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CHAPTER 18

Derivatives and Risk
Management

Derivatives: Forward, futures,
options
Put call parity, Black Scholes
Formula
Other derivatives: swaps, rights,
warrants
Hedging with derivatives

18-1

What is a derivative?

A derivative is a financial
contract between two parties to
transact an asset at a fixed price
at a future date.
It derives value from other assets
or events.

18-2

Definitions


Buyer: one who buys the derivative.
Writer: one who sells the derivative.
Long position: the position of the
buyer.
Short position: the position of the
writer.
Expiry date: the date when cash
flows would be exchanged.
18-3

Strike price (or exercise price): the transaction price of the underlying asset at the expiry date.Definitions    Underlying asset: the asset to be transacted. Counter parties: the opposite party in the derivative contract 18-4 .

The Forward Contract    A financial contract which allows the buyer to buy a specific asset at a specific price on a specific future date. The seller has to sell to the buyer that asset at that price and at that future date. Delivery date: expiry date. 18-5 .

18-6 .The Forward Contract Payof  Payof: the profit brought about by the contrac t.

18-7 .The Forward Contract Payof  Payof: the profit brought about by the contrac t.

commodity. expiry date. equity. FX etc. contract size.g.The Futures Contract     Similar to forward contracts Specifications standardized: underlying asset. Traded in exchanges Many types: e. 18-8 . interest rates.

18-9 .Features of Futures Contract  Margin account:     Initial margin Maintenance margin Margin call Mark to market:   Delivery price is updated at the end of every trading day Gains and losses are updated into margin account.

but not the obligation. to buy (or sell) an asset at some predetermined price within a specified period of time. .What is an option?   A contract that gives its holder the right. It merely gives the owner the right to 18-10 buy or sell an asset. It’s important to remember:   It does not obligate its owner to take action.

Exercise (or strike) price – the price stated in the option contract at which the security can be bought or sold. 18-11 .Option terminology     Call option – an option to buy a specified number of shares of a security within some future period. Option price – option contract’s market price. Put option – an option to sell a specified number of shares of a security within some future period.

In-the-money call – a call option whose exercise price is less than the current price of the underlying stock.   18-12 .  Exercise value – the value of an option if it were exercised today (Current stock price Strike price). Out-of-the-money call – a call option whose exercise price exceeds the current stock price.Option terminology (con’t)  Expiration date – the date the option matures.

The Call Option Payof (long position) 18-13 .

The Call Option Payof (short position) 18-14 .

00 30.50 18-15 .00 10.00 20.00 1.00 3.50 45.00 3.00 25.Determining option exercise value and option premium Stock Strike Exercis Option Option price price e value price premiu m $25.00 25.00 25.00 50.00 25.00 15.50 35.50 2.00 25.50 1.00 2.00 25.00 16.00 12.00 40.00 7.50 0.00 5.00 $0.00 25.00 21.00 $25.

Call Option Intrinsic Value and Time Value   Intrinsic Value: the value of the call option if exercised now Time value (or premium): the diference between the value of the call option and the intrinsic value 18-16 .

Call Option Intrinsic Value and Time Value 18-17 .

Relationship of Call Value with other Factors Factor Change: An increase in… Call Value Change Relationship spot price of the underlying asset Increase Positive time to expiry date Increase Positive strike price Decrease Negative risk-free interest rate Increase Positive the return volatility of the underlying asset Increase Positive 18-18 .

The Put Option Payof (long position) 18-19 .

The Put Option Payof (short position) 18-20 .

Relationship of Put Value with other Factors Factor Change: An increase in… Call Value Change Relationship spot price of the underlying asset Decrease Negative time to expiry date Increase Positive strike price Increase Positive risk-free interest rate Decrease Negative the return volatility of the underlying asset Increase Positive 18-21 .

Put Call Parity    Relates the call price and the put price with the strike price and the spot price P = K exp(-rT ) .S + C Arbitrage opportunities exist if put and call prices violate the relationship 18-22 .

S[N(-d1 )] 18-23 .σ T C  S[N(d1 )] .The Black-Scholes option pricing model   2    T  ln(S/K)   rRF    2    d1  σ T d 2  d1 .Ke P  Ke .rRF T [N(d 2 )] [N(-d 2 )] .rRF T .

5736 d2  0.5736) 0.3391 From AppendixC in the textbook N(d1 )  N(0.(0.5) 0.6327 18-24 .06 0.7071)  0.3391) 0.5 years. 2 d1  (0. and σ2 = ln($27/$25 )  [(0.3317)(0 .2168 0.Use the B-S OPM to find the option value of a call option with S = $27. rRF = 6%.1327 0.5000 0.5736.3317)(0 .11. K = $25.11 )] (0. T = 0.7071) 0.7168 N(d2 )  N(0.5000 0.

Ke -rRF T [N(d 2 )] C  $27[0.06)(0.0036 -(0.6327] 18-25 .7168] .Solving for option value C  S[N(d1 )] .5) [0.$25e C  $4.

Swaps   The exchange of cash payment obligations between two parties. 18-26 . usually because each party prefers the terms of the other’s debt contract. and the seller of the contract pays a floating rate interest based on the same notional amount periodically to the buyer. whereby the buyer of the contract pays a fixed interest based on the notional amount periodically to the seller. An interest rate swap is a financial contract based on a notional amount.

18-27 .Other Types of Derivatives   Rights and Warrants: like call options allowing the holder to buy stocks at a strike price. hence it is like a call option. The Shares as a Call Option: shares have a limited liability.

 Better comparative advantage in hedging.  18-28 .The Need to Hedge Better debt capacity and cost.  Smoother budget funding.  Reduced cases of extreme financially-poor performance.  Beneficial tax efects.

Compute the satisfactory quantity of hedging instrument to purchase. Find a hedging instrument that rewards when the loss-making situations occur—quantify the rewards. 18-29 . Purchase the satisfactory quantity of the hedging instrument. Monitor the cash flows necessary to maintain the hedge.An Approach to Risk Management      Identify the situations when the firm would make a loss—quantify the loss.

Good hedging instrument: built in leverage allows little overhead cost to get into hedge position. 18-30 .Why Derivatives are Good Hedging and Speculating Instruments   Good speculating instrument: built in leverage magnifies investment risk and return.