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Chapter 18
Derivatives and Risk

Management
 Motives for Risk Management

 Derivative Securities
 Using Derivatives
 Fundamentals of Risk Management
Introduction
 In investment, as well, as in
business, portfolio
protection is just as
important as portfolio
appreciation.
Risk management
Risk Management
 Risk management, in
business, involves
identifying events that could
have adverse financial
consequences, and
taking actions to prevent or
minimize the damage caused
by those events.
Risk Management
 How do corporate risk

managers do their job?
Risk Management
 Years ago risk managers dealt

only with insurance.
 They made sure the firm is
adequately insured against
theft, fire and other casualties
and that it had adequate
liability coverage.
Risk Management
 The scope of risk

management has broadened
to include
Controlling the cost of key
inputs.
Protecting against changes in
interest rates or exchange
rates.
Risk Management
 And the most important role

of risk managers is to ensure
that actions taken to hedge
against risk are not actually
increasing risk.
Risk Management
 For most CEOs, risk is the

possibility that future earnings
and free cash flows will be
significantly lower than
expected.
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.
Reasons That Corporations Engage in
Risk Management
 Reduced volatility of cash flows

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.
Risk Management
 Reduced volatility helps avoid

financial distress costs.
 Reduced volatility reduces the
costs of borrowing.
 Managers have a comparative
advantage in hedging
certain types of risk.
Risk Management
 Reduced volatility reduces the

higher taxes that result from
fluctuating earnings.
 Certain compensation
schemes reward managers for
achieving stable earnings.
Hedging
 Hedging is a practice every

investor should know about.
 The best way to understand
hedging is to think of it as
insurance. When people
decide to hedge, they are
insuring themselves against a
negative event.
Hedging
 Insurance doesn't prevent a

negative event from
happening, but if it does
happen and you're properly
hedged, the impact of the
event is reduced.
Hedging
 Hedging occurs almost

everywhere, and we see it
everyday.
 If you buy house insurance,
you are hedging yourself
against fires, break-ins or
other unforeseen disasters.
Hedging
 Portfolio managers, individual

investors and corporations
use hedging techniques to
reduce their exposure to
various risks.
Hedging
 In financial markets, however,

hedging becomes more
complicated than simply
paying an insurance company
a fee every year.
Hedging
 Hedging against investment

risk means strategically using
instruments in the market to
offset the risk of any adverse
price movements.
 Investors hedge one
investment by making another.
Hedging
 Technically, to hedge you

would invest in two securities
with negative correlations.
 But nothing in this world is
free, so you still have to pay
for this type of insurance in
one form or another.
Hedging
 Hedging, for the most part, is

a technique not by which you
will make money but by which
you can reduce potential loss.
Hedging
 Hedging has grown to

encompass all areas of finance
and business.
 A corporation may choose to
build a factory in another
country that it exports its
product to in order to hedge
against currency risk.
Derivatives
 The most important aspect of

risk management involves
derivative securities.
 Hedging techniques generally
involve the use of complicated
financial instruments known
as derivatives.
Derivatives
 A derivative is a security that

is neither debt nor equity but
derives its value from an
underlying asset that is often
another security.
Derivatives
 Derivative securities are not

used by corporations to raise
funds.
 Rather, they serve as a useful
tool for managing certain
aspects of firm risk.
Derivatives
 The two most common types

of derivatives are options
and futures.
Options
 An option is a contract that

gives the buyer the right, but
not the obligation, to buy or
sell an underlying asset at a
specific price on or before a
certain date.
Options
 An option, just like a stock or

bond, is a security.
 It is also a binding contract
with strictly defined terms and
properties
Options
 It’s important to remember:

Options do not obligate its
owner to take action.
It merely gives the owner
the right to buy or sell an
asset.
Options
 An everyday situation to
illustrate an option is when
you discover a house that
you'd love to purchase.
 Unfortunately, you won't have
the 1 million cash to buy it for
another three months.
Options
 You talk to the owner and

negotiate a deal that gives
you an option to buy the
house in three months for a
price.
 The owner agrees, but for this
option, you pay 150,000.
Options
 Now, consider two theoretical

situations that might arise:
 It's discovered that the house
is actually the true birthplace
of Jose Rizal!
 As a result, the market value
of the house is 5 million.
Options
 Because the owner sold you

