ISBN: 0-03-028931-9
Chapter 18 Derivatives and Risk Management
This chapter provided an introduction to derivative securities and corporate risk management. The key concepts covered are listed below:
Derivatives are securities whose values are determined by the market price or interest rate of some other security.
A hedge is a transaction that lowers risk. A natural hedge is a transaction between two counterparties where both parties' risks are reduced.
Options are financial instruments that (1) are created by exchanges rather than firms, (2) are bought and sold primarily by investors, and (3) are of importance to both investors and financial managers.
The two primary types of options are (1) call options, which give the holder the right to purchase a specified asset at a given price (the exercise or strike price) for a given period of time, and (2) put options, which give the holder the right to sell an asset at a given price for a given period of time.
Conventional options are written for terms of six months or less. If an investor chooses to invest for a longer period of time, he/she may choose to invest in Long-term Equity AnticiPation Securities(LEAPS). LEAPS offer investors maturities of up to 2 ½years.
A call option's formula value is defined as the maximum of either zero or the difference of the current price of the stock less the strike price. A put option's formula value is defined as the maximum of either zero or the difference of the strike price less the current price of the stock.
The market price of an option will always be greater than the formula price of an option. The difference between the market value and formula value of an option is called the time value of the option, and is its greatest when the option is at-the-money (the current market price and strike price are roughly the same).
The Black-Scholes Option Pricing Model (OPM) can be used to estimate the value of a call option. Its derivation rests upon the concept of a riskless hedge of buying shares of stock and simultaneously selling call options on that stock.
There is a positive relationship between the value of a call option and the option's time to maturity, current stock price, the risk-free rate, and volatility; and there is an inverse relationship with the exercise price. A put option's value, however, has a positive relationship with the option's time to maturity, exercise price, the risk-free rate, and volatility. Meanwhile, it has an inverse relationship with the current stock price.
A futures contract is a standardized contract that is traded on an exchange and is "market to market" daily, but where physical delivery of the underlying asset does not occur.
Under a forward contract, one party agrees to buy a commodity at a specific price and a specific future date and the other party agrees to make the sale. Delivery does occur.
A structured note is a debt obligation derived from another debt obligation.
A swap is an exchange of cash payment obligations. Swaps occur because the parties involved prefer someone else's payment stream.
An inverse floater is a note in which the interest paid moves counter to market rates.
In general, risk management involves the management of unpredictable events that have adverse consequences for the firm.
The three steps in risk management are as follows: (1) identify the risks faced by the company, (2) measure the potential impacts of these risks, and (3) decide how each relevant risk should be dealt with.
In most situations, risk exposure can be dealt with by one or more of the following techniques: (1) transfer the risk to an insurance company, (2) transfer the function that produces the risk to a third party, (3) purchase derivative contracts, (4) reduce the probability of occurrence of an adverse event, (5) reduce the magnitude of the loss associated with an adverse event, and (6) totally avoid the activity that gives rise to the risk.
Financial futures markets permit firms to create hedge positions to protect themselves against fluctuating interest rates, stock prices, and exchange rates.
Commodity futures can be used to hedge against input price increases.
Long hedges involve buying futures contracts to guard against price increases.
Short hedges involve selling futures contracts to guard against price declines.
A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position.
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