Topic:

Derivatives and Risk

Management

 Motives for Risk Management

 Derivative Securities
 Using Derivatives
 Fundamentals of Risk Management
18-1
Why might stockholders be indifferent to
whether a firm reduces the volatility of its
cash flows?

 Diversified shareholders may already be hedged

against various types of risk.
 Reducing volatility increases firm value (stock price)
only if it leads to higher expected cash flows and/or
a reduced WACC.
**WACC means weighted average cost of capital.
**Hedge means managing anticipated/imminent risk by
taking two positions that will offset each other’s
effect when changes occurred.

18-2
Reasons that Corporations engage in
Risk Management

 Debt capacity. Reduced volatility reduces

bankruptcy risk, which enables the firm to increase its
debt capacity.
 Maintaining the optimal capital budget over
time. By reducing the need for external equity, firms
can maintain their optimal capital budget.
 Financial distress. Reduced volatility helps avoid
financial distress costs.
 Comparative advantages in hedging. Managers
have a comparative advantage in hedging certain
types of risk.
 Borrowing costs. Reduced volatility reduces the
costs of borrowing.
18-3
Reasons that Corporations engage in
Risk Management

 Tax effects. Reduced volatility reduces the higher

taxes that result from fluctuating earnings.
 Compensation systems. Certain compensation
schemes reward managers for achieving stable
earnings.

18-4
What is a derivative?

 A derivative is a security whose value is

determined by the market price or
interest rate of some other asset.
 Example:
Options Price of some underlying asset
Interest rate, exchange Interest rate and exchange rate
rate futures and swaps levels
Commodity futures Commodity prices

18-5
Terms and Concepts

 Future dealers are middlemen who help in

making a market for future contracts.
 Speculators are those who add capital and
players to the marketplace of future contracts and
derivatives.
 Natural hedges are situations in which aggregate
risk can be reduced by derivatives transactions
between two parties known as counterparties.
 Non-symmetric hedges are situations in which
one party wants to reduce some type of risk and
another party agrees to sell a contract that protects
the first party from that specific risk like insurance.
Risks are not eliminated but transferred.
18-6
Drivers of Derivative Market

 Development of analytical techniques like the

Black-Scholes Option Pricing Model for
establishing fair prices
 Technological development where computers
and electronic communications make it easier
for counterparties to deal with one another
 Globalization that help increase the
importance of currency markets

18-7
Downsides of Derivatives

 Highly leveraged
 Complicated
 Hard to exercise control

18-8
What is an option?

 A contract that gives its holder the right,

but not the obligation, to buy (or sell) an
asset at some predetermined price within
a specified period of time.
 It’s important to remember:
 It does not obligate its owner to take action.
 It merely gives the owner the right to buy or
sell an asset.

18-9
Option Terminology

 Call option: an option to buy a specified number

of shares of a security within some future period.
 Put option: an option to sell a specified number
of shares of a security within some future period.
 Exercise (or strike) price: the price stated in the
option contract at which the security can be
bought or sold.
 Option price: option contract’s market price.

18-10
Option Terminology (Cont’d)

 Expiration date: the date the option matures.

 Exercise value: the value of an option if it were
exercised today (Current stock price – Strike
price).
 Covered option: an option written against
stock held in an investor’s portfolio.
 Naked (uncovered) option: an option written
without the stock to back it up.

18-11
Option Terminology (Cont’d)

 In-the-money call: a call option whose

exercise price is less than the current price of
the underlying stock.
 Out-of-the-money call: a call option whose
exercise price exceeds the current stock price.
 Long-term Equity AnticiPation Securities
(LEAPS): similar to normal options, but they
are longer-term options with maturities of up
to 2½ years.