the option, he is obligated to
sell you the house for
1,000,000.
 In the end, you stand to make
a profit of 3,850,000 (5 million
– 1 million - 150,000).
Options
 On the other hand, while

touring the house, you
discover not only that the
walls are full of termites, but
also ghosts haunt the master
bedroom and a family of
super-intelligent rats are in
the basement.
Options
 Though you originally thought

you had found the house of
your dreams, you now
consider it worthless.
Options
 On the upside, because you

bought an option, you are
under no obligation to go
through with the sale.
 Of course, you still lose the
150,000 price of the option.
Options
 This example demonstrates

two very important points.
 First, when you buy an option,
you have a right but not an
obligation to do something.
Options
 You can always let the

expiration date go by, at
which point the option
becomes worthless. If this
happens, you lose 100% of
your investment, which is the
money you used to pay for
the option.
Options
 Second, an option is merely a

contract that deals with an
underlying asset.
Options
 For this reason, options are

called derivatives, which
means an option derives its
value from something else.
 In our example, the house is
the underlying asset.
Options
 To purchase an option, a
fee must be paid.
Options
 The two types of options are:

Calls – an option to buy a
specified number of shares
of a security within some
future period
Options
 The two types of options are:

Puts – an option to sell a
specified number of shares
of a security within some
future period
Option Terminology
 Exercise (or strike) price:

the price stated in the option
contract at which the security
can be bought or sold.
The strike price is usually set
near the prevailing market
price of the stock at the time it
is issued.
Option Terminology
 Option price: option

contract’s market price.
Option Terminology
 Writer: the seller of an

option
 Expiration date: the date
the option matures.
 Exercise value: the value of
call option if it were exercised
today (Current stock price –
Strike price).
Option Terminology
 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.
Option Terminology
 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.
Option Terminology
 A call option is most valuable

when its strike price is well
below the market price of the
underlying stock.
 Hence, the option gives the
holder the right to buy the
stock at a bargain price.
Option Terminology
 Long-term Equity
AnticiPation Securities
(LEAPS): similar to normal
options, but they are longer-
term options with maturities
of up to 3 years.
Options
 There are two main reasons

why an investor would use
options:
to speculate and
to hedge.
Options Markets
 One way of making an options

transaction is through call and
put options dealers with the
help of a stockbroker.
 A more popular method of
investing is through the
organized options exchanges.
Options Markets
 One option is typically for 100

shares of stock.
 Traded in the spot market
with prices set by the forces
of supply and demand.
Options Trading
 Call options are typically

purchased with the
expectation that the market
price of the underlying stock
will rise by more than enough
to cover its cost resulting in a
profit.
Call Options Example
 Cindy pays $250 for a 3-month

call option on Wing Co. with a
striking price of $50. This
means that by paying $250,
she can purchase 100 shares
of Wing at $50 per share at
any time during the next 3
months.
 What must be the price of the

stock to cover the cost of the
option ignoring brokerage fees
and dividends?
 The stock must climb $2.50
per share ($250 ÷ 100 shares)
to $52.50.
 If the stock price were to rise

to $60 per share, what would
Cindy’s net profit be?
 Cindy’s net profit would be
$750 [(100 shares x
$60/share) - (100 shares x
$50/share) - $250].
Options Trading
 Put options are typically

purchased with the
expectation that the market
price of the underlying stock
will fall by more than enough
to cover its cost resulting in a
profit.
Put Options Example
 Don pays $325 for a 6-month

put option on United at a
striking price of $40. He
purchased the put option in
expectation that the price of
the stock would drop because
of a new product line of
competitor.
Put Options Example
 What must be the price of the

stock to cover the cost of the
option ignoring brokerage fees
and dividends?
 The stock must drop by $3.25
per share ($325 / 100 shares)
to $36.75 per share.
Put Options Example
 If the stock price were to drop

to $30 per share, what would
Don’s profit be?
 Don’s net profit would be $675
[(100 shares x $40/share) -
(100 shares x $30/share) -
$325].
Call Option Quotations
Stock’s Strike Calls – Last Quote

Last Price (July)
Price Sept Oct Jan
128.77 120.00 10.80 12.30 14.60

128.77 125.00 6.60 8.10 11.80
128.77 130.00 3.58 5.20 8.20
Factors Affecting Value of Call Option
 The higher the stock’s market

price in relation to the strike
price, the higher the call
option price.
 The higher the strike price,
the lower the call option price.
 The longer the option period,

the higher the call option
price.
 The more volatile a stock, the
higher the value of its call
option.
 The price of a call option

always increases as the risk-
free rate increases.
Put Option Quotations
Stock’s Strike Puts – Last Quote (July)

