This action might not be possible to undo. Are you sure you want to continue?
Dr. Keith M. Howe
Summer 2008
Definition
Risk and uncertainty
Risk aversion
Risk management
The process of formulating the benefitcost
tradeoffs of risk reduction and deciding on the
course of action to take (including the decision
to take no action at all).
Two more definitions
•
Derivatives
•
financial assets (e.g., stock option, futures, forwards, etc)
whose values depend upon the value of the underlying
assets.
•
Hedge
•
the use of financial instruments or of other tools to reduce
exposure to a risk factor.
Figure 1.2. Gains and losses from buying shares and a call option on Risky
Upside Inc.
Risky Upside Inc. price
110
Gain
20 50
$3,000
+$6,000
Panel A. Gain frombuying shares of Risky
Upside Inc. at $50 per share.
Risky Upside Inc. price
110
Gain
50
0
$1,000
20
$5,000
Panel B. Gain frombuying a call option on
shares of Risky Upside Inc. with exercise price
of $50 for a premiumof $10 per share.
Exchange rate
Income to firm
$100 million
Unhedged income
$1
$0.90
$90 million
Panel A. Income to Garman if it does not hedge.
Figure 1.3. Hedging with forward contract. Garman ’s
income is in dollars and the exchange rate is the dollar price
of one euro.
Exchange rate
Gain from contract
to firm
Forward
gain
Forward
loss
Forward rate $1
$0.9
$10 million
Panel B. Forward contract payoff.
Panel C. Hedged firm income.
Exchange rate
Income to firm
Forward
gain
Forward
loss
$100 million
Unhedged income
Hedged income
Forward rate $1
Panel D. Comparison of income with put contract and income with forward contract.
Exchange rate Exchange rate
Income to firm Income to firm
Gain with Gain with
option option
Loss with option Loss with option
$100 million
Exercise price of $1
Unhedged
income
Risk management irrelevance
proposition
•
Bottom line: hedging a risk does not increase firm value when
the cost of bearing the risk is the same whether the risk is borne
within the firm or outside the firm by the capital markets.
•
This proposition holds when financial markets are perfect.
Risk management irrelevance
proposition
•
Allows us to find out when homemade risk management is not equivalent to
risk management by the firm.
•
This is the case whenever risk management by a firm affects firm value in a
way that investors cannot mimic.
•
For risk management to increase firm value, it must be more expensive to
take a risk within the firm than to pay the capital markets to take it.
Role of risk management
Risk management can add value to the firm by:
•
Decreasing taxes
•
Decreasing transaction costs (including
bankruptcy costs)
•
Avoiding investment decision errors
Bankruptcy costs and
costs of financial distress
•
Costs incurred as a result of a bankruptcy filing are
called bankruptcy costs.
•
The extent to which bankruptcy costs affect firm
value depends on their extent and on the probability
that the firm will have to file for bankruptcy.
•
The probability that a firm will be bankrupt is the
probability that it will not have enough cash flow to
repay the debt.
•
Direct bankruptcy costs
•
Average ratio of direct bankruptcy costs to total assets: 2.8%
•
Indirect bankruptcy costs
•
Many of these indirect costs start accruing as soon as a firm’s
financial situation becomes unhealthy, called costs of financial
distress
•
Managers of a firm in bankruptcy lose control of some
decisions. They might not allowed to undertake costly new
projects, for example.
Cash flow to the
firm
Cash flow to shareholders
Unhedged cash flow
Expected cash
flow $350M
$250M $450M
$250M
$450M
Expected cash
flow $350M
Figure 3.1. Cash flow to shareholders and operating cash flow.
Figure 3.2. Creating the unhedged firm out of the hedged firm.
Forward
gain
Forward
loss
Unhedged cash flow
Hedged firm cash
flow
$350M (gold sold at forward)
$350M
(hedged)
Cashflow to
shareholders
Figure 3.3. Cash flow to claimholders and bankruptcy costs.
Cash flow to the
firm
Cash flow to claimholders
Unhedged cash flow
Expected cash
flow $350M
$250M $450M
$230M
$450M
Expected cash
flow hedged
$350M
Unhedged
$340M
Bankruptcy
cost
Value of firm unhedged = PV (C – Bankruptcy costs)
= PV (C) – PV (Bankruptcy costs)
= value of firm without bankruptcy costs – PV (bankruptcy costs)
Gain from risk management
= value of firm hedged – value of firm unhedged
= PV( bankruptcy costs)
Value of firm unhedged + gain from risk management
= value of firm hedged
= value of firm without bankruptcy costs
Analysis of decreasing
transaction cost by hedging
Taxes and risk
management
Tax rationale for risk management: If it moves a dollar away from a possible
outcome in which the taxpayer is subject to a high tax rate and shifts it to a
possible outcome where the taxpayer incurs a low tax rate, a firm or an
investor reduces the present value of taxes to be paid. It applies whenever
income is taxed differently at different levels.
 Carrybacks and carryforwards
 Tax shields
 Personal taxes
Example
The firm pays taxes at the rate of 50 percent on cash flow in excess of
$300 per ounce. For simplicity, the price of fold is either $250 or $450 with
Equal probability. The forward price is $350.
Optimal capital
structure and risk
management
•
In general, firms cannot eliminate all risk, debt is
risky.
•
By having more debt, firms increase their tax shield from debt but
increase the present value of costs of financial distress.
•
The optimal capital structure of a firm:
•
Balances the tax benefits of debt against the costs of financial
distress.
•
Through risk management:
•
A firm can reduce the present value of the costs of financial
distress by making financial distress less likely.
•
As a result, it can take on more debt.
Should the firm hedge to reduce the risk of
large undiversified shareholders?
•
Large undiversified shareholders can increase firm value
•
Risk and the incentives of managers
•
Large shareholders, managerial incentives, and homestake
Figure 3.6. Firm aftertax cash flow and debt issue.
After taxcash flowof hedged
firm
100 200 300 400
305
310
315
320
325
330
Principal amount of debt
Optimal amount of
debt, $317.073M
Risk management process
Risk identification
Risk assessment
Selection of riskmgt
techniques
Implementation
Review
The rules of risk management
• There is no return without risk
• Be transparent
• Seek experience
• Know what you don’t know
• Communicate
• Diversify
• Show discipline
• Use common sense
• Get a RiskGrade
Risk Management
Source: Riskmetrics Group (www.riskmetrics.com)
Types of risks firms face
Market risk
 interest rate
 foreign exchange
 commodity price
Hazard risk
 physical damage
 liabilities
 business interruption
Operational risk
 industry sectors
 geographical regions
Strategic risk
 competition
 reputation
 investor support
Assignment of risk responsibilities
CEO
Strategic risk
management
CRO
Market risk
management
Hazard risk
management
Operational risk
management
Hedgeable Insurable
Diversifiable
Three dimensions of risk transfer
•
Hedging
•
Insuring
•
Diversifying
A new concept of risk management
(VAR)
•
Valueatrisk (VAR) is a category of risk measures that describe
probabilistically the market risk of mostly a trading portfolio.
•
It summarizes the predicted maximum loss (or worst loss) over a
target horizon within a given confidence interval.
•
If the portfolio return is normally distributed, has zero mean, and
has volatility σ over the measurement period, the 5 percent VAR
of the portfolio is:
VAR = 1.65 X s X Portfolio value
Example of VAR
•
The US bank J.P. Morgan states in its 2000
annual report that its aggregate VAR is about
$22m.
•
The bank, one of the pioneers in risk management,
may say that for 95 percent of the time it does not
expect to lose more than $22m on a given day.
More on VAR
•
The main appeal of VAR was to describe risk in dollars  or
whatever base currency is used  making it far more transparent
and easier to grasp than previous measures.
•
VAR also represents the amount of economic capital necessary to
support a business, which is an essential component of “economic
value added” measures.
•
VAR has become the standard benchmark” for measuring financial
risk.
Instruments used in risk
management
•
Forward contracts
•
Futures contracts
•
Hedging
•
Interest rate futures contracts
•
Duration hedging
•
Swap contracts
•
Options
Forward Contracts
•
A forward contract specifies that a certain commodity will be
exchanged for another at a specified time in the future at
prices specified today.
•
Its not an option: both parties are expected to hold up their end of the deal.
•
If you have ever ordered a textbook that was not in stock, you have entered
into a forward contract.
Suppose S&P index price is $1050 in 6 months. A
holder who entered a long position at a forward price of
$1020 is obligated to pay $1020 to acquire the index,
and hence earns $1050  $1020 = $30 per unit of the
index. The short is likewise obligated to sell for $1020,
and thus loses $30.
Example
S&R Index S&R Forward
in 6 months long short
900 $120 $120
950 70 70
1000 20 20
1020 0 0
1050 30 30
1100 80 80
If the index price in 6 months = $1020, both the long and short have a 0 payoff.
If the index price > $1020, the long makes money and the short loses money.
If the index price < $1020, the long loses money and the short makes money.
Payoff after 6 months
Problem: The current S&P index is $1000. You have just
purchased a 6 month forward with a price of $1100. If
the index in 6 months has appreciated by 7%, what is
the payoff of this position?
Solution: F
0
=1100
S
1
=1000*1.07=1070
Payoff: 10701100=  $30.
Example: Valuing a Forward
Contract on a Share of Stock
Consider the obligation to buy a share of Microsoft stock one
year from now for $100. Assume that the stock currently sells
for $97 per share and that Microsoft will pay no dividends
over the coming year. Oneyear zerocoupon bonds that pay
$100 one year from now currently sell for $92. At what price
are you willing to buy or sell this obligation?
Strategy 1 the forward contract
One year from now Today
Buy stock at a price of $100.
Sell the share for cash at market
Strategy 2  the portfolio strategy
Today One year from now
Buy stock today
Sell short $100 in face value
of 1year zerocoupon bonds
Sell the stock
Buyback the zerocoupon
bonds of $100
Buy a forward contract
Valuing a forward contract
Valuing a forward contract
Cost
Today
Cash flow one
year from now
Strategy 1
Strategy 2
?
$97$92
S
1
 $100
S
1
 $100
Since strategies 1 and 2 have identical cash flows in the future,
they should have the same cost today to prevent arbitrage.
? = $97  $92 = $5
In strategy 1, the obligation to buy the stock for $100 one year
from now, should cost $5.
The noarbitrage value of a forward contract on a share of stock (the
obligation to buy a share of stock at a price of K, T years in the future),
assuming the stock pays no dividends prior to T, is
where
S
0
= current price of the stock
= the current market price of a defaultfree zerocoupon bond
paying K, T years in the future
T
f
r
K
S
) 1 (
0
+
−
T
f
r
K
) 1 ( +
Valuing a forward contract
At no arbitrage:
T
f
r S K F ) 1 (
0 0
+ · ·
0
) 1 (
0
·
+
−
T
f
r
K
S
domestic
foreign
r
r
S
F
+
+
·
1
1
0
0
Currency Forward Rates
•
Currency forward rates are a variation on forward price of stock.
