risk makes the derivatives markets more stable for the hedgers. and another party agrees to sell a contract that protects the first party from that specific event or situation. interest rates on securities with different maturities. hence risk to the speculators themselves is high. and even common stocks where portfolio managers want to “hedge their bets. risks are generally transferred rather than eliminated. Analytical techniques have been developed to help establish “fair” prices. and futures dealers helped make a market in futures contracts. 1. This improved the efficiency and lowered the cost of hedging operations. Computers and electronic communications make it much easier for counterparties to deal with one another. 2. Here one party wants to reduce some type of risk. Globalization has greatly increased the importance of currency markets and the need for reducing the exchange rate risks brought on by global trade. Speculators add capital and players to the derivatives market. D. though. 2. The derivatives markets have grown more rapidly than any other major market in recent years for a number of reasons. 3. Hedging can also be done in situations where no natural hedge exists.

A put option is an option to sell a share of stock at a certain price within a specified period. Options can be used to create hedges that protect the value of an individual stock or portfolio. It’s harder for a firm’s top management to exercise proper control over derivatives transactions. The seller of an option is called the option writer. E. Options sold without the stock to back them up are called naked options. G. a. This makes mistakes more likely than with less complex instruments. Recent trends and developments are sure to continue. These instruments are highly leveraged. a call option is in-the-money. so the use of derivatives for risk management is bound to grow. Derivatives do have a potential downside. 2. D. 1. They are complicated. When the exercise price is below the current stock price. B. Derivatives are used far more often to hedge risks than in harmful speculation. a call option is said to be out-of-the-money. H. 1. III. so small miscalculations can lead to huge losses. or “call. or exercise. . price is the price that must be paid for a share of common stock when an option is exercised. C. G.” a share of stock at a certain price within a specified period. 1. A. An investor who “writes” call options against stock held in his or her portfolio is said to be selling covered options. but a new type of option called a Long-Term Equity Anticipation Security (LEAPS) is also traded. F. 1. When the exercise price exceeds the current stock price. hence not well understood by most people. A call option is an option to buy. The strike. 4. Conventional options are generally written for 7 months or less. An option is a contract that gives its holder the right to buy (or sell) an asset at a predetermined price within a specified period of time. b.

1. LEAPS are long-term options. LEAPS provide buyers with more potential for gains and offer better long-term protection for a portfolio. although the premium declines as the stock price increases above the strike price. the greater the chance that the stock price will climb substantially above the exercise price. The higher the stock’s market price relative to the strike price. but because of their much longer time to expiration. 2. 1. H. The longer the option period. One-year LEAPS cost about twice as much as the matching three-month option. the minimum “true” value of an option is zero. 3. . having maturities of up to 3 years. 1. The higher the strike price. LEAPS are listed on exchanges and are tied both to individual stocks and to stock indexes. Option holders do not vote for corporate directors or receive dividends. 2. A call option’s exercise value is equal to the current stock price less the strike price. nor do they have any direct transactions in it. 3. The actual market price of the option lies above the exercise value at each price of the common stock. the lower the call option price. 2. 4. J. the higher the option price. The exercise value is what the option would be worth if you had to exercise it immediately. I. This occurs because the longer the time before expiration. 1. 2. Corporations on whose stocks options are written have nothing to do with the option market. a. 3. a. the higher the call option price. Options enable individuals to gain a high degree of personal leverage when buying securities. Corporations do not raise money in the option market. An option’s exercise value is only a first approximation value—it merely provides a starting point for finding the actual option value. There are at least three factors that affect a call option’s value. Realistically. because no one would exercise an out-of-the-money option.

