Part 2 - TKM0844 - 11E - IM - Ch20 PDF

Chapter 20
Corporate Risk Management
20-1. Long positions make profits when the price of the underlying asset rises (they are “bullish”). As
the graph below shows, this long forward position is profitable when the price of the underlying
asset at date T is greater than the delivery price of $65. For these higher prices, the owner of the
long position is able to buy the underlying asset for $65, even though the spot price for that asset
is higher. (For example, if the spot price at date T is $80, then the owner of the forward position
profits by $15, the difference between the $65 price he pays and the $80 he would have otherwise
have had to pay in the spot market.)
The circled point on the graph shows that when the spot price of the underlying asset at date T is
equal to the forward delivery price of $65, there is no profit or loss to the contract. However, when
the spot price is below the delivery price, there is a loss on the forward. (Since long positions
profit when the underlying asset’s price rises, they lose when the price falls.)
Compare the shape of the graph below to that in Panel A of Figure 20.1; both show that long
positions perform better when the underlying asset’s price is higher on date T.
forward contract Long position in forward contract

position: LONG $20
delivery price = $65
$15 $15
value of
$10 $10
underlying asset delivery date
at date T profit or (loss) $5 $5 PROFIT
Profit from forward contract
$40 ($25)
$45 ($20) $0 $0
$50 ($15) $40 $45 $50 $55 $60 $65 $70 $75 $80
$55 ($10) ($5) ($5)

LOSS
$60 ($5)
($10) ($10)
$65 $0 delivery price = $65
$70 $5
($15) ($15)
$75 $10
$80 $15 ($20) ($20)
($25) ($25)
($30)
Price of underlying asset (on date T)
©2011 Pearson Education, Inc. Publishing as Prentice Hall

470 Titman/Keown/Martin • Financial Management, Eleventh Edition
20-2. Because a forward contract is a “zero-sum game,” the profits to the long position are the losses to
the short position—that is, what one side gains, the other loses. Thus, the payoff diagram for this
short (“bearish”) position is the mirror image of the diagram from Problem 20-1. Now when the
spot price at the delivery date is less than the contract price of $65, the position profits; when the
spot price at date T is greater than $65, the position loses. For example, if the spot price at date T
were $30, the owner of this short position could force his counterparty to pay him $65 for the
underlying asset, making him a profit of ($65 − $30) = $35/unit. On the other hand, when the
delivery-date price is $80, this seller can only sell for $65; he loses $15.
forward contract Short position in forward contract
position: SHORT $30
$25 $25
value of
$20 $20
underlying asset delivery date
at date T profit or (loss)
$15 $15
$40 $25
$45 $20 $10 $10

$50 $15 PROFIT
$55 $10 $5 $5
$60 $5
$65 $0 $0 $0
$40 $45 $50 $55 $60 $65 $70 $75 $80
$70 ($5)
($5) ($5)
$75 ($10) LOSS
$80 ($15)
($10) ($10)
($15) ($15)
($20)
The chart below illustrates the payoffs to both the long position (the black line) and the short position
(the dark gray line). Adding the payoffs together gives the net profit—the light gray line, which
lies right along the x axis, and is always equal to zero! For example, when the spot price at date T
is $45, the long side loses ($65 − $45), since he must pay $65 for something he could have gotten
in the spot market for $45. However, the short side wins by $20, since she is selling at a price
higher than she would have otherwise gotten. Forward contracts simply transfer money from one
counterparty to the other; there is no net gain to the transaction.
forward contract Forward contracts are zero-sum games

delivery price = $65 $30
$25
value of LONG SHORT BOTH
underlying asset delivery date $20 $20
at date T profit or (loss)
$40 ($25) $25 $0 $15 $15
$45 ($20) $20 $0

$10 $10 $10

$50 ($15) $15 $0 short gains $25
$55 ($10) $10 $0 $5 $5
$60 ($5) $5 $0
$0 $0
$65 $0 $0 $0 $40 $45 $50 $55 $60 $65 $70 $75 $80
$70 $5 ($5) $0 ($5) ($5)
$75 $10 ($10) $0 long loses $25
($10) ($10) ($10)
$80 $15 ($15) $0
($15) ($15)
($20) ($20)
($25)
($30)