•
In the absence of arbitrage, the forward currency rate F0 (for example,
Euros/dollar) is related to the current exchange rate (or spot rate) S0, by the
equation
•
where r = the return (unannualized) on a domestic or foreign riskfree security
over the life of the forward agreement, as measured in the respective country's
currency
Forward Currency Rates
Example: The Relation Between Forward Currency Rates
and Interest Rates
Assume that sixmonth LIBOR on Canadian funds is 4 percent
and the US$ Eurodollar rate (sixmonth LIBOR on U.S. funds)
is 10 percent and that both rates are default free. What is the six
month forward Can$/US$ exchange rate if the current spot rate
is Can$1.25/US$? Assume that six months from now is 182
days.
Answer: (LIBOR is a zerocoupon rate based on an
actual/360 day count.) So
Canada United States
Sixmonth interest
Rate (unannualized):
The forward rate is
% 4
360
182
% 02 . 2 × · % 10
360
182
% 06 . 5 × ·
. 25 . 1
0506 . 1
0202 . 1
$
21 . 1 $
× ·
US
Can
Currency Forward Rates
Futures Contracts: Preliminaries
•
A futures contract is like a forward contract:
•
It specifies that a certain commodity will be exchanged for another at
a specified time in the future at prices specified today.
•
A futures contract is different from a forward:
•
Futures are standardized contracts trading on organized exchanges
with daily resettlement (“marking to market”) through a
clearinghouse.
Futures Contracts: Preliminaries
•
Standardizing Features:
•
Contract Size
•
Delivery Month
•
Daily resettlement
•
Minimizes the chance of default
•
Initial Margin
•
About 4% of contract value, cash or Tbills held in a
street name at your brokerage.
Daily Resettlement: An Example
Suppose you want to speculate on a rise in the $/¥ exchange
rate (specifically you think that the dollar will appreciate).
Currently $1 = ¥140.
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1month forward 0.006993007 0.007042254 143 142
3months forward 0.006666667 0.006711409 150 149
6months forward 0.00625 0.006289308 160 159
The 3month forward price is $1=¥150.
Daily Resettlement: An Example
•
Currently $1 = ¥140 and it appears that the dollar is
strengthening.
•
If you enter into a 3month futures contract to sell ¥ at the
rate of $1 = ¥150 you will make money if the yen
depreciates. The contract size is ¥12,500,000
•
Your initial margin is 4% of the contract value:
¥150
$1
0 ¥12,500,00 .04 $3,333.33 × × ·
Daily Resettlement: An Example
If tomorrow, the futures rate closes at $1 = ¥149, then
your position’s value drops.
Your original agreement was to sell ¥12,500,000 and
receive $83,333.33:
¥149
$1
0 ¥12,500,00 62 . 892 , 83 $ × ·
You have lost $559.28 overnight.
But ¥12,500,000 is now worth $83,892.62:
¥150
$1
0 ¥12,500,00 $83,333.33 × ·
Daily Resettlement: An Example
•
The $559.28 comes out of your $3,333.33 margin account,
leaving $2,774.05
•
This is short of the $3,355.70 required for a new position.
¥149
$1
0 ¥12,500,00 .04 $3,355.70 × × ·
Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds or your position will be closed out.
This is usually done with a reversing trade.
Selected Futures Contracts
Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels Chicago BOT
Wheat 5,000 bushels Chicago & KC
Cocoa 10 metric tons CSCE
OJ 15,000 lbs. CTN
Metals & Petroleum
Copper 25,000 lbs. CMX
Gold 100 troy oz. CMX
Unleaded gasoline 42,000 gal. NYM
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Eurodollar $1 million LIFFE
Futures Markets
•
The Chicago Mercantile Exchange (CME) is by far
the largest.
•
Others include:
•
The Philadelphia Board of Trade (PBOT)
•
The MidAmerica Commodities Exchange
•
The Tokyo International Financial Futures Exchange
•
The London International Financial Futures Exchange
The Chicago Mercantile Exchange
•
Expiry cycle: March, June, September, December.
•
Delivery date 3
rd
Wednesday of delivery month.
•
Last trading day is the second business day preceding
the delivery day.
•
CME hours 7:20 a.m. to 2:00 p.m. CST.
CME After Hours
•
Extendedhours trading on GLOBEX runs from 2:30 p.m. to
4:00 p.m dinner break and then back at it from 6:00 p.m. to
6:00 a.m. CST.
•
Singapore International Monetary Exchange (SIMEX) offer
interchangeable contracts.
•
There’s other markets, but none are close to CME and
SIMEX trading volume.
Open
Open High Low Settle Change High Low Interest
July 179 180 178¼ 178½ 1½ 312 177 2,837
Sept 186 186½ 184 186 ¾ 280 184 104,900
Dec 196 197 194 196½ ¼ 291¼ 194 175,187
Sept 11705 11721 11627 11705 +5 13106 11115 647,560
Dec 11619 11705 11612 11621 +5 12828 11106 13,857
Sept 11200 11285 11145 11241 17 11324 7875 18,530
Dec 11287 11385 11255 11349 17 11430 7987 1,599
Lifetime
Corn (CBT) 5,000 bu.; cents per bu.
TREASURY BONDS (CBT)  $1,000,000; pts. 32nds of 100%
DJ INDUSTRIAL AVERAGE (CBOT)  $10 times average
Expiry month
Opening price
Highest price that day
Lowest price that day
Closing price Daily Change
Highest and lowest prices over the lifetime of the contract.
Number of open contracts
Wall Street Journal Futures Price Quotes
Basic Currency Futures Relationships
•
Open Interest refers to the number of contracts outstanding
for a particular delivery month.
•
Open interest is a good proxy for demand for a contract.
•
Some refer to open interest as the depth of the market. The
breadth of the market would be how many different contracts
(expiry month, currency) are outstanding.
Hedging
•
Two counterparties with offsetting risks can eliminate
risk.
•
For example, if a wheat farmer and a flour mill enter into a forward
contract, they can eliminate the risk each other faces regarding the future
price of wheat.
•
Hedgers can also transfer price risk to speculators and
speculators absorb price risk from hedgers.
•
Speculating: Long vs. Short
Hedging and Speculating Example
You speculate that copper will go up in price, so you go long 10 copper
contracts for delivery in 3 months. A contract is 25,000 pounds in cents
per pound and is at $0.70 per pound or $17,500 per contract.
If futures prices rise by 5 cents, you will gain:
Gain = 25,000 × .05 × 10 = $12,500
If prices decrease by 5 cents, your loss is:
Loss = 25,000 × .05 × 10 = $12,500
Hedging: How many contacts?
You are a farmer and you will harvest 50,000 bushels of corn in
3 months. You want to hedge against a price decrease. Corn
is quoted in cents per bushel at 5,000 bushels per contract. It
is currently at $2.30 cents for a contract 3 months out and the
spot price is $2.05.
To hedge you will sell 10 corn futures contracts:
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
contracts 10
contract per bushels 000 , 5
bushels 000 , 50
·
Interest Rate Futures
Contracts
Pricing of Treasury Bonds
Consider a Treasury bond that pays a semiannual coupon of $C
for the next T years:
•
The yield to maturity is r
]
]
]
+
− +
+
·
T T
r r
C
r
F
PV
) 1 (
1
1
) 1 (
Value of the Tbond under a flat term structure
= PV of face value + PV of coupon payments
C
…
0 1 2 3
2T
C F C + C
Pricing of Treasury Bonds
If the term structure of interest rates is not flat, then
we need to discount the payments at different rates
depending upon maturity
T
T
r
F C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
2
3
3
2
2 1
+
+
+ +
+
+
+
+
+
·
= PV of face value + PV of coupon payments
C
…
0 1 2 3
2T
C F C + C
Pricing of Forward Contracts
An Nperiod forward contract on that TBond
C
…
0 N N+1 N+2 N+3 N+2T
C F C + C
forward
P −
Can be valued as the present value of the forward price.
N
N
T
T N N N N
r
r
F C
r
C
r
C
r
C
PV
) 1 (
) 1 ( ) 1 ( ) 1 ( ) 1 (
2
3
3
2
2 1
+
+
+
+ +
+
+
+
+
+
·
+ + + +
N
N
forward
r
P
PV
) 1 ( +
·
Futures Contracts
•
The pricing equation given above will be
a good approximation.
•
The only real difference is the daily
resettlement.
Hedging in Interest Rate Futures
•
A mortgage lender who has agreed to loan money in the
future at prices set today can hedge by selling those
mortgages forward.
•
It may be difficult to find a counterparty in the forward who
wants the precise mix of risk, maturity, and size.
•
It’s likely to be easier and cheaper to use interest rate futures
contracts however.
Duration Hedging
•
As an alternative to hedging with futures or forwards,
one can hedge by matching the interest rate risk of
assets with the interest rate risk of liabilities.
•
Duration is the key to measuring interest rate risk.
•
Duration measures the combined effect of maturity,
coupon rate, and YTM on bond’s price sensitivity
•
Measure of the bond’s effective maturity
•
Measure of the average life of the security
•
Weighted average maturity of the bond’s cash flows
Duration Hedging
Duration Formula
∑
∑
·
·
+
+
×
·
× + + × + ×
·
N
t
t
t
N
t
t
t
T
r
C
r
t C
D
PV
T C PV C PV C PV
D
1
1
2 1
) 1 (
) 1 (
) ( 2 ) ( 1 ) (
Calculating Duration
Calculate the duration of a threeyear bond that
pays a semiannual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually?
Discount Present Years x PV
Years Cash flow factor value / Bond price
0.5 $40.00 0.96154 $38.46 0.0192
1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Calculating Duration
Duration is expressed in units of time; usually years.
Duration
The key to bond portfolio management
•
Properties:
• Longer maturity, longer duration
• Duration increases at a decreasing rate
• Higher coupon, shorter duration
• Higher yield, shorter duration
•
Zero coupon bond: duration = maturity
Swaps Contracts: Definitions
•
In a swap, two counterparties agree to a contractual
arrangement wherein they agree to exchange cash flows at
periodic intervals.
•
There are two types of interest rate swaps:
•
Single currency interest rate swap
•
“Plain vanilla” fixedforfloating swaps are often just called interest rate swaps.
•
CrossCurrency interest rate swap
•
This is often called a currency swap; fixed for fixed rate debt service in two (or
more) currencies.
The Swap Bank
•
A swap bank is a generic term to describe a financial
institution that facilitates swaps between counterparties.
•
The swap bank can serve as either a broker or a dealer.
•
As a broker, the swap bank matches counterparties but does not assume any of the
risks of the swap.
•
As a dealer, the swap bank stands ready to accept either side of a currency swap,
and then later lay off their risk, or match it with a counterparty.
An Example of an Interest Rate Swap
•
Consider this example of a “plain vanilla” interest rate swap.
•
Bank A is a AAArated international bank located in the U.K.
and wishes to raise $10,000,000 to finance floatingrate
Eurodollar loans.
•
Bank A is considering issuing 5year fixedrate Eurodollar bonds at 10 percent.
•
It would make more sense to for the bank to issue floatingrate notes at LIBOR
to finance floatingrate Eurodollar loans.
An Example of an Interest Rate Swap
•
Firm B is a BBBrated U.S. company. It needs
$10,000,000 to finance an investment with a fiveyear
economic life.
•
Firm B is considering issuing 5year fixedrate Eurodollar bonds at
11.75 percent.
•
Alternatively, firm B can raise the money by issuing 5year floatingrate
notes at LIBOR + ½ percent.
•
Firm B would prefer to borrow at a fixed rate.