K. that a portfolio that consists of the stock and the call option will earn the risk-free rate. In addition to the stock price and the exercise price. The price of a call option always increases as the risk-free rate increases. Given the price of the stock. the life of the option. in equilibrium. b. a. there is but one price for the option if it is to meet the equilibrium condition. arbitrageurs will actively trade stocks and options until option prices reflect equilibrium conditions. The declining leverage impact and the increasing danger of larger losses help explain why the premium diminishes as the price of the common stock rises. The first effect tends to increase the call option’s price. The expected growth rate of a firm’s stock price increases as interest rates increase. a. it must. b. (2) the variability of the stock price. and the risk-free rate. The Binomial Option Pricing Model is an option pricing model based on a riskless hedge with two scenarios for the value of the . while the second tends to decrease it. An option on an extremely volatile stock is worth more than one on a very stable stock. 1. As a result of the unlimited upside but limited downside. A. The first effect dominates the second one. If options are not priced to reflect this condition. If an investment is riskless. A riskless hedge is a hedge in which an investor buys a stock and simultaneously sells a call option on that stock and ends up with a riskless position. the higher the value of its options. c. IV. namely. All option pricing models are based on the concept of a riskless hedge. the greater its value and the larger its premium. the option’s exercise price. C. and (3) the risk- free rate. 3. the more volatile a stock. but the present value of future cash flows decreases. D. The longer a call option has to run. the price of an option depends on three other factors: (1) the option’s time until expiration. its potential volatility. 1. yield the risk- free rate. 2. B.

The assumptions made in the OPM are: 1. . risk-free interest rate is known and is constant during the life of the option. Trading in all securities takes place continuously. 6. 3. risk-free interest rate. 5. a. V. The PV of the portfolio is discounted at the risk-free rate. B. It is based on the creation of a riskless portfolio. The short-term. Short selling is permitted. The steps in this approach to estimate the call option’s value are: 1. it is applicable to “real-world” option pricing because it allows for a complete range of ending stock prices. Any purchaser of a security may borrow any fraction of the purchase price at the short-term. The Black-Scholes model consists of the following three equations: V  P[ N(d 1 )]  Xe  rRF t [ N(d 2 )] ln(P/X)  [rRF  ( 2 / 2)]t d1   t d 2  d1   t 1. Equalize the range of payoffs for the stock and the options. Create a riskless hedged investment so that the ending total value of the portfolio is identical. The stock underlying the call option provides no dividends or other distributions during the life of the option. 2. and the stock price moves randomly. and the short seller will receive immediately the full cash proceeds of today’s price for a security sold short. The Black-Scholes Option Pricing Model (OPM) is widely used by option traders to estimate the value of a call option. 3. A. There are no transactions costs for buying or selling either the stock or the option. Price the call option as the difference between the cost of the stock and the PV of the portfolio. The call option can be exercised only on its expiration date. 2. 4. 4. Analysis assumes two scenarios for the stock price. V = current value of the call option. 5. underlying asset. Find the range of values for the option at expiration. however. 7.

Thus. 1. rRF = risk-free interest rate. X = exercise.7183. t = time until the option expires (the option period). . If the actual option price is different from the one determined by the Black-Scholes Option Pricing Model. 7. A. 2. 3. 5. 2 = variance of the rate of return on the stock. Futures contracts are generally standardized instruments that are traded on exchanges. Actual option prices conform reasonably well to values derived from the model. e  2. but with three key differences. whereas forward contracts are generally tailor-made. 1. This greatly reduces the risk of default that exists with forward contracts. 2. N(d1) and N(d2) represent areas under a standard normal distribution curve. P = current price of the underlying stock. Forward contracts are agreements where one party agrees to buy a commodity at a specific price on a specific future date and the other party agrees to make the sale. B. 4. A futures contract is similar to a forward contract. this would provide the opportunity for arbitrage profits. ln(P/X) = natural logarithm of P/X. C. or strike. 9. which would force the option price back to the value indicated by the model. Put and call options represent an important class of derivative securities. N(di) = probability that a deviation less than di will occur in a standard normal distribution. price of the option. physical delivery of the underlying asset is virtually never taken—the two parties simply settle with cash for the difference between the contracted price and the actual price on the expiration date. 1. 8. Goods are actually delivered under forward contracts. meaning that gains and losses are noted and money must be put up to cover losses. VI. 6. Futures contracts are “marked to market” on a daily basis. 3. are negotiated between two parties. but there are other types of derivatives. and are not traded after they have been signed. With futures. a.