18-12
Option Example
 A call option with an exercise price of $25, has the following values at these
prices:

Stock Price Call Option Price

$25 $ 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
18-13
Determining Option Exercise Value
and Option Premium

Exercise value =
Current stock price – Strike price

Option Premium =
Market Price Option – Exercise Value
Option

18-14
Determining Option Exercise Value
and Option Premium

Stock Strike Exercise Option Option

Price Price Value Price Premium
$25.00 $25.00 $0.00 3.00 3.00
30.00 25.00 5.00 7.50 2.50
35.00 25.00 10.00 12.00 2.00
40.00 25.00 15.00 16.50 1.50
45.00 25.00 20.00 21.00 1.00
50.00 25.00 25.00 25.50 0.50

18-15
How does the option premium change
as the stock price increases?

 The premium of the option price over the

exercise value declines as the stock price
increases.
 This is due to the declining degree of leverage
provided by options as the underlying stock
price increases, and the greater loss potential
of options at higher option prices.

18-16
Call Premium Diagram

Option
Value

30

25

20

15 Market price

10

5 Exercise value
Stock
5 10 15 20 25 30 35 40 45 Price
50

18-17
Factors Affecting the Price of an Option

 The option’s time until expiration

 The variability of the stock price
 The risk-free rate
Insights:
 The longer the option period, the higher the call
option price
 The higher the stock market price in relation to strike
price, the higher the call option price
 The higher the strike price, the lower the call option
price
18-18
Put Option

 An option to sell a share of stock at a certain

price within a specified period

Types:
 Conventional (maturity: 7 months or less)
 Long-term Equity AnticiPation Security
(LEAPS) (more than 7 months to 3 years of
maturity

18-19
Put Option

 An option to sell a share of stock at a certain

price within a specified period

Types:
 Conventional (maturity: 7 months or less)
 Long-term Equity AnticiPation Security
(LEAPS) (more than 7 months to 3 years of
maturity

18-20
 Illustration:

Sold 100 share options for 100 shares on September 1

Stock Price: 161.30/share
Strike Price: 170/share (trading out of the money)
Option Price:1.40/share for 100 shares
Specified Period: Until September 30

If the stock price remains below 170/share, the option

holder will most likely not exercise the option, thus the
option writer will have a gain of 140.

18-21
 Illustration:

But if the stock price rose to 180/share, the option

holder will most likely exercise the option and the
option writer has to sell the stocks at 170/share and
incur a net payoff of 860:

Net Payoff:
Add: Option call 1.40 x 100 = 140
Loss from stock exercise 10* x 100 = (1,000)
= 860

* MP - SP = 180 – 170 = 10
18-22
 Option Pricing Models:

Riskless Hedge
= A hedge in which an investor buys a stock and
simultaneously sells a call option on that stock and
ends up with a riskless position

Binomial Option Pricing Model

= An option pricing model based on a riskless
hedge with two scenarios for the value of the
underlying asset

18-23
 Binomial Option Pricing Model
Assumptions and Data:
Current Market Price (MP) = 40/share
Exercise (Strike ) Price = 35/share
Option Period = 1 year
Ending MP = 30/share or 50/share
Risk-free rate =8%

STEP 1: Find the range of values at expiration

Ending Stock Price Strike Price Ending Option Value

30 35 0 (lowest value)
50 35 15
20 15
18-24
 Binomial Option Pricing Model
STEP 2: Equalize the range of payoffs for the stock and the option

Ending Stock Ending Stock Ending Option

Price Value Value
30 .75 22.50 0 (lowest value)
50 .75 37.50 15
20 15.00 (absolute 15
value)

STEP 3: Create a riskless hedged investment

Ending Ending Stock Ending Ending Total

Stock Value in portfolio Option Value Value of the
Price in portfolio portfolio
(riskless value)
30 .75 22.50 0 22.50
50 .75 37.50 -15 22.50 18-25
Binomial Option Pricing Model