An Example of an Interest Rate Swap
The borrowing opportunities of the two firms are:
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
Bank
A
The swap bank makes
this offer to Bank A:
You pay LIBOR – 1/8 %
per year on $10 million
for 5 years and we will
pay you 10 3/8% on $10
million for 5 years
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Swap
Bank
LIBOR – 1/8%
10 3/8%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
Here’s what’s in it for Bank A:
They can borrow externally at
10% fixed and have a net
borrowing position of
10 3/8 + 10 + (LIBOR – 1/8) =
LIBOR – ½ % which is ½ %
better than they can borrow
floating without a swap.
10%
½% of $10,000,000 =
$50,000. That’s quite
a cost savings per
year for 5 years.
Swap
Bank
LIBOR – 1/8%
10 3/8%
Bank
A
An Example of an Interest Rate Swap
Company
B
The swap bank
makes this offer to
company B: You
pay us 10½% per
year on $10 million
for 5 years and we
will pay you
LIBOR – ¼ % per
year on $10 million
for 5 years.
Swap
Bank
10 ½%
LIBOR – ¼%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
They can borrow externally at
LIBOR + ½ % and have a net
borrowing position of
10½ + (LIBOR + ½ )  (LIBOR  ¼ ) = 11.25%
which is ½% better than they can borrow floating.
LIBOR
+ ½%
Here’s what’s in it for B:
½ % of $10,000,000 =
$50,000 that’s quite a
cost savings per year for
5 years.
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%
An Example of an Interest Rate Swap
The swap bank makes money too.
¼% of $10 million
= $25,000 per year
for 5 years.
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
10 ½  10 3/8 = 1/8
¼
Swap
Bank
Company
B
10 ½%
LIBOR – ¼% LIBOR – 1/8%
10 3/8%
Bank
A
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
Swap
Bank
Company
B
10 ½%
LIBOR – ¼% LIBOR – 1/8%
10 3/8%
Bank
A
B saves ½% A saves ½%
The swap bank makes ¼%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of a Currency Swap
•
Suppose a U.S. MNC wants to finance a £10,000,000
expansion of a British plant.
•
They could borrow dollars in the U.S. where they are well
known and exchange for dollars for pounds.
•
This will give them exchange rate risk: financing a sterling project with
dollars.
•
They could borrow pounds in the international bond market,
but pay a premium since they are not as well known abroad.
An Example of a Currency Swap
•
If they can find a British MNC with a mirror
image financing need they may both benefit
from a swap.
•
If the spot exchange rate is S
0
($/£) = $1.60/£,
the U.S. firm needs to find a British firm
wanting to finance dollar borrowing in the
amount of $16,000,000.
An Example of a Currency Swap
Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based multinational.
Both firms wish to finance a project in each other’s country of
the same size. Their borrowing opportunities are given in the
table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
$9.4%
An Example of a Currency Swap
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
$8%
£12%
Swap
Bank
Firm
A
£11%
$8%
£12%
An Example of a Currency Swap
$8%
£12%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
A’s net position is to borrow at £11%
A saves £.6%
An Example of a Currency Swap
$8%
£12%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
B’s net position is to borrow at $9.4%
B saves $.6%
An Example of a Currency Swap
$8%
£12%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
The swap bank makes money too:
At S
0
($/£) = $1.60/£, that
is a gain of $124,000 per
year for 5 years.
The swap bank
faces exchange rate
risk, but maybe
they can lay it off
(in another swap).
1.4% of $16 million
financed with 1% of
£10 million per year
for 5 years.
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
Variations of Basic Swaps
•
Currency Swaps
•
fixed for fixed
•
fixed for floating
•
floating for floating
•
amortizing
•
Interest Rate Swaps
•
zerofor floating
•
floating for floating
•
Exotica
•
For a swap to be possible, two humans must like the idea. Beyond that,
creativity is the only limit.
Risks of Interest Rate and
Currency Swaps
•
Interest Rate Risk
•
Interest rates might move against the swap bank after it has only gotten half of
a swap on the books, or if it has an unhedged position.
•
Basis Risk
•
If the floating rates of the two counterparties are not pegged to the same index.
•
Exchange Rate Risk
•
In the example of a currency swap given earlier, the swap bank would be
worse off if the pound appreciated.
Risks of Interest Rate and
Currency Swaps
•
Credit Risk
• This is the major risk faced by a swap dealer—the risk that a counter party will
default on its end of the swap.
•
Mismatch Risk
• It’s hard to find a counterparty that wants to borrow the right amount of money for
the right amount of time.
•
Sovereign Risk
• The risk that a country will impose exchange rate restrictions that will interfere with
performance on the swap.
Pricing a Swap
•
A swap is a derivative security so it can be priced in
terms of the underlying assets:
•
How to:
•
Plain vanilla fixed for floating swap gets valued just like a bond.
•
Currency swap gets valued just like a nest of currency futures.
Options
•
Many corporate securities are similar to the stock options
that are traded on organized exchanges.
•
Almost every issue of corporate stocks and bonds has
option features.
•
In addition, capital structure and capital budgeting
decisions can be viewed in terms of options.
Options Contracts: Preliminaries
•
An option gives the holder the right, but not the obligation, to
buy or sell a given quantity of an asset on (or perhaps before) a
given date, at prices agreed upon today.
•
Calls versus Puts
•
Call options gives the holder the right, but not the obligation, to buy a
given quantity of some asset at some time in the future, at prices agreed
upon today. When exercising a call option, you “call in” the asset.
•
Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you “put” the asset to someone.
Options Contracts: Preliminaries
•
Exercising the Option
•
The act of buying or selling the underlying asset through the option contract.
•
Strike Price or Exercise Price
•
Refers to the fixed price in the option contract at which the holder can buy or
sell the underlying asset.
•
Expiry
•
The maturity date of the option is referred to as the expiration date, or the
expiry.
•
European versus American options
•
European options can be exercised only at expiry.
•
American options can be exercised at any time up to expiry.
Options Contracts: Preliminaries
•
IntheMoney
•
The exercise price is less than the spot price of the underlying asset.
•
AttheMoney
•
The exercise price is equal to the spot price of the underlying asset.
•
OutoftheMoney
•
The exercise price is more than the spot price of the underlying asset.
Options Contracts: Preliminaries
•
Intrinsic Value
•
The difference between the exercise price of the option and the spot price of
the underlying asset.
•
Speculative Value
•
The difference between the option premium and the intrinsic value of the
option.
Option
Premium
=
Intrinsic
Value
Speculative
Value
+
Call Options
• Call options gives the holder the right, but not the obligation,
to buy a given quantity of some asset on or before some time
in the future, at prices agreed upon today.
• When exercising a call option, you “call in” the asset.
Basic Call Option Pricing
Relationships at Expiry
•
At expiry, an American call option is worth the same as a
European option with the same characteristics.
• If the call is inthemoney, it is worth S
T
 E.
•
If the call is outofthemoney, it is worthless.
C
aT
= C
eT
= Max[S
T

E, 0]
•
Where
S
T
is the value of the stock at expiry (time T)
E is the exercise price.
C
aT
is the value of an American call at expiry
C
eT
is the value of a European call at expiry
Call Option Payoffs
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a call
Exercise price = $50
Call Option Payoffs
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Write a call
Exercise price = $50
Call Option Profits
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Exercise price = $50; option premium = $10
Put Options
•
Put options gives the holder the right, but
not the obligation, to sell a given quantity of
an asset on or before some time in the
future, at prices agreed upon today.
•
When exercising a put, you “put” the asset
to someone.
Basic Put Option Pricing
Relationships at Expiry
•
At expiry, an American put option is worth
the same as a European option with the
same characteristics.
•
If the put is inthemoney, it is worth E  S
T
.
•
If the put is outofthemoney, it is
worthless.
P
aT
= P
eT
= Max[E  S
T
, 0]
Put Option Payoffs
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a put
Exercise price = $50
Put Option Payoffs
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
write a put
Exercise price = $50
Stock price ($)
Put Option Profits
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
Exercise price = $50; option premium = $10
10
10
Selling Options
•
The seller (or writer) of an
option has an obligation.
•
The purchaser of an option
has an option.
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
10
10
20
100 90 80 70 60 0 10 20 30 40 50
40
20
0
60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
This option has a strike price of $135;
a recent price for the stock is $138.25
July is the expiration month
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
This makes a call option with this exercise price inthe
money by $3.25 = $138¼ – $135.
Puts with this exercise price are outofthemoney.
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
On this day, 2,365 call options with this exercise price were
traded.
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
The CALL option with a strike price of $135 is trading for
$4.75.
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions.
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
On this day, 2,431 put options with this exercise price were
traded.
Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Put Call
The PUT option with a strike price of $135 is trading for
$.8125.
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions.
Combinations of Options
•
Puts and calls can serve as the building
blocks for more complex option contracts.
•
If you understand this, you can become a
financial engineer, tailoring the riskreturn
profile to meet your client’s needs.
Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Buy a put with an exercise
price of $50
Buy the
stock
Protective Put strategy has
downside protection and
upside potential
$50
$0
$50
Value at
expiry
Value of
stock at
expiry
Protective Put Strategy Profits
Buy a put with
exercise price of
$50 for $10
Buy the stock at $40
$40
Protective Put
strategy has
downside protection
and upside potential
$40
$0
$40
$50
Value at
expiry
Value of
stock at
expiry
Covered Call Strategy
Sell a call with
exercise price of
$50 for $10
Buy the stock at $40
$40
Covered call
$40
$0
$40
$10
$30
$30 $50
Value of stock at expiry
Value at
expiry
Long Straddle: Buy a Call and a Put
Buy a put with an
exercise price of
$50 for $10
$40
A Long Straddle only makes money if the
stock price moves $20 away from $50.
$40
$0
$20
$50
Buy a call with an
exercise price of
$50 for $10
$10
$30
$60 $30 $70
Value of
stock at
expiry
Value at
expiry
Short Straddle: Sell a Call and a Put
Sell a put with exercise price of
$50 for $10
$40
A Short Straddle only loses money if the stock
price moves $20 away from $50.
$40
$0
$30
$50
Sell a call with an
exercise price of $50 for $10
$10
$20
$60 $30 $70
Value of stock at
expiry
Value at
expiry
Long Call Spread
Sell a call with exercise
price of $55 for $5
$55
long call spread
$5
$0
$50
Buy a call with an
exercise price of
$50 for $10
$10
$5
$60
Value of
stock at
expiry
Value at
expiry
PutCall Parity
Sell a put with an
exercise price of $40
Buy the stock at $40
financed with some
debt: FV = $X
Buy a call option with
an exercise price of $40
$0
$40
$40P
0
rT
Xe
−
− 40 $
$40
Buy the
stock at $40
0
40 $ C +
) 40 ($
rT
Xe
−
− −
[$40P
0
]
0
C −
0
P
In market equilibrium, it mast be the case that option prices
are set such that:
0 0 0
S P Xe C
rT
+ · +
−
Otherwise, riskless portfolios with positive payoffs exist.
Value of
stock at
expiry
Value at
expiry
Valuing Options
•
The last section
concerned itself with the
value of an option at
expiry.
•
This section considers
the value of an option
prior to the expiration
date.
•
A much more
interesting question.
Option Value Determinants
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate + –
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option C
0
must fall within
max (S
0
– E, 0) < C
0
< S
0
.
The precise position will depend on these factors.
