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Chapter 18

DERIVATIVES AND RISK MANAGEMENT

Learning Objectives

After reading this chapter, students should be able to:


1. Identify the circumstances in which it makes sense for companies to
manage risk.
2. Describe the various types of derivatives and explain how they can be
used to manage risk.
3. Value options using the Binomial and Black-Scholes Option Pricing
Models.
4. Discuss the various elements of risk management and the different
processes that firms use to manage risks.

Overview
Risk management can mean many things, but in business it involves
identifying events that could have adverse financial consequences for the
firm and then undertaking actions to prevent and/or minimize the damage
caused by these events. Years ago, corporate risk managers dealt primarily
with insurancethey made sure the firm was adequately insured against
fire, theft, and other casualties and that it had adequate liability coverage.
More recently, however, the scope of risk management has been broadened
to include such things as controlling the costs of key inputs or protecting
against changes in interest rates or exchange rates. In addition, risk
managers try to ensure that actions designed to hedge against risks are not
actually increasing risks.

Outline

I. Although there is no proof that risk management adds value,


there are several good reasons for companies to manage risk.
Corporate managers frequently hedge risk even though it does
little to increase corporate value. Perhaps a more likely
explanation is that hedging creates other benefits that
ultimately lead to either higher cash flows and/or a lower
WACC.
A. Debt capacity. Risk management can reduce the volatility of cash
flows, and this decreases the probability of bankruptcy. Firms with
lower operating risks can use more debt, and this can lead to higher
stock prices due to the interest tax savings.
B. Maintaining the optimal capital budget over time. By smoothing out
the cash flows, risk management can alleviate the possibility that
internal cash flows will be too low to support the optimal capital
budget.
C. Financial distress. Financial distress is associated with having cash
flows fall below expected levels. Risk management can reduce the
likelihood of low cash flows, hence of financial distress.
D. Comparative advantages in hedging. Many investors cannot
implement a homemade hedging program as efficiently as a firm
can.
1. Firms have lower transactions costs due to a larger volume of
hedging activities.
2. Managers know more about the firms risk exposure than outside
investors, hence managers can create more effective hedges.
3. Effective risk management requires specialized skills and
knowledge that firms are more likely to have than individual
investors.
E. Borrowing costs. Firms can sometimes reduce input costs,
especially the interest rate on debt, through the use of swaps. Any
such cost reduction adds value to the firm.
F. Tax effects. Companies with volatile earnings pay more taxes than
more stable companies due to the treatment of tax credits and the
rules governing corporate loss carry-forwards and carry-backs.
Therefore, our tax system encourages risk management to stabilize
earnings.
G. Compensation systems. Many compensation systems establish
floors and ceilings on bonuses or else reward managers for
meeting targets. Typically, a managers bonus is higher if earnings
are stable. So, even if hedging does not add much value for
stockholders, it may still be beneficial to managers.
II. Perhaps the most important aspect of risk management
involves derivative securities. A historical perspective is useful
when studying derivatives. One of the first formal markets for
derivatives was the futures market for wheat.
A. Hedging with futures lowered aggregate risk in the economy.
B. The earliest futures dealings were between two parties who
arranged transactions between themselves. Soon, though,
middlemen came into the picture, and trading in futures was
established.
1. The Chicago Board of Trade was an early marketplace for this
dealing, and futures dealers helped make a market in futures
contracts.
2. This improved the efficiency and lowered the cost of hedging
operations.
C. Speculators then entered the scene.
1. Speculators add capital and players to the derivatives market,
and this stabilizes the market.
2. Derivatives markets are inherently volatile due to the leverage
