derivatives and risk f.m

8/6/2019 Derivatives and Risk F.M.

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Are stockholders concerned about whether or not a

firm reduces the volatility of its cash flows?

y Not necessarily.

y If cash flow volatility is due to systematic risk, it

can be eliminated by diversifying investorsportfolios.


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Definitions of different types of

risky Speculative risks offer the chance of a gain as

well as a loss.

y

Pure risks offer only the prospect of a loss.y Demand risks risks associated with the

demand for a firms products or services.

y Input risks risks associated with a firms input

costs.y Financial risks result from financial

transactions.


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risky Property risks risks associated with loss of

a firms productive assets.

y

Personnel risk result from human actions.y Environmental risk risk associated with

polluting the environment.

y Liability risks connected with product,

service, or employee liability.y Insurable risks risks that typically can be

covered by insurance.


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risk

y Credit Risk-- Customer or counterparty maynot settle an obligation for full value, either

when due or at any time thereafter.y Counterparty risk-- The risk that a companys

counterparty will fail to perform during the lifeof the transaction

yPrincipal/interest risk -- Failure to recoverprincipal and/or interest on the due date forpayment


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risky Issuer/position/specific risk -- Risk arising

from holding the counterpartys debtsecurities

y Currency risk -- Risk to earnings andcapital arising from adverse movements incurrency exchange rates

y

Liquidity risk -- Risk of loss arising fromchanges in the ability to sell or dispose ofan asset


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risky Operational risk -- Risk of direct or indirect

loss resulting from inadequate or failedinternal processes, people and systems andfrom external events

y Regulatory risk Risk of loss arising fromfailure to comply with legal requirements inthe relevant jurisdiction in which the companyoperates


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Risk Managementy Evaluating and controlling risk effectively will ensure

opportunities in a business are not lost, competitive

advantage is enhanced and less management time isspent fire-fighting.


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Reasons that corporations engage

in risk managementy Increase their use of debt.

y Maintain their optimal capital budget.

yAvoid financial distress costs.y Utilize their comparative advantages in

hedging, compared to investors.

y Reduce the risks and costs of borrowing.

y Reduce the higher taxes that result fromfluctuating earnings.

y Initiate compensation programs to rewardmanagers for achieving stable earnings.


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What is corporate risk management, and

why is it important to all firms?

y Corporate risk management relates to themanagement of unpredictable events that

would have adverse consequences for thefirm.

yAll firms face risks, but the lower those riskscan be made, the more valuable the firm,other things held constant. Of course, riskreduction has a cost.


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What are the three steps of

corporate risk management?1. Identify the risks faced by the firm.

2. Measure the potential impact of the identified

risks.3. Decide how each relevant risk should be

handled.


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What can companies do to minimize or

reduce risk exposure?

y Transfer risk to an insurance company by payingperiodic premiums.

y Transfer functions that produce risk to third

parties.y Purchase derivative contracts to reduce input and

financial risks.

y Take actions to reduce the probability of

occurrence of adverse events and the magnitudeassociated with such adverse events.

y Avoid the activities that give rise to risk.


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What is financial risk exposure?

y Financial risk exposure refers to the risk inherent

in the financial markets due to price

fluctuations.y Example: A firm holds a portfolio of bonds,

interest rates rise, and the value of the bond

portfolio falls.


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Financial Risk Management

Conceptsy Derivative a security whose value is derived from

the values of other assets. Swaps, options, and

futures are used to manage financial riskexposures.

yA derivative is a financial instrument that offers a

return based on the return of some other

underlying instrument


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TRADING OFDERIVATIVE

PRODUCTSy Exchange Traded Contracts have standard terms and

features and are traded on an organized trading facility

yOTCOver the Counter contracts are any transactionscreated by two parties anywhere else.


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DERIVATIVE PRODUCTSy 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 otherderivatives) can be used either as highly leveraged

speculations or to hedge and thus reduce risk.


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DERIVATIVE PRODUCTSy Forward Contracts-- A forward contract is an

agreement between two parties in which one party, the

buyer, agrees to buy from other party, the seller, anunderlying asset or other derivative, at a future date ata price established at the start of the contract.


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Financial Risk Management

Conceptsy Hedging usually used when a price change

could negatively affect a firms profits.y Long hedge involves the purchase of a futures

contract to guard against a price increase.y Short hedge involves the sale of a futures contract

to protect against a price decline.

y Swaps the exchange of cash paymentobligations between two parties, usuallybecause each party prefers the terms of theothers debt contract. Swaps can reduce eachpartys financial risk.


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How can commodity futures markets be

used to reduce input price risk?

y The purchase of a commodity futures contractwill allow a firm to make a future purchase of

the input at todays price, even if the marketprice on the item has risen substantially in theinterim.


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What is an option?yA contract that gives its holder the right, but not

the obligation, to buy (or sell) an asset at somepredetermined price within a specified period of

time.y Most important characteristic of an option:

y It does not obligate its owner to take action.

y It merely gives the owner the right to buy or sell an

asset.


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Option terminologyy Call option an option to buy a specified number

of shares of a security within some future period.

y Put option an option to sell a specified numberof shares of a security within some future period.

y Exercise (or strike) price the price stated in theoption contract at which the security can bebought or sold.

y Option price the market price of the optioncontract.


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Option terminologyy Expiration date the date the option matures.

y Exercise value the value of an option if it were

exercised today (Current stock price - Strike price).y Covered option an option written against stock held

in an investors portfolio.

y Naked (uncovered) option an option written without

the stock to back it up.


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Option terminologyy In-the-money call a call option whose exercise price is

less than the option price of the underlying stock.

y Out-of-the-money call a call option whose exercise price

exceeds the option price.

y LEAPS: Long-term Equity AnticiPation Securities are

similar to conventional options except that they are long-

term options with maturities of up to 2 1/2 years.


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Option exampleyA call option with an exercise price of $25, has the

following values at these prices:

Stock price Call option price$25 $3.0030 7.5035 12.00

40 16.5045 21.0050 25.50


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Determining option exercise value

and option premiumStock Strike Exercise Option Option

price price value price premium

$25.00 $25.00 $0.00 $3.00 $3.0030.00 25.00 5.00 7.50 2.50

35.00 25.00 10.00 12.00 2.00

40.00 25.00 15.00 16.50 1.50

45.00 25.00 20.00 21.00 1.0050.00 25.00 25.00 25.50 0.50


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How does the option premium change as

the stock price increases?

y The premium of the option price over theexercise value declines as the stock price

increases.y This is due to the declining degree of

leverage provided by options as theunderlying stock price increases, and thegreater loss potential of options at higheroption prices.


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Call premium diagram

5 10 15 20 25 30 35 40 45 50

Stock

Price

Option

value

30

25

20

15

10

5

Market price

Exercise value

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