Last Price Sept Oct Jan
Price
128.77 120.00 1.79 2.80 5.90

128.77 125.00 2.99 4.30 6.90
128.77 130.00 5.00 6.40 9.10
128.77 135.00 8.00 9.30 11.20
Factors Affecting Value of Put Option
 The higher the stock’s market

price in relation to the strike
price, the lower the put option
price.
 The higher the strike price,
the higher the put option
price.
Factors Affecting Value of Put Option
 The longer the option period,

the higher the put option
price.
 The more volatile a stock, the
higher the value of its put
option.
Options 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
Determining Option Exercise Value and
Option Premium
Stock Strike Exercise Option Option

Price Price Value Price Premium
$25.00 $25.00 $0.00 3.00 3.00
30.00 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 1.00
50.00 25.00 25.00 25.50 0.50
Call Premium Diagram
Option
Value
30
25
20
15 Market price
10
5 Exercise value
Stock
5 10 15 20 25 30 35 40 45 Price
50
18-70
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.
How does the option premium change
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.
Factors Affecting Value of Option
 The stock price.

 The strike price.
 The option’s term to maturity.
 The variability of the stock
price.
 The risk free rate.
Factors Affecting Value of Call
Option
Increase in Option Value
Variable Change
Stock volatility Increase
Time to expiration Increase
Interest rate Increase
Exercise price Decrease
Current stock price Increase
Reducing Risk with Options
 Many people mistakenly

believe that options are always
riskier investments than
stocks.
 The concept of leverage

wherein you maintain the
same sized position, but
spending less money doing so
reduces risk.
Example
 If you were going to invest

$10,000 in a $50 stock, you
would receive 200 shares.
 Instead of purchasing the 200
shares, you could also buy two
call option contracts.
 With options, you spend less

money but still control the
same number of shares.
 The number of options is
determined by the number of
shares that could have been
bought with your investment
capital.
Example
 Suppose you decide to buy

1,000 shares of XYZ at $41.75
per share for a cost of
$41,750.
Example
 But, you could also buy 10 call

option contracts whose strike
price is $30 (in-the-money) for
$1,630 per contract.
 The option purchase will
provide a total capital outlay
of $16,300 for the 10 calls.
Example
 This represents a total savings
of $25,450, or about a 60% of
what you could have invested
in XYZ stock.
 This savings can be used to
take advantage of other
opportunities, providing you
with greater diversification.
Option Pricing Models
 Nearly all option pricing

models are based on the
concept of riskless hedge.
 Riskless hedge is a hedge in
which an investor buys a stock
and simultaneously sells a call
option.
Create a Riskless Hedge to Determine
Value of a Call Option
Data: P = $15; X = $15;

t = 0.5; rRF = 6%;
PossibleEnding Strike Call Option

Stock Price Price Value
$10 $15 $0
$20 $15 $5
Range $10 $5
Step 1: Equalize the range of payoffs

for the stock and option.
Ending Ending Ending
Stock Stock Option
Price  0.5 Value Value
$10  0.5 $5 $0
$20  0.5 $10 $5
Range $10 $5 $5
Step 2: Create a riskless hedged

investment. Calculate the value
of the portfolio at the end of 6
months. (If the option is in-the-
money, it will be sold.)
Ending Ending Ending Value
Stock Stock Option of
Price  0.5 Value + Value = Portfolio
$10  0.5 $5 + $0 = $5
$20  0.5 $10 + -$5 = $5
Step 3: Calculate the PV of the riskless

portfolio today.
Future portfolio value
PV 
(1  rRF ) t
$5
PV 
1.0296
PV  $4.86
Step 4: Calculate the cost of the stock

in the portfolio.
Cost of stock in portfolio
 % of stock in portfolio  Stock price
 0.5  $15
 $7.50
Step 5: Calculate the market value of

the option.
Price of option
 Cost of stock  PV of portfolio
 $7.50  $4.86
 $2.64
Black-Scholes Option Pricing Model
 Black-Scholes Option
Pricing Model was derived
from the concept of a riskless
hedge.
 The Black-Scholes Option

Pricing Model calculates the
value of an option as the
difference between the
expected PV of the terminal
stock price and the PV of the
exercise price.
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.
 The short-term, risk-free rate

