CHAPTER 18

Derivatives and Risk Management

 Derivative securities
 Fundamentals of risk management
 Using derivatives
Are stockholders concerned about whether or
not a firm reduces the volatility of its cash
flows?
• Not necessarily.
• If cash flow volatility is due to systematic risk, it
can be eliminated by diversifying investors’
portfolios.
Reasons that corporations engage in risk
management
• Increase their use of debt.
• Maintain their optimal capital budget.
• Avoid financial distress costs.
• Utilize their comparative advantages in hedging,
compared to investors.
• Reduce the risks and costs of borrowing.
• Reduce the higher taxes that result from fluctuating
earnings.
• Initiate compensation programs to reward managers
for achieving stable earnings.
What is an option?
• A contract that gives its holder the right, but not
the obligation, to buy (or sell) an asset at some
predetermined price within a specified period of
time.
• Most important characteristic of an option:
• It does not obligate its owner to take action.
• It merely gives the owner the right to buy or sell an
asset.