involved, hence risk to the speculators themselves is high.
3. Speculators bearing that risk makes the derivatives markets
more stable for the hedgers.
D. Natural hedges are situations in which aggregate risk can be
reduced by derivatives transactions between two parties known as
counterparties. These exist for many commodities, foreign
currencies, interest rates on securities with different maturities, and
even common stocks where portfolio managers want to hedge
their bets.
E. Hedging can also be done in situations where no natural hedge
exists.
1. Here one party wants to reduce some type of risk, and another
party agrees to sell a contract that protects the first party from
that specific event or situation.
a. Insurance is an obvious example of this type of hedge.
2. With nonsymmetric hedges, risks are generally transferred
rather than eliminated.
a. Even in these instances, though, insurance companies can
reduce certain types of risk through diversification.
F. The derivatives markets have grown more rapidly than any other
major market in recent years for a number of reasons.
1. Analytical techniques have been developed to help establish
fair prices, and having a better basis for pricing hedges makes
the counterparties more comfortable with deals.
2. Computers and electronic communications make it much easier
for counterparties to deal with one another.
3. Globalization has greatly increased the importance of currency
markets and the need for reducing the exchange rate risks
brought on by global trade.
4. Recent trends and developments are sure to continue, so the use
of derivatives for risk management is bound to grow.
G. Derivatives do have a potential downside.
1. These instruments are highly leveraged, so small miscalculations
can lead to huge losses.
2. They are complicated, hence not well understood by most
people.
a. This makes mistakes more likely than with less complex
instruments.
b. Its harder for a firms top management to exercise proper
control over derivatives transactions.
H. Derivatives are used far more often to hedge risks than in harmful
speculation.
III. An option is a contract that gives its holder the right to buy (or
sell) an asset at a predetermined price within a specified period
of time.
A. The strike, or exercise, price is the price that must be paid for a
share of common stock when an option is exercised.
B. A call option is an option to buy, or call, a share of stock at a
certain price within a specified period.
1. A put option is an option to sell a share of stock at a certain
price within a specified period.
C. The seller of an option is called the option writer.
D. An investor who writes call options against stock held in his or her
portfolio is said to be selling covered options.
1. Options sold without the stock to back them up are called naked
options.
E. When the exercise price exceeds the current stock price, a call
option is said to be out-of-the-money.
1. When the exercise price is below the current stock price, a call
option is in-the-money.
F. Options can be used to create hedges that protect the value of an
individual stock or portfolio.
G. Conventional options are generally written for 7 months or less, but
a new type of option called a Long-Term Equity Anticipation
Security (LEAPS) is also traded.
1. LEAPS are listed on exchanges and are tied both to individual
stocks and to stock indexes.
2. LEAPS are long-term options, having maturities of up to 3 years.
3. One-year LEAPS cost about twice as much as the matching
three-month option, but because of their much longer time to
expiration, LEAPS provide buyers with more potential for gains
and offer better long-term protection for a portfolio.
H. Corporations on whose stocks options are written have nothing to
do with the option market.
1. Corporations do not raise money in the option market, nor do
they have any direct transactions in it.
2. Option holders do not vote for corporate directors or receive
dividends.
I. There are at least three factors that affect a call options value.
1. The higher the stocks market price relative to the strike price,
the higher the call option price.
2. The higher the strike price, the lower the call option price.
3. The longer the option period, the higher the option price.
a. This occurs because the longer the time before expiration, the
greater the chance that the stock price will climb substantially
above the exercise price.