Market Value, Time Value and Intrinsic Value for
an American Call
C
aT
> Max[S
T
 E, 0]
Profit
loss
E
S
T
Market Value
Intrinsic value
ST

E
Time value
Outofthemoney Inthemoney
ST
The value of a call option C
0
must fall within
max (S
0
– E, 0) < C
0
< S
0
.
An Option Pricing Formula ‑
•
We will start with a
binomial option pricing
formula to build our
intuition.
•
Then we will graduate
to the normal
approximation to the
binomial for some real
world option valuation.
Binomial Option Pricing Model
Suppose a stock is worth $25 today and in one period will either be worth 15% more
or 15% less. S
0
= $25 today and in one year S
1
is either $28.75 or $21.25. The riskfree
rate is 5%. What is the value of an atthemoney call option?
$25
$21.25
$28.75
S
1
S
0
Binomial Option Pricing Model
1. A call option on this stock with exercise price of $25 will have the
following payoffs.
2. We can replicate the payoffs of the call option. With a levered position in
the stock.
$25
$21.25
$28.75
S
1
S
0
C
1
$3.75
$0
Binomial Option Pricing Model
Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either $7.50
or $0.
The levered equity portfolio has twice the option’s payoff so the portfolio is
worth twice the call option value.
$25
$21.25
$28.75
S
1
S
0
debt
 $21.25
portfolio
$7.50
$0
(  ) =
=
=
C
1
$3.75
$0
 $21.25
Binomial Option Pricing Model
The levered equity portfolio value today is
today’s value of one share less the present
value of a $21.25 debt:
) 1 (
25 . 21 $
25 $
f
r +
−
$25
$21.25
$28.75
S
1
S
0
debt
 $21.25
portfolio
$7.50
$0
(  ) =
=
=
C
1
$3.75
$0
 $21.25
Binomial Option Pricing Model
We can value the option today as half of the
value of the levered equity portfolio:
,
`
.

+
− ·
) 1 (
25 . 21 $
25 $
2
1
0
f
r
C
$25
$21.25
$28.75
S
1
S
0
debt
 $21.25
portfolio
$7.50
$0
(  ) =
=
=
C
1
$3.75
$0
 $21.25
If the interest rate is 5%, the call is worth:
The Binomial Option Pricing Model
( ) 38 . 2 $ 24 . 20 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
· − ·
,
`
.

− · C
$25
$21.25
$28.75
S
1
S
0
debt
 $21.25
portfolio
$7.50
$0
(  ) =
=
=
C
1
$3.75
$0
 $21.25
If the interest rate is 5%, the call is worth:
The Binomial Option Pricing Model
( ) 38 . 2 $ 24 . 20 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
· − ·
,
`
.

− · C
$25
$21.25
$28.75
S
1
S
0
debt
 $21.25
portfolio
$7.50
$0
(  ) =
=
=
C
1
$3.75
$0
 $21.25
$2.38
C
0
Binomial Option Pricing Model
the replicating portfolio intuition.
the replicating portfolio intuition.
Many derivative securities can be valued by
valuing portfolios of primitive securities
when those portfolios have the same
payoffs as the derivative securities.
The most important lesson (so far) from the binomial
option pricing model is:
The RiskNeutral Approach to Valuation
We could value V(0) as the value of the replicating portfolio.
An equivalent method is riskneutral valuation
S(0), V(0)
S(U), V(U)
S(D), V(D)
q
1 q
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D V q U V q
V
+
× − + ×
·
The RiskNeutral Approach to Valuation
S(0) is the value of the
underlying asset today.
S(0), V(0)
S(U), V(U)
S(D), V(D)
S(U) and S(D) are the values of the asset in the next
period following an up move and a down move,
respectively.
q
1 q
V(U) and V(D) are the values of the asset in the next period following an
up move and a down move, respectively.
q is the riskneutral
probability of an “up”
move.
The RiskNeutral Approach to
Valuation
•
The key to finding q is to note that it is already impounded into
an observable security price: the value of S(0):
S(0), V(0)
S(U), V(U)
S(D), V(D)
q
1 q
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D V q U V q
V
+
× − + ×
·
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D S q U S q
S
+
× − + ×
·
A minor bit of algebra yields:
) ( ) (
) ( ) 0 ( ) 1 (
D S U S
D S S r
q
f
−
− × +
·
Example of the RiskNeutral Valuation of a Call:
$21.25,C(D)
q
1 q
Suppose a stock is worth $25 today and in one period will either
be worth 15% more or 15% less. The riskfree rate is 5%. What
is the value of an atthemoney call option?
The binomial tree would look like this:
$25,C(0)
$28.75,C(D)
) 15 . 1 ( 25 $ 75 . 28 $ × ·
) 15 . 1 ( 25 $ 25 . 21 $ − × ·
Example of the RiskNeutral Valuation of a Call:
$21.25,C(D)
2/3
1/3
The next step would be to compute the risk neutral
probabilities
$25,C(0)
$28.75,C(D)
) ( ) (
) ( ) 0 ( ) 1 (
D S U S
D S S r
q
f
−
− × +
·
3 2
50 . 7 $
5 $
25 . 21 $ 75 . 28 $
25 . 21 $ 25 $ ) 05 . 1 (
· ·
−
− ×
· q
Example of the RiskNeutral Valuation of a Call:
$21.25, $0
2/3
1/3
After that, find the value of the call in the up state and down state.
$25,C(0)
$28.75, $3.75
25 $ 75 . 28 $ ) ( − · U C
] 0 , 75 . 28 $ 25 max[$ ) ( − · D C
Example of the RiskNeutral Valuation of a Call:
Finally, find the value of the call at time 0:
$21.25, $0
2/3
1/3
$25,C(0)
$28.75,$3.75
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D C q U C q
C
+
× − + ×
·
) 05 . 1 (
0 $ ) 3 1 ( 75 . 3 $ 3 2
) 0 (
× + ×
· C
38 . 2 $
) 05 . 1 (
50 . 2 $
) 0 ( · · C
$25,$2.38
This riskneutral result is consistent with valuing the
call using a replicating portfolio.
RiskNeutral Valuation and the Replicating Portfolio
( ) 38 . 2 $ 24 . 20 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
· − ·
,
`
.

− · C
38 . 2 $
05 . 1
50 . 2 $
) 05 . 1 (
0 $ ) 3 1 ( 75 . 3 $ 3 2
0
· ·
× + ×
· C
The BlackScholes Model
The BlackScholes Model is
) N( ) N(
2 1 0
d Ee d S C
rT
× − × ·
−
Where
C
0
= the value of a European option at time t = 0
r = the riskfree interest rate.
T
T
σ
r E S
d
σ
)
2
( ) / ln(
2
1
+ +
·
T d d σ − ·
1 2
N(d) = Probability that a
standardized, normally
distributed, random
variable will be less than
or equal to d.
The BlackScholes Model allows us to value options in the
real world just as we have done in the 2state world.
The BlackScholes Model
Find the value of a sixmonth call option on the Microsoft with an
exercise price of $150
The current value of a share of Microsoft is $160
The interest rate available in the U.S. is r = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the option is $10—
our answer must be at least that amount.
The BlackScholes Model
Let’s try our hand at using the model. If you have a calculator handy,
follow along.
Then,
T
T σ r E S
d
σ
) 5 . ( ) / ln(
2
1
+ +
·
First calculate d
1
and d
2
31602 . 0 5 . 30 . 0 52815 . 0
1 2
· − · − · T d d σ
5282 . 0
5 . 30 . 0
5 ). ) 30 . 0 ( 5 . 05 (. ) 150 / 160 ln(
2
1
·
+ +
· d
The BlackScholes Model
N(d
1
) = N(0.52815) = 0.7013
N(d
2
) = N(0.31602) = 0.62401
5282 . 0
1
· d
31602 . 0
2
· d
) N( ) N(
2 1 0
d Ee d S C
rT
× − × ·
−
92 . 20 $
62401 . 0 150 7013 . 0 160 $
0
5 . 05 .
0
·
× − × ·
× −
C
e C
Assume S = $50, X = $45, T = 6 months, r = 10%,
and σ = 28%, calculate the value of a call and a put.
125 . 1 $ 45 $ 50 $ 32 . 8 $
) 50 . 0 ( 10 . 0
· + − ·
−
e P
32 . 8 $ ) 754 . 0 ( 45 ) 812 . 0 ( 50
) 50 . 0 ( 10 . 0 ) 5 . 0 ( 0
· − ·
− −
e e C
( )
884 . 0
50 . 0 28 . 0
50 . 0
2
28 . 0
0 10 . 0
45
50
ln
2
1
·
,
`
.

+ − +
· d
686 . 0 50 . 0 28 . 0 884 . 0
2
· − · d
From a standard normal probability table, look up N(d
1
) =
0.812 and N(d
2
) = 0.754 (or use Excel’s “normsdist” function)
Another BlackScholes Example
Stocks and Bonds as Options
•
Levered Equity is a Call Option.
•
The underlying asset comprise the assets of the firm.
•
The strike price is the payoff of the bond.
•
If at the maturity of their debt, the assets of the firm are greater
in value than the debt, the shareholders have an inthemoney
call, they will pay the bondholders and “call in” the assets of the
firm.
•
If at the maturity of the debt the shareholders have an outofthe
money call, they will not pay the bondholders (i.e. the
shareholders will declare bankruptcy) and let the call expire.
Stocks and Bonds as Options
•
Levered Equity is a Put Option.
•
The underlying asset comprise the assets of the firm.
•
The strike price is the payoff of the bond.
•
If at the maturity of their debt, the assets of the firm are less in
value than the debt, shareholders have an inthemoney put.
•
They will put the firm to the bondholders.
•
If at the maturity of the debt the shareholders have an outof
themoney put, they will not exercise the option (i.e. NOT
declare bankruptcy) and let the put expire.
Stocks and Bonds as Options
•
It all comes down to putcall parity.
Value of a
call on the
firm
Value of a
put on the
firm
Value of a
riskfree
bond
Value of
the firm
=
+
–
T r
e X P S C
−
− + ·
0 0
Stockholder’s
position in terms
of call options
Stockholder’s
position in terms
of put options
CapitalStructure Policy and Options
•
Recall some of the agency costs of debt:
they can all be seen in terms of options.
•
For example, recall the incentive
shareholders in a levered firm have to take
large risks.
Balance Sheet for a Company in Distress
Assets BVMVLiabilities BVMV
Cash $200$200LT bonds $300?
Fixed Asset $400$0Equity $300 ?
Total $600$200Total $600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
Selfish Strategy 1: Take Large Risks
(Think of a Call Option)
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
133 $
50 . 1
100 $
200 $
− ·
+ − ·
NPV
NPV
Selfish Stockholders Accept Negative NPV Project with
Large Risks
•
Expected cash flow from the Gamble
•
To Bondholders = $300 × 0.10 + $0 = $30
•
To Stockholders = ($1000  $300) × 0.10 + $0 = $70
•
PV of Bonds Without the Gamble = $200
•
PV of Stocks Without the Gamble = $0
•
PV of Bonds With the Gamble = $30 / 1.5 = $20
•
PV of Stocks With the Gamble = $70 / 1.5 = $47
The stocks are worth more with the high risk project because
the call option that the shareholders of the levered firm hold
is worth more when the volatility is increased.