STEP 4: Pricing the call option

Riskless value = 22.50

Present Value of riskless value = 22.50/ (1+risk-free rate)1.08

= 22.50/ 1.08
= 20.83

Cost of stock in portfolio = .75 x 40

= 30

Cost of call option = Cost of stock in portfolio – PV of portfolio

= 30 – 20.83
= 9.17

18-26
Exercise:

Assumptions and Data:

Current Market Price (MP) = 100/share

Exercise (Strike ) Price = 95/share
Option Period = 1 year
Ending MP = 90/share or 120/share
Risk-free rate = 10 %

18-27
Assignment/Seatwork

Problem 18-8: Binomial Model

Page No. 637

18-28
Black-Scholes Option Pricing Model

Derived from the concept of a riskless hedge. This model calculates the value
of the option as the difference between the expected PV of the terminal stock
price and the PV of the exercise price.

Assumptions:
1.The stock underlying the call option provides no dividends or other
distributions during the life of the option
2.There are no transaction costs for buying or selling the stock or the option
3.The short-term, risk-free interest rate is known and is constant during the life
of the option
4.Any purchaser of a security may borrow any fraction of the purchase price at
the short-term, risk-free interest rate
5.Short selling is permitted, and the short-term seller will receive immediately
the full cash proceeds of today’s price for a security sold short
6.The call option can be exercised only on its expiration date
7.Trading in all securities takes place continuously, and the stock price moves
randomly
18-29
Black-Scholes Option Pricing Model
Formula

   2 
ln(P/X)  rRF   (t)
  2 
d1 
σ t
d2  d1  σ t

V  P[N(d1 )]  Xe -rRF t [N(d2 )]

18-30
Illustration

V = current value of the call option

P = current price of the underlying stock
N(di) = probability that a deviation less than di will occur
in a standard normal distribution. Thus, N(di) and
(Nd2) represent areas under a standard normal
distribution curve
X = exercise or strike or price of the option
e~ = 2.7183
rRF = risk-free interest rate
t = time until the option expires (the option
period)
In(P/X) = natural logarithm of P/X
o2 = variance of the rate of return on the stock
18-31
Illustration

P = P 21
X = P 21
t = .36 year
rRF =5%
o2 = .09
o = square root of .09 = 0.30

d1 = In(21/21) + [.05 + (.09/2)](.36)

.30 (0.6)
= 0 + 0.0342
.18
= .19

18-32
Illustration

d2 = d1 - .30 √ .36 = .19 - .18 = .01

V = 21 [N(d1)] – 21e^- [(.05)(.36)] [N(d2)]

= 21 [N(.19)] – 21 [(2.7183)^- [(.05)(.36)]] [N(.01)]
= 21 [N(.19)] – 21 (.98216) [N(.01)]
= 21 [.5753] – 20.625 (.504)
= 12.081 – 10.395
= 1.686

18-33
Exercise

P = P 28
X = P 28
t = .18 year
rRF =7%
o2 = .09

18-34
Assignment/Seatwork

Problem 18-4: Black-Scholes

Page No. 636

18-35
Standard Normal Probabilities Table

18-36
Standard Normal Probabilities Table

18-37
 Effects of Option Pricing Models on
Factors on the Value of a Call Option
 Current stock price. The value of the option increases
as the stock price increases
 Exercise price. The decrease in the option value is less
than the exercise price increase, but the percentage
change in the option value exceeds the percentage change
in the exercise price
 Option period. The value of the option increases as the
time to expiration increases
 Risk-free rate. The value of the option increases as the
risk-free rate increases
 Variance. The value of the option increases as the
variance increases from the base case

18-38
 Forward and Future Contracts

 Forward Contract.
A contract under which one party agrees to buy a
commodity at a specific price on a specific future
date and the other party agrees to make the sale.
Physical delivery occurs.
 Future Contract.
A standardized contracts that are traded on
exchanges and are “marked to market” daily, but
where physical delivery of the underlying asset is
never taken. Used for commodities, debt securities
and stock indexes
18-39
Forward and Future Contracts

 Difference of future contracts with forward

contracts:

1.Futures contracts are “marked to market” on

a daily basis where gains and losses are noted
2.Physical delivery of the underlying asset is
never taken
3.Generally standardized instruments that are
traded on exchanges

18-40
 Classes of Future Contracts
 Commodity Futures:
A contract that is used to hedge against price changes
for input materials
Examples: oil, grains, oilseeds, livestock, meats,
fibers, metals and woods.