called a maintenance margin. then the owner may be required to add additional funds to the margin account. E. not to create them.C. When futures contracts are purchased. If interest rates in the economy rise. risks. The primary motivation behind these contracts is to reduce risks. 1. b. Futures contracts are never settled by delivery of the securities involved. a. D. Commodity futures are contracts that are used to hedge against price changes for input materials. the more money must be added. The transaction is completed by reversing the trade. a. Futures and forward contracts were originally used for commodities. 2. or reduce. and exchange rates. Futures contracts are divided into two classes: commodity futures and financial futures. the value of the hypothetical T-note will fall. the purchaser is required to post an initial margin. 1. and vice versa. 4. 1. The actual gains and losses on the contract are realized when the futures contract is closed. Forward contracts and futures can be used to hedge. and the more the contract value falls. b. but today more trading is done in foreign exchange and interest rate futures. 3. Financial futures are contracts that are used to hedge against fluctuating interest rates. . Interest rate futures are based on a hypothetical 10-year Treasury note with a 6% semiannual coupon. Interest rate futures represent another huge and growing market. the purchaser does not have to put up the full amount of the purchase price. a. Investors are required to maintain a certain value in the margin account. F. Futures contracts and options are similar to one another. If the value of the contract declines. stock prices. which amounts to selling the contract back to the original seller. rather. 2.

a. Futures are used for commodities. Options exist both for individual stocks and for bundles of stocks. a. generally obligations to make specified payment streams. which would match up counterparties. Originally. and a host of other “exotic” contracts. 2. inverse floaters. but today most swaps are between companies and banks. structured notes. An interest rate swap occurs when one firm exchanges a fixed- rate debt obligation for another firm’s variable-rate debt obligation. 3. additional payments needed to get the other party to agree to the swap. The purpose of the interest rate swap is to match the best debt payment stream with each firm’s cash flow stream. debt securities. swaps were arranged between companies by money center banks. No matter how low or how high the price goes. forwards. with the banks then taking steps to ensure that their own risks are hedged. but generally not for commodities. A. 1. the two parties must settle the contract at the agreed-upon price. Such matching still occurs. A futures contract is a definite agreement on the part of one party to buy something on a specific date and a specific price. VII. Most swaps today involve either interest payments or currencies. An option gives someone the right to buy (call) or sell (put) an asset. . 4. but the holder of the option does not have to complete the transaction. 1. Options. A currency swap occurs when one firm exchanges debt denominated in one currency for another firm’s debt denominated in another currency. but there are other types of derivatives. and futures are among the most important classes of derivative securities. Note that swaps can involve side payments. and the other party agrees to sell on the same terms. In a swap two parties agree to swap something. b. a. including swaps. The purpose of the currency swap is to protect each firm against exposure to exchange rate risk. 2. a. and stock indexes. a.

the issuing firm assembles a portfolio of debt instruments. If interest rates fall. Firms are subject to numerous risks related to interest rate. If interest rates in the economy rose. a. one of the most obvious ways to reduce financial risks is to hold a broadly diversified portfolio of stocks and debt securities. CDOs are similar to CMOs but instead of assembling a portfolio of mortgages. b. Investment bankers can create notes called IOs. At the same time. For an investor. Zeros formed by stripping T-bonds were one of the first types of structured notes. the interest rate paid on an inverse floater would fall. stock price. VIII. Another important type of structured note backed by the interest and principal payments on mortgages is a collateralized mortgage obligation. a. 3. b. lowering its cash interest payments. Futures and swaps help manage certain types of risk. the value of an inverse floater will soar. C. The overall risk is partitioned into several classes. Wall Street firms have put together instruments called collateralized debt obligations (CDOs). Structured notes permit a partitioning of risks to give investors what they want. which provide cash flows from the interest component of the mortgage amortization payments. More recently. for Principal Only. The combined effect of lower cash flows and a higher discount rate would lead to a very large decline in the value of the inverse floater. 3. and POs. A structured note is a debt obligation derived from another debt obligation. 2. . With an inverse floater. however. B. and exchange rate fluctuations in the financial markets. 4. 2. for Interest Only. 1. 1. Inverse floaters are exceptionally vulnerable to increases in interest rates. derivatives can also be used to reduce the risks associated with financial and commodity markets. the rate paid on the note moves counter to market rates. which are paid from the principal repayment stream. the discount rate used to value the inverse floater’s cash flows would rise along with other rates. A floating-rate note has an interest rate that rises and falls with some interest rate index.