Mergers and Options
•
This is an area rich with optionality, both
in the structuring of the deals and in their
execution.
Investment in Real Projects & Options
•
Classic NPV calculations typically ignore
the flexibility that realworld firms typically
have.
•
The next chapter will take up this point.
Summary and Conclusions
•
The most familiar options are puts and calls.
•
Put options give the holder the right to sell stock at a set
price for a given amount of time.
•
Call options give the holder the right to buy stock at a set
price for a given amount of time.
•
PutCall parity
0 0
P S e X C
T r
+ · +
−
Summary and Conclusions
•
The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Riskfree interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
•
Much of corporate financial theory can be presented in
terms of options.
1. Common stock in a levered firm can be viewed as a call option on the assets
of the firm.
2. Real projects often have hidden option that enhance value.
Definition
Risk and uncertainty Risk management
Risk aversion
The process of formulating the benefitcost tradeoffs of risk reduction and deciding on the course of action to take (including the decision to take no action at all).
Two more definitions
•
Derivatives
•
financial assets (e.g., stock option, futures, forwards, etc) whose values depend upon the value of the underlying assets. the use of financial instruments or of other tools to reduce exposure to a risk factor.
•
Hedge
•
2. Gains and losses from buying shares and a call option on Risky Upside Inc. .000 20 50 110 P el A G fro b y gsh an .000 Risky Upside Inc. price $3.Figure 1. 5 er are. Gain +$6. ain m u in ares o R y f isk U sid In at $ 0 p sh p e c.
ith cise p rice of $ fora p em mof $10p sh e. ain u in p sh r of R yU sid In w exer a es isk p e c.000 20 50 R isky U pside Inc.G ain $5. price 110 P el B G fromb y g acall o tion on an .00 0 0 $1. 50 r iu er ar .
Hedging with forward contract.3.Figure 1. Unhedged income Income to firm $100 million $90 million Exchange rate $0. Income to Garman if it does not hedge. . Garman ’s income is in dollars and the exchange rate is the dollar price of one euro.90 $1 Panel A.
Forward contract payoff. .9 Forward rate $1 Panel B.Gain from contract to firm $10 million Forward gain Forward loss Exchange rate $0.
. Hedged firm income.U nhedged incom e Incom e to firm $100 m illion Forw ard gain Forw ard loss H edged incom e E xchange rate Forw ard rate $1 Panel C.
. Comparison of income with put contract and income with forward contract.Incom to firm e Unhedged incom e G with ain option $100 m illion Loss with option Exchange rate Exercise price of $1 Panel D.
Risk management irrelevance proposition • Bottom line: hedging a risk does not increase firm value when the cost of bearing the risk is the same whether the risk is borne within the firm or outside the firm by the capital markets. . • This proposition holds when financial markets are perfect.
Risk management irrelevance proposition • Allows us to find out when homemade risk management is not equivalent to risk management by the firm. This is the case whenever risk management by a firm affects firm value in a way that investors cannot mimic. it must be more expensive to take a risk within the firm than to pay the capital markets to take it. For risk management to increase firm value. • • .
Role of risk management Risk management can add value to the firm by: • • Decreasing taxes Decreasing transaction costs (including bankruptcy costs) Avoiding investment decision errors • .
Bankruptcy costs and costs of financial distress .
• • . The probability that a firm will be bankrupt is the probability that it will not have enough cash flow to repay the debt.• Costs incurred as a result of a bankruptcy filing are called bankruptcy costs. The extent to which bankruptcy costs affect firm value depends on their extent and on the probability that the firm will have to file for bankruptcy.
. called costs of financial distress • Managers of a firm in bankruptcy lose control of some decisions.8% • Indirect bankruptcy costs • Many of these indirect costs start accruing as soon as a firm’s financial situation becomes unhealthy. They might not allowed to undertake costly new projects.• Direct bankruptcy costs • Average ratio of direct bankruptcy costs to total assets: 2. for example.
Figure 3. Cash flow to shareholders and operating cash flow.1. C ash flow to shareholders U nhedged cash flow $450M Expected cash flow $350M $250M Expected cash $250M flow $350M $450M C ash flow to the firm .
Unhedged cash flow Cashflow to shareholders $350M (hedged) Forward loss Hedged firm cash Forward gain flow $350M (gold sold at forward) .2.Figure 3. Creating the unhedged firm out of the hedged firm.
3. Cash flow to claimholders Unhedged cash flow $450M Expected cash flow hedged $350M Unhedged $340M $230M Bankruptcy cost Expected cash $250M flow $350M $450M Cash flow to the firm . Cash flow to claimholders and bankruptcy costs.Figure 3.
Analysis of decreasing transaction cost by hedging Value of firm unhedged = PV (C – Bankruptcy costs) = PV (C) – PV (Bankruptcy costs) = value of firm without bankruptcy costs – PV (bankruptcy costs) Gain from risk management = value of firm hedged – value of firm unhedged = PV( bankruptcy costs) Value of firm unhedged + gain from risk management = value of firm hedged = value of firm without bankruptcy costs .
Taxes and risk management .
a firm or an investor reduces the present value of taxes to be paid.Carrybacks and carryforwards .Tax shields .Tax rationale for risk management: If it moves a dollar away from a possible outcome in which the taxpayer is subject to a high tax rate and shifts it to a possible outcome where the taxpayer incurs a low tax rate.Personal taxes . It applies whenever income is taxed differently at different levels. .
. The forward price is $350.Example The firm pays taxes at the rate of 50 percent on cash flow in excess of $300 per ounce. For simplicity. the price of fold is either $250 or $450 with Equal probability.
Optimal capital structure and risk management .
it can take on more debt. debt is risky. As a result. • The optimal capital structure of a firm: • Balances the tax benefits of debt against the costs of financial distress. firms increase their tax shield from debt but increase the present value of costs of financial distress. • . • Through risk management: • A firm can reduce the present value of the costs of financial distress by making financial distress less likely.• In general. • By having more debt. firms cannot eliminate all risk.
and homestake . managerial incentives.Should the firm hedge to reduce the risk of large undiversified shareholders? • • • Large undiversified shareholders can increase firm value Risk and the incentives of managers Large shareholders.
Figure 3.073M . Firm aftertax cash flow and debt issue. $317.6. After tax cash flow of hedged firm 30 3 35 2 30 2 35 1 30 1 35 0 Principal amount of debt 10 0 20 0 30 0 40 0 Optimal amount of debt.
Risk management process Risk identification Risk assessment Review Selection of riskmgt techniques Implementation .
com) .The rules of risk management Risk Management • There is no return without risk • Be transparent • Seek experience • Know what you don’t know • Communicate • Diversify • Show discipline • Use common sense • Get a RiskGrade Source: Riskmetrics Group (www.riskmetrics.
commodity price Hazard risk .competition .reputation .Types of risks firms face Market risk .liabilities .investor support .interest rate .physical damage .business interruption Operational risk .industry sectors .geographical regions Strategic risk .foreign exchange .
Assignment of risk responsibilities CEO Strategic risk management CRO Market risk management Hedgeable Hazard risk management Insurable Operational risk management Diversifiable .
Three dimensions of risk transfer •Hedging •Insuring •Diversifying .
65 X s X Portfolio value . It summarizes the predicted maximum loss (or worst loss) over a target horizon within a given confidence interval. If the portfolio return is normally distributed. and has volatility σ over the measurement period. the 5 percent VAR of the portfolio is: • • VAR = 1. has zero mean.A new concept of risk management (VAR) • Valueatrisk (VAR) is a category of risk measures that describe probabilistically the market risk of mostly a trading portfolio.
Example of VAR • The US bank J. Morgan states in its 2000 annual report that its aggregate VAR is about $22m. may say that for 95 percent of the time it does not expect to lose more than $22m on a given day. • The bank. . one of the pioneers in risk management.P.
which is an essential component of “economic value added” measures. VAR also represents the amount of economic capital necessary to support a business.making it far more transparent and easier to grasp than previous measures. VAR has become the standard benchmark” for measuring financial risk.or whatever base currency is used .More on VAR • The main appeal of VAR was to describe risk in dollars . • • .
Instruments used in risk management • • • • • • • Forward contracts Futures contracts Hedging Interest rate futures contracts Duration hedging Swap contracts Options .
• • Its not an option: both parties are expected to hold up their end of the deal.Forward Contracts • A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. If you have ever ordered a textbook that was not in stock. you have entered into a forward contract. .
Example Suppose S&P index price is $1050 in 6 months. and thus loses $30.$1020 = $30 per unit of the index. and hence earns $1050 . The short is likewise obligated to sell for $1020. A holder who entered a long position at a forward price of $1020 is obligated to pay $1020 to acquire the index. .
both the long and short have a 0 payoff. If the index price > $1020.Payoff after 6 months If the index price in 6 months = $1020. the long loses money and the short makes money. If the index price < $1020. the long makes money and the short loses money. S&R Index in 6 months 900 950 1000 1020 1050 1100 S&R Forward long $120 70 20 0 30 80 short $120 70 20 0 30 80 .
07=1070 Payoff: 10701100= .Problem: The current S&P index is $1000.month forward with a price of $1100. . You have just purchased a 6.$30. what is the payoff of this position? Solution: F0=1100 S1=1000*1. If the index in 6 months has appreciated by 7%.
At what price are you willing to buy or sell this obligation? . Oneyear zerocoupon bonds that pay $100 one year from now currently sell for $92.Example: Valuing a Forward Contract on a Share of Stock Consider the obligation to buy a share of Microsoft stock one year from now for $100. Assume that the stock currently sells for $97 per share and that Microsoft will pay no dividends over the coming year.
the portfolio strategy Today Buy stock today Sell short $100 in face value of 1year zerocoupon bonds One year from now Sell the stock Buyback the zerocoupon bonds of $100 .the forward contract Today Buy a forward contract One year from now Buy stock at a price of $100. Sell the share for cash at market Strategy 2 .Valuing a forward contract Strategy 1.
.$100 Since strategies 1 and 2 have identical cash flows in the future. the obligation to buy the stock for $100 one year from now. ? = $97 . should cost $5.$100 S1.$92 = $5 In strategy 1.Valuing a forward contract Cost Today Cash flow one year from now Strategy 1 Strategy 2 ? $97$92 S1. they should have the same cost today to prevent arbitrage.
is S0 − where S0 = current price of the stock paying K. assuming the stock pays no dividends prior to T. T years in the future K (1 + rf )T K (1 + rf )T = the current market price of a defaultfree zerocoupon bond At no arbitrage: S 0 − K =0 T (1 + rf ) T F0 = K = S 0 (1 + rf ) . T years in the future).Valuing a forward contract The noarbitrage value of a forward contract on a share of stock (the obligation to buy a share of stock at a price of K.
by the equation F0 1 + rforeign = S 0 1 + rdomestic • where r = the return (unannualized) on a domestic or foreign riskfree security over the life of the forward agreement.Currency Forward Rates • • Currency forward rates are a variation on forward price of stock. In the absence of arbitrage. Euros/dollar) is related to the current exchange rate (or spot rate) S0. as measured in the respective country's currency . the forward currency rate F0 (for example.
funds) is 10 percent and that both rates are default free. .S.Forward Currency Rates Example: The Relation Between Forward Currency Rates and Interest Rates Assume that sixmonth LIBOR on Canadian funds is 4 percent and the US$ Eurodollar rate (sixmonth LIBOR on U. What is the sixmonth forward Can$/US$ exchange rate if the current spot rate is Can$1.25/US$? Assume that six months from now is 182 days.