J. A call options exercise value is equal to the current stock price less
the strike price.
1. The exercise value is what the option would be worth if you had
to exercise it immediately.
2. Realistically, the minimum true value of an option is zero,
because no one would exercise an out-of-the-money option.
3. An options exercise value is only a first approximation valueit
merely provides a starting point for finding the actual option
value.
4. The actual market price of the option lies above the exercise
value at each price of the common stock, although the premium
declines as the stock price increases above the strike price.
a. Options enable individuals to gain a high degree of personal
leverage when buying securities.
b. The declining leverage impact and the increasing danger of
larger losses help explain why the premium diminishes as the
price of the common stock rises.
K. In addition to the stock price and the exercise price, the price of an
option depends on three other factors: (1) the options time until
expiration, (2) the variability of the stock price, and (3) the risk-
free rate.
1. The longer a call option has to run, the greater its value and the
larger its premium.
2. An option on an extremely volatile stock is worth more than one
on a very stable stock.
a. As a result of the unlimited upside but limited downside, the
more volatile a stock, the higher the value of its options.
3. The price of a call option always increases as the risk-free rate
increases.
a. The expected growth rate of a firms stock price increases as
interest rates increase, but the present value of future cash
flows decreases.
b. The first effect tends to increase the call options price, while
the second tends to decrease it.
c. The first effect dominates the second one.
IV. All option pricing models are based on the concept of a riskless
hedge.
A. A riskless hedge is a hedge in which an investor buys a stock and
simultaneously sells a call option on that stock and ends up with a
riskless position.
B. If an investment is riskless, it must, in equilibrium, yield the risk-
free rate.
C. Given the price of the stock, its potential volatility, the options
exercise price, the life of the option, and the risk-free rate, there is
but one price for the option if it is to meet the equilibrium condition,
namely, that a portfolio that consists of the stock and the call
option will earn the risk-free rate.
1. If options are not priced to reflect this condition, arbitrageurs will
actively trade stocks and options until option prices reflect
equilibrium conditions.
D. The Binomial Option Pricing Model is an option pricing model based
on a riskless hedge with two scenarios for the value of the
underlying asset. The steps in this approach to estimate the call
options value are:
1. Analysis assumes two scenarios for the stock price.
2. Find the range of values for the option at expiration.
3. Equalize the range of payoffs for the stock and the options.
4. Create a riskless hedged investment so that the ending total
value of the portfolio is identical.
5. Price the call option as the difference between the cost of the
stock and the PV of the portfolio.
a. The PV of the portfolio is discounted at the risk-free rate.
V. The Black-Scholes Option Pricing Model (OPM) is widely used
by option traders to estimate the value of a call option. It is
based on the creation of a riskless portfolio; however, it is
applicable to real-world option pricing because it allows for a
complete range of ending stock prices.
A. The assumptions made in the OPM are:
1. The stock underlying the call option provides no dividends or
other distributions during the life of the option.
2. There are no transactions costs for buying or selling either the
stock or the option.
3. The short-term, risk-free interest rate is known and is constant
during the life of the option.
4. Any purchaser of a security may borrow any fraction of the
purchase price at the short-term, risk-free interest rate.
5. Short selling is permitted, and the short seller will receive
immediately the full cash proceeds of todays price for a security
sold short.
6. The call option can be exercised only on its expiration date.
7. Trading in all securities takes place continuously, and the stock
price moves randomly.
B. The Black-Scholes model consists of the following three equations:
V P[ N(d 1 )] Xe rRF t [ N(d 2 )]
ln(P/X) [rRF ( 2 / 2)]t
d1
t
d 2 d1 t