 Financial Futures:
A contract that is used to hedge against fluctuating
interest rates, stock prices and exchange rates
Examples: Treasury bills, notes, bonds, certificates
of deposit, foreign currencies

18-41
 Other Types of Derivatives
 Swap:
Two parties agree to exchange obligations to make
specified payment streams
Classes:
a. Interest swap
b. Currency swap
 Structured Note:
A debt obligation derived from another debt obligation
 Inverse Floaters:
A note in which the interest rate paid moves counter to
market rates

18-42
 Other terms and concepts on
derivatives
 Speculations – with futures, it involves betting on
future price movements
 Hedging – using transactions to lower risk
 Long Hedges – futures contracts are bought in
anticipation of (or to guard against) price increases
 Short Hedges – futures contracts are sold to guard
against price declines
 Perfect Hedge – Occurs when the gain or loss on the
hedged transaction exactly offsets the loss or gain
on the unhedged position

18-43
 Risk Management
 Involves the management of unpredictable events that have
adverse consequences for a firm

 Terms and Definitions:

1.Pure risks offer only the prospect of a loss
2.Speculative risks offer the chance of a gain but might result in a loss
3.Demand risks are associated with the demand for a firm’s products
or services
4.Input risks are associated with input costs, including labor and
materials
5.Financial risks result from financial transactions
6.Property risks are associated destruction of productive assets
7.Personnel risks result from employees’ actions
8.Environmental risks include risks associated with polluting the
environment
18-44
 Risk Management
 Terms and Definitions:
9.Liability risks are associated with product, service or employee
actions
10.Insurable risks can be covered by insurance

18-45
 Approaches to Risk Management

1. Identify the risks that the firm faces.

2. Measure the potential effect of each risk.
3. Decide how each relevant risk should be handled.
a. Transfer the risk to an insurance company.
b. Transfer the function that produces the risk to a third party
c. Purchase derivative contracts to reduce risk
d. Reduce the probability of the occurrence of an adverse event
e. Reduce the magnitude of the loss associated with an adverse
event
f. Totally avoid the activity that gives rise to the risk

18-46
End of Presentation

18-47
Solving for Option Value

-rRF t
V  P[N(d1 )]  Xe [N(d2 )]
V  $27[0.7168]  $25e - (0.06)(0.5 )
[0.6327]
V  $4.0036

18-48
Use the B-S OPM to Find the Option
Value of a Call Option

P= $27, X = $25, rRF = 6%, t = 0.5 years,

and σ2 = 0.11
  0.11 
ln($27/$25)  0.06   (0.5)
  2 
d1   0.5736
(0.3317)(0.7071)

d2  0.5736  (0.3317)(0.7071)  0.3391

From Appendix C in the textbook

N(d1 )  N(0.5736)  0.5000  0.2168  0.7168
N(d2 )  N(0.3391)  0.5000  0.1327  0.6327
18-49
Create a Riskless Hedge to
Determine Value of a Call Option
Data: P = $15; X = $15; t = 0.5; rRF = 6%

Ending Call
Stock Strike Option
Price Price Value
$10 $15 $0
$20 $15 $5
Range $10 $5

18-50
Create a Riskless Hedge to
Determine Value of a Call Option
Step 1: Calculate the value of the portfolio at
the end of 6 months. (If the option is
in-the-money, it will be sold.)