06% = ×10% 360 360 Can$1. US $ 1.25.) So Canada Sixmonth interest Rate (unannualized): The forward rate is 2.02% = United States 182 182 × 4% 5.Currency Forward Rates Answer: (LIBOR is a zerocoupon rate based on an actual/360 day count.21 1.0202 = × 1.0506 .
.Futures Contracts: Preliminaries • A futures contract is like a forward contract: • It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. • A futures contract is different from a forward: • Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.
cash or Tbills held in a street name at your brokerage. • Daily resettlement • • Initial Margin • .Futures Contracts: Preliminaries • Standardizing Features: • • Contract Size Delivery Month Minimizes the chance of default About 4% of contract value.
00625 0.006289308 Currency per U.S.S.007042254 3months forward 0. The 3month forward price is $1=¥150.006711409 6months forward 0.007194245 1month forward 0.006993007 0.Daily Resettlement: An Example Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate).006666667 0. U. $ equivalent W ed Tue Japan (yen) 0. .007142857 0. $ W ed Tue 140 139 143 142 150 149 160 159 Currently $1 = ¥140.
500.33 = .04 × ¥12.500.Daily Resettlement: An Example • Currently $1 = ¥140 and it appears that the dollar is strengthening.333. The contract size is ¥12. If you enter into a 3month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates.00 0 × ¥150 .000 • • Your initial margin is 4% of the contract value: $1 $3.
33: $1 $83.892. Your original agreement was to sell ¥12.500.33 = ¥12.333. .62 = ¥12.00 0 × ¥150 But ¥12.333.000 and receive $83.62: $1 $83.500.892.000 × ¥149 You have lost $559.000 is now worth $83. then your position’s value drops.Daily Resettlement: An Example If tomorrow. the futures rate closes at $1 = ¥149.500.500.28 overnight.
leaving $2. Then you must post additional funds or your position will be closed out.355.05 This is short of the $3.Daily Resettlement: An Example • • The $559. $1 $3.333.28 comes out of your $3.04 × ¥12.70 = .355.774.00 0 × ¥149 Your broker will let you slide until you run through your maintenance margin.500. . This is usually done with a reversing trade.70 required for a new position.33 margin account.
000 lbs. 42.5 million $1 million Exchange Chicago BOT Chicago & KC CSCE CTN CMX CMX NYM IMM IMM LIFFE .500 ¥12.Selected Futures Contracts Contract Agricultural Contract Size Corn Wheat Cocoa OJ Metals & Petroleum Copper Gold Unleaded gasoline Financial British Pound Japanese Yen Eurodollar 5.000 gal.000 bushels 10 metric tons 15. 25.000 bushels 5. 100 troy oz.000 lbs. £62.
Others include: • • • • • The Philadelphia Board of Trade (PBOT) The MidAmerica Commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange .Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest.
December. Last trading day is the second business day preceding the delivery day. June. • CME hours 7:20 a. September. CST.The Chicago Mercantile Exchange • • • Expiry cycle: March. .m.m. to 2:00 p. Delivery date 3rd Wednesday of delivery month.
. but none are close to CME and SIMEX trading volume. to 4:00 p.m dinner break and then back at it from 6:00 p. • There’s other markets.m. to 6:00 a.CME After Hours • Extendedhours trading on GLOBEX runs from 2:30 p. • Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. CST.m.m.
857 Closing price Daily Change DJ INDUSTRIAL AVERAGE (CBOT) . 179 180 178¼ 178½ 1½ 186 186½ 184 186 ¾ 196 197 194 196½ ¼ 312 280 291¼ 177 184 194 2.560 11619 11705 11612 11621 +5 12828 11106 13.000.000. pts.187 Opening price Sept Dec Sept Dec TREASURY BONDS (CBT) .900 175. 32nds of 100% 11705 11721 11627 11705 +5 13106 11115 647.$1. cents per bu..$10 times average 11200 11285 11145 11241 17 11324 7875 11287 11385 11255 11349 17 11430 7987 18.000 bu.837 104.Wall Street Journal Futures Price Quotes Highest price that day Open High Low Settle Change Lifetime High Low Open Interest Highest and lowest prices over the lifetime of the contract.599 Lowest price that day Expiry month Number of open contracts .530 1. July Sept Dec Corn (CBT) 5.
Open interest is a good proxy for demand for a contract. currency) are outstanding. • • .Basic Currency Futures Relationships • Open Interest refers to the number of contracts outstanding for a particular delivery month. The breadth of the market would be how many different contracts (expiry month. Some refer to open interest as the depth of the market.
• For example. • Hedgers can also transfer price risk to speculators and speculators absorb price risk from hedgers.Hedging • Two counterparties with offsetting risks can eliminate risk. they can eliminate the risk each other faces regarding the future price of wheat. Short • . if a wheat farmer and a flour mill enter into a forward contract. Speculating: Long vs.
000 pounds in cents per pound and is at $0. so you go long 10 copper contracts for delivery in 3 months.500 If prices decrease by 5 cents.05 × 10 = $12. A contract is 25.000 × . your loss is: Loss = 25.500 .500 per contract.70 per pound or $17. you will gain: Gain = 25.05 × 10 = $12.000 × .Hedging and Speculating Example You speculate that copper will go up in price. If futures prices rise by 5 cents.
000 bushels of corn in 3 months. Corn is quoted in cents per bushel at 5. To hedge you will sell 10 corn futures contracts: 50.05. You want to hedge against a price decrease. .Hedging: How many contacts? You are a farmer and you will harvest 50.000 bushels per contract Now you can quit worrying about the price of corn and get back to worrying about the weather. It is currently at $2.30 cents for a contract 3 months out and the spot price is $2.000 bushels per contract.000 bushels = 10 contracts 5.
Interest Rate Futures Contracts .
Pricing of Treasury Bonds • Consider a Treasury bond that pays a semiannual coupon of $C for the next T years: The yield to maturity is r C C C … C+F 0 1 2 3 2T Value of the Tbond under a flat term structure = PV of face value + PV of coupon payments F C 1 PV = + 1 − T (1 + r ) r (1 + r )T .
then we need to discount the payments at different rates depending upon maturity C C C … C+F 0 1 2 3 2T = PV of face value + PV of coupon payments C C C C+F PV = + + ++ 2 3 T (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r2T ) .Pricing of Treasury Bonds If the term structure of interest rates is not flat.
Pricing of Forward Contracts
An Nperiod forward contract on that TBond
− Pforward C C C
…
C+F
0 N N+1 N+2 N+3 N+2T Can be valued as the present value of the forward price.
PV =
Pforward
(1 + rN ) N
C C C C+F + + ++ 2 3 (1 + rN +1 ) (1 + rN + 2 ) (1 + rN +3 ) (1 + rN + 2T )T PV = (1 + rN ) N
Futures Contracts
• •
The pricing equation given above will be a good approximation. The only real difference is the daily resettlement.
Hedging in Interest Rate Futures
•
A mortgage lender who has agreed to loan money in the future at prices set today can hedge by selling those mortgages forward. It may be difficult to find a counterparty in the forward who wants the precise mix of risk, maturity, and size. It’s likely to be easier and cheaper to use interest rate futures contracts however.
•
•
• .Duration Hedging • As an alternative to hedging with futures or forwards. Duration is the key to measuring interest rate risk. one can hedge by matching the interest rate risk of assets with the interest rate risk of liabilities.
and YTM on bond’s price sensitivity • • • Measure of the bond’s effective maturity Measure of the average life of the security Weighted average maturity of the bond’s cash flows .Duration Hedging • Duration measures the combined effect of maturity. coupon rate.
Duration Formula PV (C1 ) ×1 + PV (C2 ) × 2 + + PV (CT ) × T D= PV N Ct × t ∑ (1 + r )t = D = tN1 Ct ∑ (1 + r )t t =1 .
Calculating Duration Calculate the duration of a threeyear bond that pays a semiannual coupon of $40. has a $1.000 par value when the YTM is 8% semiannually? .
46 0.82193 0.79031 Present Years x PV value / Bond price $38. .7259 years Bond price Bond duration Duration is expressed in units of time.00 2 $40.56 0.19 0.5 $40.0370 $35.0533 $34.0822 $821.4658 $1.93 2.00 0. usually years.85480 0.92456 0.Calculating Duration Discount Years Cash flow factor 0.5 $40.98 0.00 3 $1.96154 0.00 2.00 1.0192 $36.00 1 $40.00 2.000.040.88 0.0684 $32.88900 0.5 $40.
Duration The key to bond portfolio management • Properties: • • • • Longer maturity. shorter duration • Zero coupon bond: duration = maturity . shorter duration Higher yield. longer duration Duration increases at a decreasing rate Higher coupon.
fixed for fixed rate debt service in two (or more) currencies.Swaps Contracts: Definitions • In a swap. There are two types of interest rate swaps: • • Single currency interest rate swap • “Plain vanilla” fixedforfloating swaps are often just called interest rate swaps. • CrossCurrency interest rate swap • . This is often called a currency swap. two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.
the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer. • • As a broker. • .The Swap Bank • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. and then later lay off their risk. the swap bank stands ready to accept either side of a currency swap. or match it with a counterparty. The swap bank can serve as either a broker or a dealer.
K.000.An Example of an Interest Rate Swap • • Consider this example of a “plain vanilla” interest rate swap.000 to finance floatingrate Eurodollar loans. and wishes to raise $10. • • Bank A is considering issuing 5year fixedrate Eurodollar bonds at 10 percent. Bank A is a AAArated international bank located in the U. It would make more sense to for the bank to issue floatingrate notes at LIBOR to finance floatingrate Eurodollar loans. .
75 percent.An Example of an Interest Rate Swap • Firm B is a BBBrated U.S. • • . Alternatively.000. Firm B would prefer to borrow at a fixed rate. It needs $10. company.000 to finance an investment with a fiveyear economic life. firm B can raise the money by issuing 5year floatingrate notes at LIBOR + ½ percent. • Firm B is considering issuing 5year fixedrate Eurodollar bonds at 11.
5% 10% LIBOR .An Example of an Interest Rate Swap The borrowing opportunities of the two firms are: COMPANY B BANK A Fixed rate Floating rate 11.75% LIBOR + .
An Example of an Interest Rate Swap
Swap
10 3/8%
Bank
LIBOR – 1/8%
Bank A
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years
BANK A 10% LIBOR
An Example of an Interest Rate Swap
½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years.
10 3/8%
Swap Bank
Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of 10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.
LIBOR – 1/8%
Bank
10%
A
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR
An Example of an Interest Rate Swap
The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.
Fixed rate Floating rate
Swap Bank
10 ½% LIBOR – ¼%
Company
B
COMPANY B 11.75% LIBOR + .5% BANK A 10% LIBOR
An Example of an Interest Rate Swap Here’s what’s in it for B: Swap Bank They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) .¼ ) = 11. Company B LIBOR + ½% . COMPANY B Fixed rate Floating rate 11.(LIBOR .000 = $50.5% BANK A 10% LIBOR 10 ½% LIBOR – ¼% ½ % of $10.000 that’s quite a cost savings per year for 5 years.75% LIBOR + .25% which is ½% better than they can borrow floating.000.