(rRF) is known and constant
during the life of the option.
 Unlimited borrowing and
lending at the short-term, risk-
free rate (rRF).
 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.
 The Black-Scholes 5 variables

Current stock price ( P )
Time to expiration ( t )
Exercise price ( X )
Short-term interest rate ( r )
RF
Standard deviation of the

stock price
Using the Black-Scholes Option
Pricing Model
-r t
V  P[N(d1 )]  Xe RF
[N(d 2 )]
   2 
ln(P/X)  rRF    (t )

  2 
d1 
σ t
d 2  d1  σ t
Use the B-S OPM to Find the Option
P= $27, X = $25, rRF = 6%, t = 0.5 years,

and σ2 = 0.11
  0.11 
ln($27/$25)  0.06   (0.5)
  2 
d1   0.5736
(0.3317)(0.7071)
d2  0.5736  (0.3317)(0.7071)  0.3391
From Appendix C in the textbook

N(d1 )  N(0.5736)  0.5000  0.2168  0.7168
N(d2 )  N(0.3391)  0.5000  0.1327  0.6327
Solving for Option Value
-rRF t
V  P[N(d1 )]  Xe [N(d2 )]
V  $27[0.7168]  $25e - (0.06)(0.5 )
[0.6327]
V  $4.0036
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 Increases
Risk-free rate Increases
Stock return Increases
volatility
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 Increases
Risk-free rate Decreases
Stock return Increases
volatility
Valuation of Put Options
 If the stock pays no dividends

and the option can be
exercised only upon its
expiration date, what is the
put option value?
 Put-call parity is the

relationship that must exist
between the prices of
European put and call options
that both have the same
underlier, strike price and
expiration date.
 Put option + Stock = Call

option + PV of exercise price
 Put option = V – P + Xe
-rt
Current stock price ( P )

Time to expiration ( t )
Exercise price ( X )
Short-term interest rate ( r RF )
Forward Contracts
 A forward contract is an
agreement between two
counterparties - a buyer and
seller.
 The buyer agrees to buy an
underlying asset from the
other party (the seller).
Forward Contracts
 The delivery of the asset

occurs at a later time, but the
price is determined at the
time of purchase.
Forward 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.
Forward Contracts
 Because forward contracts are

private agreements, there is
always a chance that a party
may default on its side of the
agreement.
Forward Contracts
 A forward contract can be

used for hedging or
speculation, although its non-
standardized nature makes it
particularly apt for hedging.
Forward Contracts: Key Features
 Highly customized - parties

can determine and define the
terms and features to fit their
specific needs, including when
delivery will take place and
the exact identity of the
underlying asset.
 All parties are exposed to

counterparty default risk.
 This is the risk that the other
party may not make the
required delivery or payment.
 Transactions take place in

large, private and largely
unregulated markets
consisting of banks,
investment banks,
government and corporations.
 Underlying assets can be

stocks, bonds, foreign
currencies, commodities or
some combination thereof.
 The underlying asset could
even be interest rates.
 They tend to be held to

maturity and have little or no
market liquidity.
 Any commitment between
two parties to trade an asset
in the future is a forward
contract.
Forward Contracts: Example
 Assume that you have taken

up sailing and like it so well
that you expect to buy your
own sailboat in 12 months.
 Your sailing buddy expects to
upgrade to a newer, larger
sailboat model in 12 months.
 You and your buddy could

enter into a forward contract
in which you agree to buy
John's boat for $150,000 and
he agrees to sell it to you in
12 months for that price.
 In this scenario, as the

buyer, you have entered a
long forward contract.
 Conversely, the seller will
have the short forward
contract.
 At the end of one year, you

find that the current market
valuation of the sailboat is
$165,000.
 Because seller is obliged to

sell his boat to you for only
$150,000, you will have
effectively made a profit of
$15,000.
 The seller has lost $15,000 in
potential proceeds from the
transaction.
 Like all forward contracts, no

money exchanged hands
when the contract was
negotiated and the initial
value of the contract was
zero.
Futures Contracts
 Futures contract are also

agreements between two
parties in which the buyer
agrees to buy an underlying
asset from the other party
(the seller).
Futures Contracts
 Parties in a futures contract:

a short position - the party
who agrees to deliver a
commodity - and
a long position - the party who
agrees to receive a
commodity.
Futures Contracts
 A speculator will benefit when

