DERIVATIVES AND RISK MANAGEMENT

RISK MANAGEMENT

Involves identifying events that could have adverse financial consequences and
taking the appropriate action to prevent or minimize the damage of these events
 WHY MANAGE RISK?

All companies are exposed to risk

• volatile product prices, demand, input costs and other sources or business risks
• volatile exchange and interest rates that may affect how a company does business.

RISK MANAGEMENT is employed to reduce firm risk, preventing catastrophic

blunders and lead to a lower cost of capital.

… by anticipating events that may cause the company to financially bleed out, managing
the risk is one way for the firms to do damage control.
 RISK MANAGEMENT AND A VALUE OF A
CORPORATION

• Risk management helps firms in increasing its value by:

• Having greater debt capacity
• Having the optimal capital budget without having to raise additional equity.
• Helps avoid financial distress
• Utilize comparative advantage in hedging relative to hedging ability of investors
• Reduces borrowing costs
• Minimize the negative tax effects
 THE RISK MANAGEMENT PROCESS

1. Identify the risk the firm is facing

2. Measure the potential effect of each risk identified
3. Decide how the risk should be handled:
a. Transfer the risk to an insurance company
b. Transfer the function that produces the risk to a third party
c. Purchase derivative contracts to reduce risk
d. Reduce the probability of occurrence of an adverse event
e. Totally avoid the activity that gives rise to the risk
DERIVATIVES
 DERIVATIVES

•Security whose value stems or is

derived from the value of other assets.
Swaps, options, and futures are used to
manage financial risk exposures
 TYPES OF DERIVATIVES

Forward contracts are agreements in which one party agrees to buy a

commodity at a specific price on a specific future date and the other party agrees
to sell the product.

Futures. Contracts which call for the purchase or sale of a financial (or real)
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.
 FORWARD CONTRACTS: AN EXAMPLE

Think of farmers who face considerable price uncertainty

each year. Their crops fail due to insects, disease, or weather,
and the demand for their crops may fluctuate substantially.

To protect against uncertainty, farmers may draw up a

forward contract and sell it to a private buyer. For example,
large food manufacturers may purchase a farmer's wheat
forward contract to lock in the price and control their
manufacturing cost.
 LET’S TALK FUTURES

Commodity futures: cover oil, various grains, oilseeds, livestock, meats, fibers,
metals, and wood

Financial futures: include Treasury bills, notes, bonds, certificates of deposit,

Eurodollar deposits, foreign currencies, and stock indexes.
 MORE ON FUTURES AND HEDGING

• Hedging. Generally conducted where 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 in commodities or financial securities.
• Perfect hedge. Gains on the futures contract would exactly offset losses on
the bonds.
FUTURES: AN EXAMPLE
 FUTURES: AN EXAMPLE

In August, Carson Foods is considering a plan to

issue $10,000,000 of 20-year bonds in March to
finance a capital expenditure program. The interest
rate would be 9% paid semiannually if the bonds
were issued today.
 FUTURES: AN EXAMPLE, CONTINUED

In March, when Carson issues its bonds, renewed

fears of inflation push interest rates up by 100 basis
points. What would the bond proceeds be if Carson
still tried to issue 9% coupon bonds when the
market requires a 10% rate of return?
FUTURES OR
CONTRACTS,
WHAT’S THE
DIFFERENCE?
 OTHER TYPES OF DERIVATIVES

• Swaps. Involve the exchange of cash payment obligations between two

parties, usually because each party prefers the terms of the other’s debt
contract. Swaps can reduce each party’s financial risk.
 LET’S TALK SWAPS

Major changes have occurred over time in the swaps market. First, standardized
contracts have been developed for the most common types of swaps, which has
had two effects:
(1) Standardized contracts lower the time and effort involved in arrang- ing
swaps, and this lowers transactions costs.
(2) The development of standardized contracts has led to a secondary market
for swaps, which has increased the liquidity and efficiency of the swaps
market.
 SWAPS: AN EXAMPLE

An electric utility company recently issued a 5-year

floating-rate note tied to the prime rate. The prime
rate could rise significantly over the period, so the
note carries a high degree of interest rate risk.
 OTHER TYPES OF DERIVATIVES

An Option is a contract that gives its owner the right to buy (or sell) an asset at
some predetermined price within a specified period.
• A call option gives its owner the right to buy a share of stock at a fixed price,
which is called the strike price (sometimes called the exercise price because
it is the price at which you exercise the option).
• A put option gives its owner the right to sell a share of stock at a fixed strike
price.
• Expiration date: the date after which the option may no longer be exercised.
 OPTIONS

quoted price
stock price
of the
option
 MORE ON OPTIONS

In-the-money: the current stock price is greater than strike price.

Out of the money: the current stock price is below the current strike price.
At the money: the current stock price equals the current strike price.
Exercise value: any profit gained from immediately exercising the option

for a call option: Exercise value = current asset price – strike price
for a put option: Exercise value = strike price – current asset price
OPTION PRICING APPROACHES
 BINOMIAL OPTION PRICING MODEL

With binomial option price models, the assumptions are that there are two
possible outcomes—hence, the binomial part of the model. With a pricing model,
the two outcomes are a move up, or a move down. The major advantage of a
binomial option pricing model is that they’re mathematically simple.Yet these
models can become complex in a multi-period model.

