1. Chapter 18 Derivatives & Risk Management
Motives for Risk Management
Derivative Securities
Using Derivatives
Fundamentals of Risk Management

2. Risk Management
Risk management involves identifying events that could have adverse financial consequences and then taking actions to prevent and/or minimize the damage caused by those events.

3. 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.
You can hedge the risk of oil by buying oil stocks in your portfolio for example
However, many firms still do it. This could indicate that risk management is beneficial however through other means that ultimately
Affect future cash flows or WACC

4. 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.
2nd point: risk management smooths future cash flows and hence reduces fluctuations and needs for external equity
3rd point: financial distress costs: higher interest rates, customers defection
Risk management usually requires the use of derivatives. Define derivatives and their types
Derivatives markets started with wheat futures. Farmers and mill owners. This later on evolved into the Chicago Board of Trade
where you have dealers
Speculators then came along. Discuss their benefits. Why do speculators like derivatives? Leveraged positions
Define a natural hedge. Hedging can also occur with no natural hedge (e.g. insurance). Here you are transferring the risk.
Derivatives markets are much bigger nowadays. Significant downside (the collapse of Barings Bank). Financial Crisis

5. Derivatives
Derivatives are securities whose values are determined by the market price of some other asset.
Examples:
Options
Interest rate and exchange rate futures and  swaps
Commodity futures
Derivatives markets started with wheat futures.
Chicago Board of Trade

6. Natural hedge
Natural hedges are defined as situations in which aggregate risk can be reduced by derivatives transactions between two parties (called counterparties).
In a natural hedge risk is reduced for both parties and not transferred from one to another.
E.g. cotton farms and cotton mills.
Hedging also can be in situations where no natural hedge exists. One party wants to reduce risk and another party agrees to take on that risk. E.g. Insurance.

7. Speculators Why do speculators like derivatives?
Most derivatives, including futures, are highly leveraged, meaning that a small change in the value of the underlying asset will produce a large change in the price of the derivative.
Do speculators increase market risk?
Not necessary, speculators add capital and players to the market, which tends to stabilize the market.

8. Examples of hedging going wrong..
Bankruptcy of Britain’ s oldest bank, Barings Bank.
Long-Term Capital Management LP nearly collapsed because of bad bets made in the derivatives market.
Gulf Bank crisis

9. Examples of hedging adding value…

10. 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.

11. 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.

12. Option Terminology (Cont’d)
Expiration date: the date the option matures.
Exercise value: the value of an option if it were exercised today
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.

13. Exercise value For call option:
Exercise value call option = Max[(Stock price – Strike price), 0]
For put option:
Exercise value put option = Max[(Strike price – Stock price), 0]

14. 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.
In-the-money put: a put option whose exercise price exceeds the current stock price.
Out-of-the-money put: a put option whose exercise price is less than the current price of the underlying stock.

15. 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
What is one factor affecting call option price?

16. Factors affecting option price..
How does these factors affect a call option’s price?
The option’ s time to maturity?
The volatility of the stock price?
The risk-free rate?
Rrf:  The expected growth rate of a firm’ s stock price increases as interest rates increase, but the
present value of future cash flows decreases. The first effect tends to increase the
call option’ s price, while the second tends to decrease it. As it turns out, the first
effect dominates the second one; so the price of a call option always increases as
the risk-free rate increases.

17. Determining Option Exercise Value & Option Premium
Option premium (time value) = Option price - Exercise value
Stock Price
Strike Price
Exercise Value
Option Price
Option Premium
$25.00
$0.00
3.00
30.00
25.00
5.00
7.50
2.50
35.00
10.00
12.00
2.00
40.00
15.00
16.50
1.50
45.00
20.00
21.00
1.00
50.00
25.50
0.50
Define exercise value
Why do we pay a premium beyond the exercise value?

18. 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.

19. Problem 18-1

20. 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.
Widely used model by option traders

21. Using the Black-Scholes Option Pricing Model
Based on the concept of a risk-less portfolio. Risk-less portfolio is priced using the risk-free rate
What are the factors affecting the price of a call option?
Explain first term and second term

22. 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

23. Solving for Option Value

24. 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
Risk-free rate
Stock return volatility

25. 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
Risk-free rate
Stock return volatility

26. Problem 18-4

27. Create a Riskless Hedge to Determine Value of a Call Option
Data: P = $15; X = $15; t = 0.5; rRF = 6%
Ending Stock Price
Strike Price
Call Option Value
$10
$15 $0
$20 $5
Range
We call this the binomial pricing model.
We need to make the range of ending stock price = range of call option value. How?
Buy 0.5 stock for each call sold. Why buy and sell? Because you want to have a risk-less portfolio in which the two securities
offset each other

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

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

30. Create a Riskless Hedge to Determine Value of a Call Option
Step 3: Calculate the cost of the stock in the portfolio. Step 4: Calculate the market value of the option.

31. Problem 18-8

32. 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
Forward contract: risk of default. Futures no default risk due to mark to market
Give examples. How trading commodity futures came to exist?
Discuss margin, maintenance margin. How can it be used as hedge?

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. What are the three steps of corporate risk management?
Identify the risks faced by the firm.
Measure the potential impact of the identified risks.
Decide how each relevant risk should be handled.