she is long (buyer) if the
prices rise, short (seller) if
the price falls.
Futures Contracts
 Futures contract:
standardized, exchange-
traded contracts in which
physical delivery of the
underlying asset does not
actually occur.
Commodity futures
Financial futures
Forward vs Futures Contracts
 Futures contracts are

marked to market on a
daily basis.
Gains and losses are noted
and money must be put to
cover losses, reducing the
risk of default in forwards.
 With futures, physical delivery

of the underlying asset is
never taken.
The parties simply settle
with cash the difference
between the contracted
price and the actual price on
the expiration date.
 Futures contracts are

generally standardized,
exchange-traded contracts,
whereas forwards are
negotiated between the
parties and not traded.
Futures Contracts
 Commodity futures: a
contract that is used to hedge
against price changes for
input materials.
Futures Contracts
 Financial futures: a
contract that is used to hedge
against fluctuating interest
rates, stock prices, and
exchange rates.
Use T-bills, notes, bonds and
currencies
Futures Contracts Example
 CONTRACT 1: Agree to sell

$100 in face value of long-
term treasuries for a price of
$110 in a year
 Why would you make this
kind of contract?
 You’re betting on the fact

that in a year, the price of
the treasuries you’re looking
to sell is going to be lower
than $110.
 If that’s true, you can buy

the treasuries for the market
price and then turn right
around and sell for the
agreed price of $110,
making a nice little profit.
 On the other hand, if the

price ends up being more
than $110, you’ve locked
yourself in for a loss.
 Buying the future is a form

of speculation, and it allows
people to do large-scale
speculation at a lower cost.
 CONTRACT 2: Agree to buy

$100 in face value of long-
term treasuries for a price of
$110 in a year
 Now we’re on the other side

of the contract. We’re
betting that the price of the
investment will be higher
than $110 in a year.
 If that’s true, we buy at our

locked in price of $110, turn
around and sell, and make a
profit.
 Then again, if the price is
below $110, we lose
(speculation).
Futures Contracts
 Illustration of futures
contract on page 622 Table
18-3
Futures Contracts
 A margin in the futures

market is the amount of
cash an investor must put
up to open an account to
start trading.
Futures Contracts
 The initial margin is the

initial amount of cash that
must be deposited in the
account to start trading
contracts.
Futures Contracts
 The initial margin acts as

a down payment on the
underlying asset and helps
ensure that both parties
fulfill their obligations.
 Both buyers and sellers must
put up payments.
Futures Contracts
 The maintenance margin

is the balance a trader must
maintain in his account as
the balance changes due to
price fluctuations.
Futures Contracts
 If the balance in the trader's

account drops below this
maintenance margin, the
trader is required to deposit
enough funds to bring the
account back up to the initial
margin requirement.
Futures Contracts vs Options
 A futures contracts is a
definite agreement on the
part of one party to buy
something on a specific date
at a specific price, and the
other party agrees to sell on
the same terms.
 An option, on the other

hand, gives someone the
right to buy or sell an asset,
but the holder of the option
does not have to complete
the transaction.
 Options exist for stocks but

not for commodities.
 Futures, on the other hand,
are used for commodities ,
debt securities and stock
indexes.
Swaps
 A swap is a cash-settled
contract between two parties
to exchange (or "swap") cash
flow streams.
 As long as the present value
of the streams is equal, swaps
can entail almost any type of
future cash flow.
Swaps
 A swap is often used to

change the character of an
asset or liability without
actually having to liquidate
that asset or liability.
Swaps
 Example: An investor holding

common stock can exchange
the returns from that
investment for lower risk fixed
income cash flows - without
having to liquidate his equity
position.
Swaps
 Two of the most basic swaps

are:
Interest Rate Swap
Currency Swap
Swaps
 Interest Rate Swap - 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
 Currency Swap - This is

similar to an interest rate
swap except that the cash
flows are in different
currencies.
 Currency swaps can be used
to exploit inefficiencies in
international debt markets.
Currency Swaps Example
 Assume that a corporation

needs to borrow $10 million
euros and the best rate it can
negotiate is a fixed 6.7%.
 In the U.S., lenders are
offering 6.45% on a
comparable loan.
Currency Swaps Example
 The corporation could take

the U.S. loan and then find a
third party willing to swap it
into an equivalent euro loan.
 By doing so, the firm would
obtain its euros at more
favorable terms.
Swaps
 Swaps can reduce each

party’s financial risk.
Structured Notes
 Structured notes are debt

obligations derived from
another debt obligation.
Structured Notes
 Structured notes have a fixed

maturity and include two
components – a bond
component and an embedded
derivative.
Structured Notes
 Structured notes are

securities issued by financial
institutions whose returns are
based on equity indexes, a
single or basket of equity
securities, interest rates,
commodities, and/or foreign
currencies.
Structured Notes
 Structured notes’ return is