10 3/8 = 1/8 ¼ COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5% Company B BANK A 10% LIBOR .000 per year for 5 years. 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank A LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ . Swap 10 3/8% Bank ¼% of $10 million = $25.An Example of an Interest Rate Swap The swap bank makes money too.
5% BANK A 10% LIBOR B saves ½% .75% LIBOR + .An Example of an Interest Rate Swap The swap bank makes ¼% Swap 10 3/8% Bank 10 ½% LIBOR – ¼% LIBOR – 1/8% Bank A A saves ½% Fixed rate Floating rate Company B COMPANY B 11.
An Example of a Currency Swap
•
Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.
•
•
This will give them exchange rate risk: financing a sterling project with dollars.
•
They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
An Example of a Currency Swap
•
•
If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap. If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.
An Example of a Currency Swap
Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.
$ 8.0% 10.0%
£ 11.6% 12.0%
Company A Company B
An Example of a Currency Swap
Swap Bank
$8% £11% $8% $9.4% £12%
Firm A
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
Firm B
£12%
0% 10.6% 12.6% $ Company A Company B 8.4% £12% Firm A A saves £.0% £ 11.An Example of a Currency Swap A’s net position is to borrow at £11% Swap Bank $8% £11% $8% $9.0% Firm B £12% .
An Example of a Currency Swap B’s net position is to borrow at $9.0% 10.0% Firm B £12% B saves $.4% £12% Firm A $ Company A Company B 8.6% 12.0% £ 11.4% Swap Bank $8% £11% $8% $9.6% .
000 per B year for 5 years.6% risk.4% of $16 million financed with 1% of £10 million per year for 5 years.0% they can lay it off (in another swap). The swap bank Company A Company B faces exchange rate 8.60/£.4% £12% Firm A Firm £12% At S0($/£) = $1. $9.0% 12.An Example of a Currency Swap The swap bank makes money too: Swap Bank $8% £11% $8% 1. that is a gain of $124.0% 11. $ £ . but maybe 10.
two humans must like the idea.Variations of Basic Swaps • Currency Swaps • • • • fixed for fixed fixed for floating floating for floating amortizing • Interest Rate Swaps • • zerofor floating floating for floating • Exotica • For a swap to be possible. Beyond that. . creativity is the only limit.
• Basis Risk • If the floating rates of the two counterparties are not pegged to the same index. • Exchange Rate Risk • In the example of a currency swap given earlier. or if it has an unhedged position. the swap bank would be worse off if the pound appreciated. .Risks of Interest Rate and Currency Swaps • Interest Rate Risk • Interest rates might move against the swap bank after it has only gotten half of a swap on the books.
.Risks of Interest Rate and Currency Swaps • Credit Risk • This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. • Sovereign Risk • The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap. • Mismatch Risk • It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Pricing a Swap • A swap is a derivative security so it can be priced in terms of the underlying assets: • How to: • • Plain vanilla fixed for floating swap gets valued just like a bond. . Currency swap gets valued just like a nest of currency futures.
• Almost every issue of corporate stocks and bonds has option features. . capital structure and capital budgeting decisions can be viewed in terms of options.Options • Many corporate securities are similar to the stock options that are traded on organized exchanges. • In addition.
but not the obligation. • . When exercising a call option. but not the obligation. When exercising a put. you “call in” the asset. to buy a given quantity of some asset at some time in the future. • Put options gives the holder the right. at prices agreed upon today. to sell a given quantity of an asset at some time in the future. at prices agreed upon today. to buy or sell a given quantity of an asset on (or perhaps before) a given date. you “put” the asset to someone. at prices agreed upon today.Options Contracts: Preliminaries • • An option gives the holder the right. Calls versus Puts Call options gives the holder the right. but not the obligation.
or the expiry. • Expiry • The maturity date of the option is referred to as the expiration date. • Strike Price or Exercise Price • Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset. .Options Contracts: Preliminaries • Exercising the Option • The act of buying or selling the underlying asset through the option contract. American options can be exercised at any time up to expiry. • European versus American options • • European options can be exercised only at expiry.
Options Contracts: Preliminaries • IntheMoney • The exercise price is less than the spot price of the underlying asset. . • AttheMoney • The exercise price is equal to the spot price of the underlying asset. • OutoftheMoney • The exercise price is more than the spot price of the underlying asset.
Option Premium = Intrinsic Value Speculative + Value . • Speculative Value • The difference between the option premium and the intrinsic value of the option.Options Contracts: Preliminaries • Intrinsic Value • The difference between the exercise price of the option and the spot price of the underlying asset.
at prices agreed upon today. • When exercising a call option. to buy a given quantity of some asset on or before some time in the future.Call Options • Call options gives the holder the right. . but not the obligation. you “call in” the asset.
CaT is the value of an American call at expiry CeT is the value of a European call at expiry • . If the call is outofthemoney. CaT = CeT = Max[ST .Basic Call Option Pricing Relationships at Expiry • • • At expiry. it is worth ST . it is worthless. If the call is inthemoney. an American call option is worth the same as a European option with the same characteristics.E. 0] Where ST is the value of the stock at expiry (time T) E is the exercise price.E.
Call Option Payoffs 60 40 Buy a call Option payoffs ($) 20 0 20 40 60 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Exercise price = $50 .
Call Option Payoffs 60 40 Option payoffs ($) 20 0 20 40 60 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Write a call Exercise price = $50 .
Call Option Profits 60 40 Buy a call Option profits ($) 20 0 20 40 60 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Write a call Exercise price = $50. option premium = $10 .
you “put” the asset to someone. When exercising a put.Put Options • Put options gives the holder the right. to sell a given quantity of an asset on or before some time in the future. at prices agreed upon today. • . but not the obligation.
ST. 0] .Basic Put Option Pricing Relationships at Expiry • • • At expiry. If the put is outofthemoney. If the put is inthemoney.ST. an American put option is worth the same as a European option with the same characteristics. PaT = PeT = Max[E . it is worthless. it is worth E .
Put Option Payoffs 60 40 Buy a put Option payoffs ($) 20 0 20 40 60 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Exercise price = $50 .
Put Option Payoffs 60 40 Option payoffs ($) 20 0 20 40 60 write a put 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Exercise price = $50 .
option premium = $10 .Option profits ($) Put Option Profits 60 40 20 10 0 10 20 40 60 Write a put 0 10 20 30 40 50 60 70 80 Buy a put 90 100 Stock price ($) Exercise price = $50.
Buy a call Write a put 0 10 20 30 40 50 60 70 80 Buy a put Write a call 90 100 Stock price ($) .Selling Options • The seller (or writer) of an option has an obligation. Option profitsOption profits ($) ($) 60 40 20 10 0 10 20 40 60 • The purchaser of an option has an option.
Last Vol. Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ . IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol.Reading The Wall Street Journal Option/Strike Exp.
Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ a recent price for the stock is $138. Option/Strike Exp.Reading The Wall Street Journal This option has a strike price of $135. Last Vol.25 July is the expiration month . IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol.
Last Vol.25 = $138¼ – $135. Last IBM 130 Oct 364 15¼ 107 5¼ 138¼ 130 Jan 112 19½ 420 9¼ 138¼ 135 Jul 2365 4¾ 2431 13/16 138¼ 135 Aug 1231 9¼ 94 5½ 138¼ 140 Jul 1826 1¾ 427 2¾ 138¼ 140 Aug 2193 6½ 58 7½ Puts with this exercise price are outofthemoney. CallPutOption/Strike Exp. Vol.Reading The Wall Street Journal This makes a call option with this exercise price inthemoney by $3. .
.365 call options with this exercise price were traded. IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol.Reading The Wall Street Journal Option/Strike Exp. 2. Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ On this day. Last Vol.
Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ Since the option is on 100 shares of stock. Last Vol.Reading The Wall Street Journal The CALL option with a strike price of $135 is trading for $4. IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol. buying this option would cost $475 plus commissions. .75. Option/Strike Exp.
. IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol.Reading The Wall Street Journal Option/Strike Exp. Last Vol. 2.431 put options with this exercise price were traded. Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ On this day.
8125. Option/Strike Exp. .25 plus commissions. IBM 130 Oct 138¼ 130 Jan 138¼ 135 Jul 138¼ 135 Aug 138¼ 140 Jul 138¼ 140 Aug CallPutVol.Reading The Wall Street Journal The PUT option with a strike price of $135 is trading for $. Last 364 15¼ 107 5¼ 112 19½ 420 9¼ 2365 4¾ 2431 13/16 1231 9¼ 94 5½ 1826 1¾ 427 2¾ 2193 6½ 58 7½ Since the option is on 100 shares of stock. Last Vol. buying this option would cost $81.
tailoring the riskreturn profile to meet your client’s needs. you can become a financial engineer.Combinations of Options • Puts and calls can serve as the building blocks for more complex option contracts. If you understand this. • .
Protective Put Strategy: Buy a Put and Buy the Underlying Stock: Payoffs at Expiry Value at expiry Protective Put strategy has downside protection and upside potential $50 Buy the stock $0 $50 Value of stock at expiry Buy a put with an exercise price of $50 .
Protective Put Strategy Profits Value at expiry $40 Buy the stock at $40 Protective Put strategy has downside protection and upside potential $40 $50 $40 Buy a put with exercise price of $50 for $10 Value of stock at expiry $0 .
Covered Call Strategy Value at expiry $40 Buy the stock at $40 $10 $0 $30 $40 $50 $30 $40 Covered call Value of stock at expiry Sell a call with exercise price of $50 for $10 .
.Long Straddle: Buy a Call and a Put Value at expiry $40 $30 Buy a call with an exercise price of $50 for $10 $0 $10 $20 $30 $40 $50 $60 Buy a put with an $70 exercise price of $50 for $10 Value of stock at expiry A Long Straddle only makes money if the stock price moves $20 away from $50.
Sell a put with exercise price of $50 for $10 Value of stock at expiry $30 $40 $30 $40 $50 $60 $70 Sell a call with an exercise price of $50 for $10 $20 $10 $0 .Short Straddle: Sell a Call and a Put Value at expiry A Short Straddle only loses money if the stock price moves $20 away from $50.
Long Call Spread Value at expiry Buy a call with an exercise price of $50 for $10 long call spread Value of stock at expiry $5 $0 $5 $10 $50 $60 $55 Sell a call with exercise price of $55 for $5 .
Value at expiry Buy a call option with an exercise price of $40 Buy the Buy the stock at $40 stock at $40 financed with some debt: FV = $X P0 − C0 − ($40 − Xe $0 Sell a put with an exercise price of $40 [$40P0] − rT ) $40P0 $40 $40 + C0 $40 $40 − Xe − rT Value of stock at expiry . it mast be the case that option prices − rT are set such that: C0 + Xe = P0 + S0 Otherwise. riskless portfolios with positive payoffs exist.PutCall Parity In market equilibrium.
• This section considers the value of an option prior to the expiration date. A much more interesting question.Valuing Options • The last section concerned itself with the value of an option at expiry. • .
0) < C0 < S0. 4. . 2. 3. 5. The precise position will depend on these factors. Stock price Exercise price Interest rate Volatility in the stock price Expiration date + Call Put + – – + – + + + + The value of a call option C0 must fall within max (S0 – E.Option Value Determinants 1.