1. V = current value of the call option.


2. P = current price of the underlying stock.
3. N(di) = probability that a deviation less than di will occur in a
standard normal distribution. Thus, N(d1) and N(d2) represent
areas under a standard normal distribution curve.
4. X = exercise, or strike, price of the option.
5. e 2.7183.
6. rRF = risk-free interest rate.
7. t = time until the option expires (the option period).
8. ln(P/X) = natural logarithm of P/X.
9. 2 = variance of the rate of return on the stock.
C. If the actual option price is different from the one determined by
the Black-Scholes Option Pricing Model, this would provide the
opportunity for arbitrage profits, which would force the option price
back to the value indicated by the model.
1. Actual option prices conform reasonably well to values derived
from the model.
VI. Put and call options represent an important class of derivative
securities, but there are other types of derivatives.
A. Forward contracts are agreements where one party agrees to buy a
commodity at a specific price on a specific future date and the other
party agrees to make the sale.
1. Goods are actually delivered under forward contracts.
B. A futures contract is similar to a forward contract, but with three
key differences.
1. Futures contracts are marked to market on a daily basis,
meaning that gains and losses are noted and money must be put
up to cover losses.
a. This greatly reduces the risk of default that exists with
forward contracts.
2. With futures, physical delivery of the underlying asset is virtually
never takenthe two parties simply settle with cash for the
difference between the contracted price and the actual price on
the expiration date.
3. Futures contracts are generally standardized instruments that
are traded on exchanges, whereas forward contracts are
generally tailor-made, are negotiated between two parties, and
are not traded after they have been signed.
C. Futures and forward contracts were originally used for commodities,
but today more trading is done in foreign exchange and interest
rate futures.
1. Interest rate futures represent another huge and growing
market.
2. Interest rate futures are based on a hypothetical 10-year
Treasury note with a 6% semiannual coupon.
a. If interest rates in the economy rise, the value of the
hypothetical T-note will fall, and vice versa.
D. Futures contracts are divided into two classes: commodity futures
and financial futures.
1. Commodity futures are contracts that are used to hedge against
price changes for input materials.
2. Financial futures are contracts that are used to hedge against
fluctuating interest rates, stock prices, and exchange rates.
3. When futures contracts are purchased, the purchaser does not
have to put up the full amount of the purchase price; rather, the
purchaser is required to post an initial margin.
a. Investors are required to maintain a certain value in the
margin account, called a maintenance margin.
b. If the value of the contract declines, then the owner may be
required to add additional funds to the margin account, and
the more the contract value falls, the more money must be
added.
4. Futures contracts are never settled by delivery of the securities
involved.
a. The transaction is completed by reversing the trade, which
amounts to selling the contract back to the original seller.
b. The actual gains and losses on the contract are realized when
the futures contract is closed.
E. Forward contracts and futures can be used to hedge, or reduce,
risks.
1. The primary motivation behind these contracts is to reduce risks,
not to create them.
F. Futures contracts and options are similar to one another.
1. A futures contract is a definite agreement on the part of one
party to buy something on a specific date and a specific price,
and the other party agrees to sell on the same terms.
a. No matter how low or how high the price goes, the two
parties must settle the contract at the agreed-upon price.
b. Futures are used for commodities, debt securities, and stock
indexes.
2. An option gives someone the right to buy (call) or sell (put) an
asset, but the holder of the option does not have to complete the
transaction.
a. Options exist both for individual stocks and for bundles of
stocks, but generally not for commodities.
VII. Options, forwards, and futures are among the most important
classes of derivative securities, but there are other types of
derivatives, including swaps, structured notes, inverse floaters,
and a host of other exotic contracts.
A. In a swap two parties agree to swap something, generally
obligations to make specified payment streams. Most swaps today
involve either interest payments or currencies.
1. An interest rate swap occurs when one firm exchanges a fixed-
rate debt obligation for another firms variable-rate debt
obligation.
a. The purpose of the interest rate swap is to match the best
debt payment stream with each firms cash flow stream.
2. A currency swap occurs when one firm exchanges debt
denominated in one currency for another firms debt
denominated in another currency.
a. The purpose of the currency swap is to protect each firm
against exposure to exchange rate risk.
3. Note that swaps can involve side payments, additional payments
needed to get the other party to agree to the swap.
4. Originally, swaps were arranged between companies by money
center banks, which would match up counterparties.
a. Such matching still occurs, but today most swaps are
between companies and banks, with the banks then taking
steps to ensure that their own risks are hedged.
B. A structured note is a debt obligation derived from another debt
obligation. Structured notes permit a partitioning of risks to give
investors what they want.
1. Zeros formed by stripping T-bonds were one of the first types of
structured notes.
2. Another important type of structured note backed by the interest
and principal payments on mortgages is a collateralized
mortgage obligation.
3. Investment bankers can create notes called IOs, for Interest
Only, which provide cash flows from the interest component of
the mortgage amortization payments, and POs, for Principal
Only, which are paid from the principal repayment stream.
4. More recently, Wall Street firms have put together instruments
called collateralized debt obligations (CDOs).