The binomial option pricing model uses an iterative procedure, allowing for the
specification of nodes, or points in time, during the time span between the
valuation date and the option's expiration date.
 BINOMIAL OPTION PRICING MODEL

• In the single period binomial model, there is only

one period being considered
• At the end of the period, the stock price can only
take one of two values
 BINOMIAL OPTION PRICING MODEL

Example:

Western Cellular, a cell phone manufacturer have call options

that permit the holder to buy 1 share of the company at an
exercise price of $35. These options will expire after 6
months. Western’s current stock price is at $40 per share.
Western’s stock will either go up by a factor of 1.25 or go
down by a factor of 0.80.
 BINOMIAL OPTION PRICING MODEL

Strike price (X) = $35

current stock price (P) = $40
up factor of the stock (u) = 1.25
down factor of the stock (d) = 0.80
expiration date (t) 6 months or 0.5 years
 BINOMIAL OPTION PRICING MODEL

Ending up Stock Price P(u) Ending up option payoff (Cu)

= $40 x 1.25 = $50 = MAX[P(u) – X,0]
= MAX [($50 - $35),0]
Current Stock Price(P1) =$15
$ 40 Current Option Price(Vc)
Ending down Stock Price ?
Ending down option payoff (Cd)
P(d)
= MAX[P(d) – X,0]
=$40 x 0.80 = $32 = MAX [($32 - $35),0]
=$0
BINOMIAL OPTION PRICING MODEL
FORMULA
 BINOMIAL PRICING MODEL EXAMPLE

Let’s go back to our example earlier and calculate the Value of the option (V c)
using the binomial pricing model:

Western Cellular, a cell phone manufacturer have call options that permit the
holder to buy 1 share of the company at an exercise price of $35. These options
will expire after 6 months. Western’s current stock price is at $40 per share.
Western’s stock will either go up by a factor of 1.25 or go down by a factor of
0.80. Let us assume that the risk-free rate is at 8%.
 BINOMIAL PRICING MODEL EXAMPLE

•
 BINOMIAL PRICING MODEL EXAMPLE

•
 BINOMIAL PRICING MODEL EXAMPLE

•
 BLACK-SCHOLES OPTION PRICING MODEL

In deriving their option pricing model, Fischer Black and Myron Scholes made the following assumptions.
• The stock underlying the call option provides no dividends or other distributions during the life of the
option.
• There are no transaction costs for buying or selling either the stock or the option.
• The short-term, risk-free interest rate is known and is constant during the life of the option.
• Any purchaser of a security may borrow any fraction of the purchase price at the short-term, risk-free
interest rate.
• Short selling is permitted, and the short seller will receive immediately the full cash proceeds of today’s
price for a security sold short.
• The call option can be exercised only on its expiration date.
• Trading in all securities takes place continuously, and the stock price moves randomly.
BLACK-SCHOLES PRICING MODEL
THE BLACK-SCHOLES OPTION PRICING
MODEL
 THE BLACK-SCHOLES OPTION PRICING
MODEL

As per the BSM Model, the value of the option is a function of five variables:

(1) P, the stock’s price;

(2) t, the option’s time to expiration;
(3) X, the strike price;
(4) σ, the standard deviation of the underlying stock; and
(5) the risk-free rate or rRF
FIVE FACTORS THAT AFFECT OPTION PRICING

P, the stock’s price

• The option price increases as stock price increases. Because the strike price is fixed,
an increase in the stock increases the probability that the option will be in the money
at the time of expiration
t, the option’s time to expiration
• The longer the option has until its expiration, the greater its value. This is because the
stocks move up or down on average. The longer time the option has, it has greater
chances to be in the money at the time of the expiration.
FIVE FACTORS THAT AFFECT OPTION PRICING

X, the strike price

• The strike price determines if the option has intrinsic value
σ, sigma, the standard deviation of the underlying stock
• the riskier the underlying security, the more valuable the option
the risk-free rate or rRF
• As the risk-free rate increases, the value of the option increases. The principal effect of
an increase in rRF is to reduce the present value of the exercise price, which increases
the current value of the option.
 VALUATION OF PUT OPTIONS

A put option gives its owner the right to sell a share of stock at a fixed strike
price.
put-call parity relationship: If the two portfolios have identical payoffs, then
they must have identical values.
Put option + stock = call option + PV of the exercise price

If Vc is the Black-Scholes value of the call option, then the value of a put is:
PUT-CALL PARITY RELATIONSHIPS
 PUT-CALL PARITY RELATIONSHIPS: A SECOND
EXAMPLE

• Mark purchases a European call option for a stock that trades at $30. The strike price is $25, the
maturity is in 6 months, and Mark pays $5 to acquire the call option. If at maturity the stock trades at
$40, Mark will exercise his call option and realize a profit of $40 – $30 = $10- $5 = $5.
• Mark writes also a European put option for the same stock, with a strike price of $25, maturity in 6
months, and a cost of $5 to sell the put. If at maturity the stock trades at $20, the option holder will
sell Mark the stock at $30, and Mark will get $30 – $25 = $5. So, he will break-even.
 PUT-CALL PARITY RELATIONSHIPS

Another way to frame the put-call parity formula is:

• C + PV(x) = P + S
where:
• C = price of the European call option
• PV(x) = the present value of the strike price (x), discounted from the value on the expiration date at the risk-free rate
• P = price of the European put
• S = spot price or the current market value of the underlying asset

To understand further put-call parity relationships, click the link below:

https://www.investopedia.com/terms/p/putcallparity.asp
https://www.myaccountingcourse.com/accounting-dictionary/put-call-parity