E. ST CaT > Max[ST . Time Value and Intrinsic Value for an American Call Profit The value of a call option C0 must fall within max (S0 – E.Market Value. 0) < C0 < S0. 0] Market Value Time value loss ST E Intrinsic value E Outofthemoney Inthemoney ST .
• Then we will graduate to the normal approximation to the binomial for some realworld option valuation. .An Option‑Pricing Formula • We will start with a binomial option pricing formula to build our intuition.
75 or $21.25 . S0= $25 today and in one year S1is either $28.Binomial Option Pricing Model Suppose a stock is worth $25 today and in one period will either be worth 15% more or 15% less.75 $25 $21. What is the value of an atthemoney call option? S0 S1 $28.25. The riskfree rate is 5%.
A call option on this stock with exercise price of $25 will have the following payoffs. We can replicate the payoffs of the call option.Binomial Option Pricing Model 1. S0 S1 $28.75 $25 $21. 2.75 C1 $3.25 $0 . With a levered position in the stock.
75 $25 $21.50 or $0. The net payoff for this levered equity portfolio in one period is either $7.$21.25 = $7.75 .debt ) = portfolio C1 $3.25 today and buy 1 share. The levered equity portfolio has twice the option’s payoff so the portfolio is worth twice the call option value.25.Binomial Option Pricing Model Borrow the present value of $21.25 = $0 $0 .50 ( S1 . S0 $28.$21.
debt ) = portfolio C1 $25 $21.25 debt: $21.25.75 S0 $28.25 = $7.25 = $0 $0 .25 (1 + rf ) $3.75 .50 ( S1 .$21.$21.Binomial Option Pricing Model $25 − The levered equity portfolio value today is today’s value of one share less the present value of a $21.
75 .25 = $7.25.$21.75 $25 $21.debt ) = portfolio C1 $3.25 C0 = $25 − 2 (1 + rf ) S0 $28.50 ( S1 .Binomial Option Pricing Model We can value the option today as half of the value of the levered equity portfolio: 1 $21.25 = $0 $0 .$21.
The Binomial Option Pricing Model If the interest rate is 5%.25 1 = ( $25 − 20.$21.$21.25 = $0 $0 .05) 2 S0 $28.24 ) = $2.75 $25 $21.75 .debt ) = portfolio C1 $3.38 C0 = $25 − 2 (1.50 ( S1 .25.25 = $7. the call is worth: 1 $21.
25 1 = ( $25 − 20.75 .50 ( S1 .debt ) = portfolio C1 $3. the call is worth: 1 $21.$21.75 $25 $2.25 = $7.38 C0 = $25 − 2 (1.The Binomial Option Pricing Model If the interest rate is 5%.05) 2 S0 C0 $28.25 = $0 $0 .24 ) = $2.25.$21.38 $21.
.Binomial Option Pricing Model The most important lesson (so far) from the binomial option pricing model is: the replicating portfolio intuition. Many derivative securities can be valued by valuing portfolios of primitive securities when those portfolios have the same payoffs as the derivative securities.
An equivalent method is riskneutral valuation V ( 0) = q × V (U ) + (1 − q ) × V ( D) (1 + rf ) .q S(D). V(U) q S(0). V(0) 1.The RiskNeutral Approach to Valuation S(U). V(D) We could value V(0) as the value of the replicating portfolio.
respectively. . V(0) 1. V(U) and V(D) are the values of the asset in the next period following an up move and a down move.q S(0) is the value of the underlying asset today. respectively.The RiskNeutral Approach to Valuation S(U). V(U) q S(0). S(D). V(D) S(U) and S(D) are the values of the asset in the next period following an up move and a down move. q is the riskneutral probability of an “up” move.
V(U) q S(0). V(0) 1.q S(D). V(D) V ( 0) = q × V (U ) + (1 − q ) × V ( D) (1 + rf ) • The key to finding q is to note that it is already impounded into an observable security price: the value of S(0): q × S (U ) + (1 − q ) × S ( D) S ( 0) = (1 + rf ) A minor bit of algebra yields: q = (1 + rf ) × S (0) − S ( D ) S (U ) − S ( D) .The RiskNeutral Approach to Valuation S(U).
25.Example of the RiskNeutral Valuation of a Call: Suppose a stock is worth $25 today and in one period will either be worth 15% more or 15% less.25 = $25 × (1 − .15) $25.75 = $25 × (1.q $21.C(D) .C(0) 1. What is the value of an atthemoney call option? The binomial tree would look like this: $28.15) q $28.75. The riskfree rate is 5%.C(D) $21.
C(D) $25.C(D) .05) × $25 − $21.C(0) 1/3 $21.25 $5 = =2 3 $28.75 − $21.Example of the RiskNeutral Valuation of a Call: The next step would be to compute the risk neutral probabilities q= (1 + r f ) × S (0) − S ( D) S (U ) − S ( D) q= (1.25.75.25 $7.50 2/3 $28.
25. find the value of the call in the up state and down state. C (U ) = $28.75 − $25 2/3 $28.Example of the RiskNeutral Valuation of a Call: After that. $3.75.75.0] $25. $0 .C(0) 1/3 $21.75 C ( D) = max[$25 − $28.
find the value of the call at time 0: q × C (U ) + (1 − q ) × C ( D ) C ( 0) = (1 + rf ) C ( 0) = 2 3 × $3.$2.38 $25.75 $25.50 C ( 0) = = $2.38 (1.Example of the RiskNeutral Valuation of a Call: Finally.75. $0 .75 + (1 3) × $0 (1.$3.05) 2/3 $28.C(0) 1/3 $21.05) $2.25.
24 ) = $2.38 (1. 2 3 × $3.50 C0 = = = $2.05) 1.RiskNeutral Valuation and the Replicating Portfolio This riskneutral result is consistent with valuing the call using a replicating portfolio.25 1 = ( $25 − 20.05) 2 .05 1 $21.38 C0 = $25 − 2 (1.75 + (1 3) × $0 $2.
. normally distributed.The BlackScholes Model The BlackScholes Model is Where C0 = the value of a European option at time t = 0 r = the riskfree interest rate. σ2 ln(S / E ) + (r + )T 2 d1 = σ T d 2 = d1 − σ T N(d) = Probability that a standardized. random variable will be less than or equal to d. C0 = S × N(d1 ) − Ee − rT × N(d 2 ) The BlackScholes Model allows us to value options in the real world just as we have done in the 2state world.
.The BlackScholes Model Find the value of a sixmonth call option on the Microsoft with an exercise price of $150 The current value of a share of Microsoft is $160 The interest rate available in the U.S. Before we start. The option maturity is 6 months (half of a year). note that the intrinsic value of the option is $10— our answer must be at least that amount. is r = 5%. The volatility of the underlying asset is 30% per annum.
30) 2 ).30 .5(0.5282 0. d 2 = d1 − σ T = 0.5 = 0.5 Then. ln(160 / 150) + (. If you have a calculator handy.05 + .30 .The BlackScholes Model First calculate d1 and d2 ln( S / E ) + (r + .5 d1 = = 0.5σ 2 )T d1 = σ T Let’s try our hand at using the model. follow along.52815 − 0.31602 .
62401 C0 = $160 × 0.7013 − 150e −.31602 C0 = $20.62401 .52815) = 0.05×.7013 N(d2) = N(0.The BlackScholes Model C0 = S × N(d1 ) − Ee − rT × N(d 2 ) d1 = 0.31602) = 0.5 × 0.92 N(d1) = N(0.5282 d 2 = 0.
5) (0.884 − 0. and σ = 28%.10 − 0 + 45 2 d1 = = 0. X = $45.50 ln 50 + 0. r = 10%.32 − $50 + $45e −0. calculate the value of a call and a put.32 P = $8.754 (or use Excel’s “normsdist” function) C = 50 e −0 ( 0.812) − 45 e −0. 0. T = 6 months.125 .50) (0. look up N(d1) = 0.10( 0.50 = 0.812 and N(d2) = 0.686 From a standard normal probability table.282 0.Another BlackScholes Example Assume S = $50.10( 0.50 ) = $1.754) = $8.28 0.50 ( ) d 2 = 0.884 0.28 0.
• If at the maturity of their debt. they will not pay the bondholders (i. they will pay the bondholders and “call in” the assets of the firm. the shareholders have an inthemoney call.Stocks and Bonds as Options • Levered Equity is a Call Option. the shareholders will declare bankruptcy) and let the call expire. • • The underlying asset comprise the assets of the firm. The strike price is the payoff of the bond. If at the maturity of the debt the shareholders have an outofthemoney call. • .e. the assets of the firm are greater in value than the debt.
They will put the firm to the bondholders. NOT declare bankruptcy) and let the put expire. The strike price is the payoff of the bond. they will not exercise the option (i.Stocks and Bonds as Options • Levered Equity is a Put Option. If at the maturity of the debt the shareholders have an outofthemoney put. • • . • If at the maturity of their debt. shareholders have an inthemoney put.e. • • The underlying asset comprise the assets of the firm. the assets of the firm are less in value than the debt.
C0 = S + P0 − X e Value of a call on the firm −rT Value of a Value of = the firm + put on the – firm Value of a riskfree bond Stockholder’s position in terms of call options Stockholder’s position in terms of put options .Stocks and Bonds as Options • It all comes down to putcall parity.
CapitalStructure Policy and Options • Recall some of the agency costs of debt: they can all be seen in terms of options. • . For example. recall the incentive shareholders in a levered firm have to take large risks.
the shareholders get nothing. .Balance Sheet for a Company in Distress Assets Cash Fixed Asset Total BVMVLiabilities $200$200LT bonds $400$0Equity $300 $600$200Total $600 BVMV $300? ? $200 What happens if the firm is liquidated today? The bondholders get $200.
10 + $0 = $100 $100 NPV = −$200 + 1.50 NPV = −$133 .Selfish Strategy 1: Take Large Risks (Think of a Call Option) The Gamble Win Big Lose Big Probability 10% 90% Payoff $1.000 $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.
$300) × 0.10 + $0 = $70 • • • • • PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble = $30 / 1.10 + $0 = $30 • To Stockholders = ($1000 . .5 = $20 PV of Stocks With the Gamble = $70 / 1.Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected cash flow from the Gamble To Bondholders = $300 × 0.5 = $47 The stocks are worth more with the high risk project because the call option that the shareholders of the levered firm hold is worth more when the volatility is increased.
Mergers and Options • This is an area rich with optionality. both in the structuring of the deals and in their execution. .
• .Investment in Real Projects & Options • Classic NPV calculations typically ignore the flexibility that realworld firms typically have. The next chapter will take up this point.
Summary and Conclusions • The most familiar options are puts and calls. Call options give the holder the right to buy stock at a set price for a given amount of time. • • PutCall parity C0 + X e −rT = S + P0 . • Put options give the holder the right to sell stock at a set price for a given amount of time.
Real projects often have hidden option that enhance value. . Time remaining until the option contract expires. 3. • Much of corporate financial theory can be presented in terms of options. Strike price specified in the option contract. Current price of underlying stock. 4. 2. Dividend yield of the underlying stock. 2. Common stock in a levered firm can be viewed as a call option on the assets of the firm. Price volatility of the underlying stock. 1.Summary and Conclusions • The value of a stock option depends on six factors: 1. 6. 5. Riskfree interest rate over the life of the contract.
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