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1、Derivative securities Fundamentals of risk management Using derivatives to reduce interest rate risk,CHAPTER 18 Derivatives and Risk Management,If volatility is due to systematic risk, it can be eliminated by diversifying investors portfolios.,Why might stockholders be indifferent to whether or not
2、a firm reduces the volatility of its cash flows?,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.,Reasons Risk Management Might Increase
3、the Value of a Corporation,Reduce the higher taxes that result from fluctuating earnings. Initiate compensation programs to reward managers for achieving stable earnings.,An option is a contract that gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined
4、price within a specified period of time.,What is an option?,It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset.,What is the single most important characteristic of an option?,Call option: An option to buy a specified number of shares of a s
5、ecurity 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 Terminology,Option price: The market price of
6、 the option contract. Expiration date: The date the option matures. Exercise value: The value of a call option if it were exercised today = Current stock price - Strike price.,Covered option: A call option written against stock held in an investors portfolio. Naked (uncovered) option: An option sold
7、 without the stock to back it up. In-the-money call: A call option whose exercise price is less than the current price of the under-lying stock.,Out-of-the-money call: A call option whose exercise price exceeds the current stock price. LEAPS: Long-term Equity AnticiPation Securities are similar to c
8、onventional options except that they are long-term options with maturities of up to 2 1/2 years.,Stock Price Call Option Price $25 $ 3.00 30 7.50 35 12.00 40 16.50 45 21.00 50 25.50 Exercise price = $25.,Consider the following data:,Create a table which shows (a) stock price, (b) strike price, (c) e
9、xercise value, (d) option price, and (e) premium of option price over the exercise value.,Price of Strike Exercise Value Stock (a) Price (b) of Option (a) (b) $25.00 $25.00 $0.00 30.00 25.00 5.00 35.00 25.00 10.00 40.00 25.00 15.00 45.00 25.00 20.00 50.00 25.00 25.00,Exercise Value Mkt. Price Premiu
10、m of Option (c) of Option (d) (d) (c) $ 0.00 $ 3.00 $ 3.00 5.00 7.50 2.50 10.00 12.00 2.00 15.00 16.50 1.50 20.00 21.00 1.00 25.00 25.50 0.50,Table (Continued),What happens to the premium of the option price over the exercise value as the stock price rises?,The premium of the option price over the e
11、xercise 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.,Call Premium Diagram,5 10 15 20 25 30 35 40 45 50,Stock Price,Option va
12、lue,30 25 20 15 10 5,Market price,Exercise value,The stock underlying the call option provides no dividends during the call options life. There are no transactions costs for the sale/purchase of either the stock or the option. kRF is known and constant during the options life.,What are the assumptio
13、ns of the Black-Scholes Option Pricing Model?,(More.),Security buyers may borrow any fraction of the purchase price at the short-term, risk-free rate. No penalty for short selling and sellers receive immediately full cash proceeds at todays price. Call option can be exercised only on its expiration
14、date. Security trading takes place in continuous time, and stock prices move randomly in continuous time.,V = PN(d1) Xe -kRFtN(d2). d1 = . s t d2 = d1 s t.,What are the three equations that make up the OPM?,ln(P/X) + kRF + (s2/2)t,What is the value of the following call option according to the OPM?
15、Assume: P = $27; X = $25; kRF = 6%; t = 0.5 years: s2 = 0.11,V = $27N(d1) $25e-(0.06)(0.5)N(d2). ln($27/$25) + (0.06 + 0.11/2)(0.5) (0.3317)(0.7071) = 0.5736. d2 = d1 (0.3317)(0.7071) = d1 0.2345 = 0.5736 0.2345 = 0.3391.,d1 =,N(d1) = N(0.5736) = 0.5000 + 0.2168 = 0.7168. N(d2) = N(0.3391) = 0.5000
16、+ 0.1327 = 0.6327. Note: Values obtained from Table A-5 in text. V = $27(0.7168) $25e-0.03(0.6327) = $19.3536 $25(0.97045)(0.6327) = $4.0036.,Current stock price: Call option value increases as the current stock price increases. Exercise price: As the exercise price increases, a call options value d
17、ecreases.,What impact do the following para- meters have on a call options value?,Option period: As the expiration date is lengthened, a call options value increases (more chance of becoming in the money.) Risk-free rate: Call options value tends to increase as kRF increases (reduces the PV of the e
18、xercise price). Stock return variance: Option value increases with variance of the underlying stock (more chance of becoming in the money).,Corporate risk management relates to the management of unpredictable events that would have adverse consequences for the firm.,What is corporate risk management
19、?,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.,Why is corporate risk management important to all firms?,Speculative risks: Those that offer the chance of a gain as well as a loss. Pure risks
20、: Those that offer only the prospect of a loss. Demand risks: Those associated with the demand for a firms products or services. Input risks: Those associated with a firms input costs.,Definitions of Different Types of Risk,(More.),Financial risks: Those that result from financial transactions. Prop
21、erty risks: Those associated with loss of a firms productive assets. Personnel risk: Risks that result from human actions. Environmental risk: Risk associated with polluting the environment. Liability risks: Connected with product, service, or employee liability. Insurable risks: Those that typicall
22、y can be covered by insurance.,Step 1. Identify the risks faced by the firm. Step 2. Measure the potential impact of the identified risks. Step 3. Decide how each relevant risk should be handled.,What are the three steps of corporate risk management?,Transfer risk to an insurance company by paying p
23、eriodic premiums. Transfer functions that produce risk to third parties. Purchase derivative contracts to reduce input and financial risks.,What are some actions that companies can take to minimize or reduce risk exposure?,(More.),Take actions to reduce the probability of occurrence of adverse event
24、s. Take actions to reduce the magnitude of the loss associated with adverse events. Avoid the activities that give rise to risk.,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, an
25、d the value of the bonds falls.,What is a financial risk exposure?,Derivative: Security whose value stems or 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 r
26、eal) 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.,Financial Risk Management Concepts,(More.),Hedging: Generally conducted where a price change could negatively affect
27、a firms 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 in commodities or financial securities.,(More.),Swaps: Involve the exchange of cash payment obligations
28、between two parties, usually because each party prefers the terms of the others debt contract. Swaps can reduce each partys financial risk.,The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at todays price, even if the market price on the item has risen substantially in the interim.,How can commodity futures markets be used to reduce input price risk?,