Ending Ending Ending Value

Stock Stock Option of
Price  0.5 Value + Value = Portfolio
$10  0.5 $5 + $0 = $5
$20  0.5 $10 + -$5 = $5

18-51
Create a Riskless Hedge to
Determine Value of a Call Option
Step 2: Calculate the PV of the riskless portfolio
today.

Future portfolio value

PV 
(1  rRF ) t
$5
PV 
1.0296
PV  $4.86

18-52
Create a Riskless Hedge to
Determine Value of a Call Option
Step 3: Calculate the cost of the stock in the
portfolio.
Cost of stock in portfolio  % of stock in portfolio  Stock price
 0.5  $15
 $7.50

Step 4: Calculate the market value of the option.

Price of option  Cost of stock  PV of portfolio
 $7.50  $4.86
 $2.64
18-53
How do the factors of the B-S OPM
affect a call option’s value?

As Factor Increases Option Value

Current stock price Increases
Exercise price Decreases
Time to expiration Increases
Risk-free rate Increases
Stock return volatility Increases

18-54
How do the factors of the B-S OPM
affect a put option’s value?

As Factor Increases Option Value

Current stock price Decreases
Exercise price Increases
Time to expiration Increases
Risk-free rate Decreases
Stock return volatility Increases

18-55
What are the assumptions of the Black-
Scholes Option Pricing Model?

 The stock underlying the call option pays no dividends during

the call option’s life.
 There are no transactions costs for the sale/purchase of either
the stock or the option.
 Unlimited borrowing and lending at the short-term, risk-free
rate (rRF), which is known and constant.
 No penalty for short selling and sellers receive immediately full
cash proceeds at today’s price.
 Option can only be exercised on its expiration date.
 Security trading takes place in continuous time, and stock
prices move randomly in continuous time.

18-56
Forward and Futures Contracts

 Forward contract: one party agrees to buy a

commodity at a specific price on a future date
and the counterparty agrees to make the
sale. There is physical delivery of the
commodity.
 Futures contract: standardized, exchange-
traded contracts in which physical delivery of
the underlying asset does not actually occur.
 Commodity futures
 Financial futures
18-57
Swaps

 The exchange of cash payment obligations

between two parties, usually because each
party prefers the terms of the other’s debt
contract.
 Fixed-for-floating
 Floating-for-fixed
 Swaps can reduce each party’s financial risk.

18-58
Hedging Risks

 Hedging is usually used when a price change

could negatively affect a firm’s profits.
 Long hedge: involves the purchase of a futures
contract to guard against a price increase.
 Short hedge: involves the sale of a futures
contract to protect against a price decline.

18-59
How can commodity futures markets be
used to reduce input price risk?

 The purchase of a commodity futures contract

will allow a firm to make a future purchase of
the input at today’s price, even if the market
price on the item has risen substantially in the
interim.

18-60
What is corporate risk management,
and why is it important to all firms?

 Corporate risk management relates to the

management of unpredictable events that
would have adverse consequences for the
firm.
 All firms face risks, but the lower those risks
can be made, the more valuable the firm,
other things held constant. Of course, risk
reduction has a cost.

18-61
Definitions of Different Types of Risk

 Speculative risks: offer the chance of a gain as

well as a loss.
 Pure risks: offer only the prospect of a loss.
 Demand risks: risks associated with the
demand for a firm’s products or services.
 Input risks: risks associated with a firm’s input
costs.
 Financial risks: result from financial
transactions.

18-62
Definitions of Different Types of
Risk
 Property risks: risks associated with loss of a
firm’s productive assets.
 Personnel risk: result from human actions.
 Environmental risk: risk associated with
polluting the environment.
 Liability risks: connected with product,
service, or employee liability.
 Insurable risks: risks that typically can be
covered by insurance.

18-63
What are the three steps of
corporate risk management?
1. Identify the risks faced by the firm.
2. Measure the potential impact of the identified
risks.
3. Decide how each relevant risk should be
handled.

18-64