CHAPTER 18
Derivatives and Risk Management
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Derivative securities
Fundamentals of risk management
Using derivatives
18-1
Are stockholders concerned about
whether or not a firm reduces the
volatility of its cash flows?
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Not necessarily.
If cash flow volatility is due to
systematic risk, it can be eliminated
by diversifying investors’ portfolios.
18-2
Reasons that corporations
engage in risk management
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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.
18-3
What is an option?
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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:
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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
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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 – the market price of the option
contract.
18-5
Option terminology
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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.
18-6
Option terminology
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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.
18-7
Option example
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A call option with an exercise price of $25,
has the following values at these prices:
Stock price
$25
30
35
40
45
50
Call option price
$3.00
7.50
12.00
16.50
21.00
25.50
18-8
Determining option exercise
value and option premium
Stock
price
$25.00
30.00
35.00
40.00
45.00
50.00
Strike
price
$25.00
25.00
25.00
25.00
25.00
25.00
Exercise
value
$0.00
5.00
10.00
15.00
20.00
25.00
Option Option
price premium
$3.00
$3.00
7.50
2.50
12.00
2.00
16.50
1.50
21.00
1.00
25.50
0.50
18-9
How does the option premium
change as the stock price increases?
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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
Option
value
30
25
20
Market price of
option
15
10
5
Exercise value of
option
Stock
Price
5
10
15
20
25
30
35
40
45
50
18-11
What are the assumptions of the
Black-Scholes Option Pricing Model?
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The stock underlying the call option
provides no dividends during the call
option’s life.
There are no transactions costs for the
sale/purchase of either the stock or the
option.
kRF is known and constant during the
option’s life.
Security buyers may borrow any fraction
of the purchase price at the short-term,
risk-free rate.
18-12
What are the assumptions of the
Black-Scholes Option Pricing Model?
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No penalty for short selling and
sellers receive immediately full cash
proceeds at today’s price.
Call option can be exercised only on
its expiration date.
Security trading takes place in
continuous time, and stock prices
move randomly in continuous time.
18-13
Which equations must be solved to
find the Black-Scholes option price?

ln(P/X)  [k RF  
2

d1 
σ t
d2  d1 - σ t
2
V  P[N(d1 )] - Xe
-k RF t

 t]

[N(d2 )]
18-14
Use the B-S OPM to find the option value
of a call option with P = $27, X = $25,
kRF = 6%, t = 0.5 years, and σ2 = 0.11.
ln($27/$25 )  [(0.06  0.11 )] (0.5)
2
d1 
 0.5736
(0.3317)(0 .7071)
d2  0.5736 - (0.3317)(0 .7071)  0.3391
From Table A - 5 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
18-15
Solving for option value
V  P[N(d1 )] - Xe
-k RF t
[N(d2 )]
-(0.06)(0.5 )
V  $27[0.7168] - $25e
[0.6327]
V  $4.0036
18-16
How do the factors of the B-S
OPM affect a call option’s value?
As the factor increases …
Current stock price
Exercise price
Option value …
Increases
Decreases
Time to expiration
Risk-free rate
Stock return variance
Increases
Increases
Increases
18-17
What is corporate risk management,
and why is it important to all firms?
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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.
18-18
Definitions of different types
of risk
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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.
18-19
Definitions of different types
of risk
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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.
18-20
What are the three steps of
corporate risk management?
1.
2.
3.
Identify the risks faced by the firm.
Measure the potential impact of the
identified risks.
Decide how each relevant risk
should be handled.
18-21
What can companies do to
minimize or reduce risk exposure?
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Transfer risk to an insurance company by
paying periodic premiums.
Transfer functions that produce risk to third
parties.
Purchase derivative contracts to reduce input
and financial risks.
Take actions to reduce the probability of
occurrence of adverse events and the
magnitude associated with such adverse events.
Avoid the activities that give rise to risk.
18-22
What is financial risk exposure?
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Financial risk exposure refers to the
risk inherent in the financial markets
due to price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the
value of the bond portfolio falls.
18-23
Financial Risk Management
Concepts
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Derivative – a security whose value is
derived from the values of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.
Futures – contracts that call for the purchase
or sale of a financial (or real) asset at some
future date, but at a price determined today.
Futures (and other derivatives) can be used
either as highly leveraged speculations or to
hedge and thus reduce risk.
18-24
Financial Risk Management
Concepts
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Hedging – usually used when a price change
could negatively affect a firm’s profits.
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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.
Swaps – the exchange of cash payment
obligations between two parties, usually
because each party prefers the terms of the
other’s debt contract. Swaps can reduce
each party’s financial risk.
18-25
How can commodity futures markets
be used to reduce input price risk?
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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.
18-26