“linked” to the performance of
a reference asset or index.
 Financial institutions typically
design and issue structured
notes, and broker-dealers sell
them to individual investors.
Inverse Floater
 Inverse floater is a note in

which the interest rate paid
moves counter to market
rates.
Inverse Floater
 When the interest rate goes

up the coupon payment rate
will go down because the
interest rate is deducted from
the coupon payment.
 A higher interest rate means
more is deducted, thus less is
paid to the holder.
Inverse Floater
 You would want to invest in

an inverse floater if the
benchmark rate is high and
you think the rate will
decrease in the future at a
faster rate than the forwards
show.
Inverse Floater
 With an inverse floater, as

interest rates fall, the coupon
rate rises because less is
taken off.
Economic Importance of the
Futures Market
 Price Discovery - Due to its

highly competitive nature, the
futures market has become
an important economic tool to
determine prices based on
today's and tomorrow's
estimated amount of supply
and demand.
Futures Market
 Price Discovery - Factors

such as weather, war, debt
default and deforestation can
all have a major effect on
supply and demand and, as a
result, the present and future
price of a commodity.
Futures Market
 Risk Reduction - Futures

markets are also a place for
people to reduce risk when
making purchases.
Futures Market
 Risk Reduction - The price

is pre-set, there is less of a
chance that manufacturers
will jack up prices to make up
for profit losses in the cash
market.
Futures Market
 The players in the futures

market fall into two
categories: hedgers and
speculators.
Speculation
 Speculation involves betting

on future price movements.
Hedging Risks
 Hedging is usually used when

a price change could
negatively affect a firm’s
profits.
 Hedging uses transactions to
reduce risk.
Hedging Risks
 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.
Futures Market
Trader Short Long

Secure a price Secure a price
The now to protect now to protect
Hedger against future against future
declining prices rising prices
Secure a price Secure a price
The now in now in
Speculator anticipation of anticipation of
declining prices rising prices
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.
What is corporate risk management,
and why is it important to all firms?
 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.
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.
Definitions of Different Types of Risk
 Speculative risks: offer the

chance of a gain as well as a
loss. (new projects,
marketable securities)
 Pure risks: offer only the
prospect of a loss. (fire,
product liability)
Definitions of Different Types of
Risk
 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.
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.
Risk
 Liability risks:connected with

product, service, or employee
liability.
 Insurable risks: risks that
typically can be covered by
insurance.
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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Chapter 18

Derivatives and Risk

 Motives for Risk Management

 How do corporate risk

 Years ago risk managers dealt

 The scope of risk

 And the most important role

 For most CEOs, risk is the

 Diversified shareholders may

 Reduced volatility of cash flows

 Reduced volatility helps avoid

 Reduced volatility reduces the

 Hedging is a practice every

 Insurance doesn't prevent a

 Hedging occurs almost

 Portfolio managers, individual

 In financial markets, however,

 Hedging against investment

 Technically, to hedge you

 Hedging, for the most part, is

 Hedging has grown to

 The most important aspect of

 A derivative is a security that

 Derivative securities are not

 The two most common types

 An option is a contract that

 An option, just like a stock or

 It’s important to remember:

 You talk to the owner and

 Now, consider two theoretical

 Because the owner sold you

 On the other hand, while

 Though you originally thought

 On the upside, because you

 This example demonstrates

 You can always let the

 Second, an option is merely a

 For this reason, options are

 The two types of options are:

 The two types of options are:

 Exercise (or strike) price:

 Option price: option

 Writer: the seller of an

 Covered option: an option

 In-the-money call: a call

 A call option is most valuable

 There are two main reasons

 One way of making an options

 One option is typically for 100

 Call options are typically

 Cindy pays $250 for a 3-month

 What must be the price of the

 If the stock price were to rise

 Put options are typically

 Don pays $325 for a 6-month

 What must be the price of the

 If the stock price were to drop

Stock’s Strike Calls – Last Quote