CH18DerivativesandRiskManagement.ppt

DerivativesecuritiesFundamentalsofriskmanagementUsingderivativestoreduceinterestraterisk,CHAPTER18DerivativesandRiskManagement,Ifvolatilityisduetosystematicrisk,itcanbeeliminatedbydiversifyinginvestorsportfolios.,Whymightstockholdersbeindifferenttowhetherornotafirmreducesthevolatilityofitscashflows?,Increasetheiruseofdebt.Maintaintheiroptimalcapitalbudget.Avoidfinancialdistresscosts.Utilizetheircomparativeadvantagesinhedging,comparedtoinvestors.Reducetherisksandcostsofborrowing.,ReasonsRiskManagementMightIncreasetheValueofaCorporation,Reducethehighertaxesthatresultfromfluctuatingearnings.Initiatecompensationprogramstorewardmanagersforachievingstableearnings.,Anoptionisacontractthatgivesitsholdertheright,butnottheobligation,tobuy(orsell)anassetatsomepredeterminedpricewithinaspecifiedperiodoftime.,Whatisanoption?,Itdoesnotobligateitsownertotakeanyaction.Itmerelygivestheownertherighttobuyorsellanasset.,Whatisthesinglemostimportantcharacteristicofanoption?,Calloption:Anoptiontobuyaspecifiednumberofsharesofasecuritywithinsomefutureperiod.Putoption:Anoptiontosellaspecifiednumberofsharesofasecuritywithinsomefutureperiod.Exercise(orstrike)price:Thepricestatedintheoptioncontractatwhichthesecuritycanbeboughtorsold.,OptionTerminology,Optionprice:Themarketpriceoftheoptioncontract.Expirationdate:Thedatetheoptionmatures.Exercisevalue:Thevalueofacalloptionifitwereexercisedtoday=Currentstockprice-Strikeprice.,Coveredoption:Acalloptionwrittenagainststockheldinaninvestorsportfolio.Naked(uncovered)option:Anoptionsoldwithoutthestocktobackitup.In-the-moneycall:Acalloptionwhoseexercisepriceislessthanthecurrentpriceoftheunder-lyingstock.,Out-of-the-moneycall:Acalloptionwhoseexercisepriceexceedsthecurrentstockprice.LEAPS:Long-termEquityAnticiPationSecuritiesaresimilartoconventionaloptionsexceptthattheyarelong-termoptionswithmaturitiesofupto21/2years.,StockPriceCallOptionPrice$25$3.00307.503512.004016.504521.005025.50Exerciseprice=$25.,Considerthefollowingdata:,Createatablewhichshows(a)stockprice,(b)strikeprice,(c)exercisevalue,(d)optionprice,and(e)premiumofoptionpriceovertheexercisevalue.,PriceofStrikeExerciseValueStock(a)Price(b)ofOption(a)(b)$25.00$25.00$0.0030.0025.005.0035.0025.0010.0040.0025.0015.0045.0025.0020.0050.0025.0025.00,ExerciseValueMkt.PricePremiumofOption(c)ofOption(d)(d)(c)$0.00$3.00$3.005.007.502.5010.0012.002.0015.0016.501.5020.0021.001.0025.0025.500.50,Table(Continued),Whathappenstothepremiumoftheoptionpriceovertheexercisevalueasthestockpricerises?,Thepremiumoftheoptionpriceovertheexercisevaluedeclinesasthestockpriceincreases.Thisisduetothedecliningdegreeofleverageprovidedbyoptionsastheunderlyingstockpriceincreases,andthegreaterlosspotentialofoptionsathigheroptionprices.,CallPremiumDiagram,5101520253035404550,StockPrice,Optionvalue,30252015105,Marketprice,Exercisevalue,Thestockunderlyingthecalloptionprovidesnodividendsduringthecalloptionslife.Therearenotransactionscostsforthesale/purchaseofeitherthestockortheoption.kRFisknownandconstantduringtheoptionslife.,WhataretheassumptionsoftheBlack-ScholesOptionPricingModel?,(More.),Securitybuyersmayborrowanyfractionofthepurchasepriceattheshort-term,risk-freerate.Nopenaltyforshortsellingandsellersreceiveimmediatelyfullcashproceedsattodaysprice.Calloptioncanbeexercisedonlyonitsexpirationdate.Securitytradingtakesplaceincontinuoustime,andstockpricesmoverandomlyincontinuoustime.,V=PN(d1)Xe-kRFtN(d2).d1=.std2=d1st.,WhatarethethreeequationsthatmakeuptheOPM?,ln(P/X)+kRF+(s2/2)t,WhatisthevalueofthefollowingcalloptionaccordingtotheOPM?Assume:P=$27;X=$25;kRF=6%;t=0.5years: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)=d10.2345=0.57360.2345=0.3391.,d1=,N(d1)=N(0.5736)=0.5000+0.2168=0.7168.N(d2)=N(0.3391)=0.5000+0.1327=0.6327.Note:ValuesobtainedfromTableA-5intext.V=$27(0.7168)$25e-0.03(0.6327)=$19.3536$25(0.97045)(0.6327)=$4.0036.,Currentstockprice:Calloptionvalueincreasesasthecurrentstockpriceincreases.Exerciseprice:Astheexercisepriceincreases,acalloptionsvaluedecreases.,Whatimpactdothefollowingpara-metershaveonacalloptionsvalue?,Optionperiod:Astheexpirationdateislengthened,acalloptionsvalueincreases(morechanceofbecominginthemoney.)Risk-freerate:CalloptionsvaluetendstoincreaseaskRFincreases(reducesthePVoftheexerciseprice).Stockreturnvariance:Optionvalueincreaseswithvarianceoftheunderlyingstock(morechanceofbecominginthemoney).,Corporateriskmanagementrelatestothemanagementofunpredictableeventsthatwouldhaveadverseconsequencesforthefirm.,Whatiscorporateriskmanagement?,Allfirmsfacerisks,butthelowerthoseriskscanbemade,themorevaluablethefirm,otherthingsheldconstant.Ofcourse,riskreductionhasacost.,Whyiscorporateriskmanagementimportanttoallfirms?,Speculativerisks:Thosethatofferthechanceofagainaswellasaloss.Purerisks:Thosethatofferonlytheprospectofaloss.Demandrisks:Thoseassociatedwiththedemandforafirmsproductsorservices.Inputrisks:Thoseassociatedwithafirmsinputcosts.,DefinitionsofDifferentTypesofRisk,(More.),Financialrisks:Thosethatresultfromfinancialtransactions.Propertyrisks:Thoseassociatedwithlossofafirmsproductiveassets.Personnelrisk:Risksthatresultfromhumanactions.Environmentalrisk:Riskassociatedwithpollutingtheenvironment.Liabilityrisks:Connectedwithproduct,service,oremployeeliability.Insurablerisks:Thosethattypicallycanbecoveredbyinsurance.,Step1.Identifytherisksfacedbythefirm.Step2.Measurethepotentialimpactoftheidentifiedrisks.Step3.Decidehoweachrelevantriskshouldbehandled.,Whatarethethreestepsofcorporateriskmanagement?,Transferrisktoaninsurancecompanybypayingperiodicpremiums.Transferfunctionsthatproducerisktothirdparties.Purchasederivativecontractstoreduceinputandfinancialrisks.,Whataresomeactionsthatcompaniescantaketominimizeorreduceriskexposure?,(More.),Takeactionstoreducetheprobabilityofoccurrenceofadverseevents.Takeactionstoreducethemagnitudeofthelossassociatedwithadverseevents.Avoidtheactivitiesthatgiverisetorisk.,Financialriskexposurereferstotheriskinherentinthefinancialmarketsduetopricefluctuations.Example:Afirmholdsaportfolioofbonds,interestratesrise,andthevalueofthebondsfalls.,Whatisafinancialriskexposure?,Derivative:Securitywhosevaluestemsorisderivedfromthevaluesofotherassets.Swaps,options,andfuturesareusedtomanagefinancialriskexposures.Futures:Contractsthatcallforthepurchaseorsaleofafinancial(orreal)assetatsomefuturedate,butatapricedeterminedtoday.Futures(andotherderivatives)canbeusedeitherashighlyleveragedspeculationsortohedgea