In theory. Standardized contracts have been developed for the most common types of swaps. the reduction in risk resulting from a hedge transaction should have a value exactly equal to the cost of the hedge. 1. Standardized contracts lower the time and effort involved in arranging swaps. b. b. Hedging is done by a firm or individual to protect against a price change that would otherwise negatively affect profits. Short hedges involve futures contracts sold to guard against price declines. A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position. a. Futures are used for both speculation and hedging. a firm should be indifferent to hedging. because in most cases the underlying asset is not identical to the futures asset. 4. this protection has a cost—the firm must pay commissions.A. and even when they are. In reality. against changes that occur between the time a decision is reached and the time when the transaction will be completed. In finance. at least partially. and futures are used because of the leverage inherent in the contract. However. Speculation involves betting on futures price movements. 1. A swap is another method for reducing financial risks. Long hedges involve futures contracts bought in anticipation of (or to guard against) price increases. prices (and interest rates) may not move exactly together in the spot and futures markets. in which each party to the swap prefers the payment type or pattern of the other party. There are two basic types of hedges. it is virtually impossible to construct perfect hedges. 3. because the firm can be protected. a. . B. Thus. 2. a. Major changes have occurred over time in the swaps market. a. and thus lower transaction costs. The futures and options markets permit flexibility in the timing of financial transactions. 2. it is an exchange of cash payment obligations. and this has had two effects.

1. As businesses become increasingly complex. A. B. The development of standardized contracts has led to a secondary market for swaps. and (3) decide how each relevant risk should be handled. input risks. 1. and insurable risks. D. C. Firms often use the following three-step approach to risk management: (1) identify the risks faced by the firm. (2) measure the potential effect of the risks identified. they have the potential to create very large losses in very short periods. . a risk. C. property risks. 2. While the use of derivatives to hedge risk is an important tool for risk managers. which has increased the liquidity and efficiency of the swaps market. IX. Often. personnel risks. If a company can safely and inexpensively hedge its risk. and commodity price variability. financial risks. currency. liability risks. Risk can be classified in many ways and different classifications are commonly used in different industries. demand risks. and different classifications are commonly used in different industries. it is advantageous to insure against. it should do so. b. speculative risks. Risk management involves the management of unpredictable events that have adverse consequences for the firm. environmental risks. Insurability does not necessarily mean that a risk should be covered by insurance. Transfer the risk to an insurance company. a. if improperly constructed or if derivatives are used for speculation purposes. Here’s one list that provides an idea of the wide variety of risks to which a firm can be exposed: pure risks. D. companies need to have someone systematically look for potential problems and design safeguards to minimize potential damage. Futures markets were established for many commodities long before they began to be used for financial instruments. a. Hedging allows managers to concentrate on running their core businesses without having to worry about interest rate. and hence transfer. There are several techniques used to reduce risk exposure: 1. These risk classifications are somewhat arbitrary.

Transfer the function that produces the risk to a third party. 5. b. 4. Risk management decisions. risks can be reduced most easily by passing them on to some other company that is not an insurance company. The same financial management techniques applied to other corporate decisions can also be applied to risk management decisions. 6. E. which means bearing the risk directly rather than paying to have another party bear the risk. 2. In some situations. In some instances. should be based on a cost/benefit analysis for each feasible alternative. Firms use derivatives to hedge risk. Reduce the probability of the occurrence of an adverse event. 3. Totally avoid the activity that gives rise to the risk. 1. . like all corporate decisions. Purchase derivative contracts to reduce risk. Reduce the magnitude of the loss associated with an adverse event. It might be better for the company to self-insure. it is possible to take action to reduce the probability that an adverse event will occur.