Derivatives and Risk Management,Motives for Risk ManagementDerivative SecuritiesUsing DerivativesFundamentals of Risk Management,Chapter 18,18-1,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 only if it leads to higher expected cash flows and/or a reduced WACC.,18-2,Reasons That Corporations Engage in Risk Management,Reduced volatility reduces bankruptcy risk, which enables the firm to increase its debt capacity.By reducing the need for external equity, firms can maintain their optimal capital budget.Reduced volatility helps avoid financial distress costs.Managers have a comparative advantage in hedging certain types of risk.Reduced volatility reduces the costs of borrowing.Reduced volatility reduces the higher taxes that result from fluctuating earnings.Certain compensation schemes reward managers for achieving stable earnings.,18-3,What is an option?,A contract that gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time.Its 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.,18-4,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 contracts market price.,18-5,Option Terminology (Contd),Expiration date: the date the option expires.Exercise value: the value of an option if it were exercised today (Current stock price Strike price).Covered option: an option written against stock held in an investors portfolio.Naked (uncovered) option: an option written without the stock to back it up.,18-6,Option Terminology (Contd),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 2 years.,18-7,Option Example,A call option with an exercise price of $25, has the following values at these prices:,18-8,Determining Option Exercise Value and Option Premium,18-9,How does the option premium change as the stock price increases?,The premium of the option price over the exercise value declines as the stock price increases.This is due to the declining degree of leverage provided by options as the underlying stock price increases, and the greater loss potential of options at higher option prices.,18-10,Call Premium Diagram,18-11,What are the assumptions of the Black-Scholes Option Pricing Model?,The stock underlying the call option pays no dividends during the call options 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 todays 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.,18-12,Using the Black-Scholes Option Pricing Model,18-13,Use the B-S OPM to Find the Option Value of a Call Option,18-14,P = $27, X = $25, rRF = 6%, t = 0.5 years, and 2 = 0.11From Appendix C in the textbookN(d1) = N(0.5736) = 0.5000 + 0.2168 = 0.7168N(d2) = N(0.3391) = 0.5000+ 0.1327 = 0.6327,Solving for Option Value,18-15,Create a Riskless Hedge to Determine Value of a Call Option,Data: P = $15; X = $15; t = 0.5; rRF = 6%,18-16,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.),18-17,Create a Riskless Hedge to Determine Value of a Call Option,Step 2: Calculate the PV of the riskless portfolio today.,18-18,Create a Riskless Hedge to Determine Value of a Call Option,Step 3:Calculate the cost of the stock in the portfolio.,18-19,Step 4:Calculate the market value of the option.,How do the factors of the B-S OPM affect a call options value?,18-20,How do the factors of the B-S OPM affect a put options value?,18-21,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 futuresFinancial futures,