a. CDOs are similar to CMOs but instead of assembling a
portfolio of mortgages, the issuing firm assembles a portfolio
of debt instruments.
b. The overall risk is partitioned into several classes.
C. A floating-rate note has an interest rate that rises and falls with
some interest rate index. With an inverse floater, the rate paid on
the note moves counter to market rates.
1. If interest rates in the economy rose, the interest rate paid on
an inverse floater would fall, lowering its cash interest payments.
2. At the same time, the discount rate used to value the inverse
floaters cash flows would rise along with other rates.
a. The combined effect of lower cash flows and a higher discount
rate would lead to a very large decline in the value of the
inverse floater.
b. Inverse floaters are exceptionally vulnerable to increases in
interest rates.
3. If interest rates fall, the value of an inverse floater will soar.
VIII. Firms are subject to numerous risks related to interest rate,
stock price, and exchange rate fluctuations in the financial
markets. For an investor, one of the most obvious ways to
reduce financial risks is to hold a broadly diversified portfolio
of stocks and debt securities; however, derivatives can also be
used to reduce the risks associated with financial and
commodity markets. Futures and swaps help manage certain
types of risk.
A. Futures are used for both speculation and hedging.
1. Speculation involves betting on futures price movements, and
futures are used because of the leverage inherent in the
contract.
2. Hedging is done by a firm or individual to protect against a price
change that would otherwise negatively affect profits. There are
two basic types of hedges.
a. Long hedges involve futures contracts bought in anticipation
of (or to guard against) price increases.
b. Short hedges involve futures contracts sold to guard against
price declines.
3. A perfect hedge occurs when the gain or loss on the hedged
transaction exactly offsets the loss or gain on the unhedged
position.
a. In reality, it is virtually impossible to construct perfect
hedges, because in most cases the underlying asset is not
identical to the futures asset, and even when they are, prices
(and interest rates) may not move exactly together in the
spot and futures markets.
4. The futures and options markets permit flexibility in the timing of
financial transactions, because the firm can be protected, at
least partially, against changes that occur between the time a
decision is reached and the time when the transaction will be
completed.
a. However, this protection has a costthe firm must pay
commissions.
b. In theory, the reduction in risk resulting from a hedge
transaction should have a value exactly equal to the cost of
the hedge. Thus, a firm should be indifferent to hedging.
B. A swap is another method for reducing financial risks.
1. In finance, it is an exchange of cash payment obligations, in
which each party to the swap prefers the payment type or
pattern of the other party.
2. Major changes have occurred over time in the swaps market.
Standardized contracts have been developed for the most
common types of swaps, and this has had two effects.
a. Standardized contracts lower the time and effort involved in
arranging swaps, and thus lower transaction costs.
b. The development of standardized contracts has led to a
secondary market for swaps, which has increased the liquidity
and efficiency of the swaps market.
C. Futures markets were established for many commodities long
before they began to be used for financial instruments.
D. While the use of derivatives to hedge risk is an important tool for
risk managers, if improperly constructed or if derivatives are used
for speculation purposes, they have the potential to create very
large losses in very short periods.
1. Hedging allows managers to concentrate on running their core
businesses without having to worry about interest rate,
currency, and commodity price variability.
a. If a company can safely and inexpensively hedge its risk, it
should do so.
IX. As businesses become increasingly complex, companies need
to have someone systematically look for potential problems
and design safeguards to minimize potential damage.
A. Risk management involves the management of unpredictable
events that have adverse consequences for the firm.
B. Risk can be classified in many ways and different classifications are
commonly used in different industries.
1. Heres one list that provides an idea of the wide variety of risks
to which a firm can be exposed: pure risks, speculative risks,
demand risks, input risks, financial risks, property risks,
personnel risks, environmental risks, liability risks, and insurable
risks.
2. These risk classifications are somewhat arbitrary, and different
classifications are commonly used in different industries.
C. Firms often use the following three-step approach to risk
management: (1) identify the risks faced by the firm; (2) measure
the potential effect of the risks identified; and (3) decide how each
relevant risk should be handled.
D. There are several techniques used to reduce risk exposure:
1. Transfer the risk to an insurance company. Often, it is
advantageous to insure against, and hence transfer, a risk.
a. Insurability does not necessarily mean that a risk should be
covered by insurance.
b. It might be better for the company to self-insure, which
means bearing the risk directly rather than paying to have
another party bear the risk.
2. Transfer the function that produces the risk to a third party. In
some situations, risks can be reduced most easily by passing
them on to some other company that is not an insurance
company.
3. Purchase derivative contracts to reduce risk. Firms use
derivatives to hedge risk.
4. Reduce the probability of the occurrence of an adverse event. In
some instances, it is possible to take action to reduce the
probability that an adverse event will occur.
5. Reduce the magnitude of the loss associated with an adverse
event.
6. Totally avoid the activity that gives rise to the risk.
E. Risk management decisions, like all corporate decisions, should be
based on a cost/benefit analysis for each feasible alternative.
1. The same financial management techniques applied to other
corporate decisions can also be applied to risk management
decisions.