Solutions to End of Chapter Problems—Chapter 20 471
20-3. The Specialty Chemical Company is considering locking in their price of their raw material, crude
oil, by using a forward contract. If they choose to go ahead, they will buy a contract (take a long
position), since they want to lock in their buy price for the material that they will need in the
future. The specific contract they are considering has a delivery price of $130, so they would be
committing to paying $130/barrel (bbl) for 1,000,000 bbl of oil.
To evaluate their decision, we can consider the profits they would earn with and without this hedge,
assuming that they would sell their finished product for $170/bbl used, and that their refining costs
were $40/bbl. Given these dollar values, Specialty’s unhedged profits can be found as:
unhedged profits = total revenues − total costs
= total revenues − (cost of oil + refining costs)
= [$170 − (spot price of oil in 1 year + $40)] ∗ (1M bbl)
= [$130 − spot price of oil in 1 year] ∗ (1M bbl)
We can see these profits in the graph below. The black, unhedged profit line falls as the spot price
of crude in one year rises; once this cost rises above $130/bbl, Specialty begins to lose money. It is
this eventuality that the company wishes to avoid by using the forward contract.
If Specialty uses the forward contract, it will pay $130/bbl with certainty. Thus when it turns out
that the future spot price is lower than $130, the company will lose (paying $130 for something it
could have bought more cheaply in the spot market); when the spot price is greater than $130, the
company wins. Since fixing the price of oil means that all of Specialty’s costs are fixed ($130 for
oil plus $40 for refining), and since we assume that their sales price is also fixed, we end up with a
fixed profit amount in the hedged case. (This is the idea of hedging: We add an element to our
portfolio that is designed to stabilize the payoffs we receive from our structural position.) We can
see this in the graph below: The gray line, representing the hedged profits, is completely flat, and
showing zero profit as the $170 selling price less $130 crude cost and $40 refining cost net to
zero—it does not vary with the future spot price of crude. When crude prices end up above $130,
Specialty is better off for having put on this hedge; when crude prices are lower, they would have
been better off without the hedge. Since Specialty has no way of knowing today how high the
price of crude will be in the future, they may find the ability to eliminate uncertainty with the
hedge more compelling than the extra profits they might earn if the future spot price ends up low.
Note that the shape of the relationships in the graph below is just like that in Figure 20.3 in the text.
Thus this is not a very compelling opportunity!
Gains and losses from hedging

$25,000,000
$20,000,000
$15,000,000
profits without
$10,000,000 hedging
losses from
profits with hedging
hedging
$5,000,000
profits
$0
$100 $110 $120 $130 $140 $150 $160
($5,000,000)
gains from
hedging
($10,000,000)
($15,000,000)
($20,000,000)
($25,000,000)
price of crude oil in one year

20-4. Forward contracts are tailored arrangements designed to meet the specific needs of a pair of
counterparties. At the delivery date, one of these counterparties will lose (that is, will face a spot
price at date T that will make her wish she had not entered into the forward—for example, a long
position that faces a spot price that is lower than the delivery price). The loser will be forced to
make a transfer of money to the other counterparty. There is a strong incentive for the loser to
walk away from her losses, breaking her contract and denying her counterparty his payment.
Given this strong incentive for the loser to walk away, and given that no one knows which of the two
counterparties will end up the loser, each party to a forward transaction must trust the other. This trust
is usually developed through costly counterparty credit evaluation, as discussed in Section 20.3 of the
text. Futures contracts mitigate the parties’ credit risk by inserting a third party—the exchange—
between the long and short positions to act as counterparty to both, by requiring each side to post
margin as collateral, and by marking the margin positions to market every day. The margin required is
a percentage of the value of the underlying contract (for example, 10–15% of its value). Since the
parties are required to post margin, they have skin in the game from the very beginning. As prices
change during the life of the contract, their margin positions are adjusted daily, with the daily loser
making transfers to the daily winner (for example, if the day’s close is higher than the delivery price,
the long side would be the daily winner, and would receive a transfer from the short). By forcing the
daily marking, the exchange prevents an accumulation of daily losses that may become large enough
to encourage the loser to walk away from her obligations. At the delivery date, the winner is certain
that the cash required to settle the contract is safely in the loser’s margin account.
Some of the costs of this arrangement are the standardization of the contracts (they can no longer
be tailored to specific counterparties, which limits flexibility and introduces basis risk); the
opportunity cost of the margin funds; and the possibility of “gambler’s ruin”—the chance that a
long string of adverse price moves will exhaust a trader’s funds, forcing him to close a position
that, if left open, ultimately would have emerged a winner.
20-5. A long call position is bullish—it does better when the stock price at expiration is higher. (Note
that we know this is a long position, since we are paying the premium.) With a long option
position, the most that the buyer can lose is the premium: if the stock price at expiration leaves the
option out-of-the-money, the buyer will walk away (let the option expire worthless), receiving no
terminal cash flow, and therefore losing her entire premium. However, as the stock price at
expiration moves beyond the exercise price, the option expires in-the-money, and the buyer will
exercise it. For every dollar that the stock is above the exercise price, the buyer receives a dollar
when she exercises; that is, her payoff at expiration is (stock price at date T − exercise price). If
her payoff at date T exceeds her premium, she ends up profiting from her position. Since there is
no upper limit to the possible stock price, there is no upper limit to this potential profit.
The first diagram below shows the profit to a long call position, assuming an exercise price (X) of
$50 and a call premium (C) of $5. As long as the stock price at date T (ST, shown on the horizontal
axis) is greater than the exercise price of $50, the option will be exercised, and the buyer receives
a payoff of (ST − X). Note that, as ST increases without limit, so does this payoff. However, the
profit is lower than the terminal payoff, since the option buyer had to pay the initial premium of
$5. She therefore breaks even when ST = $55 = X + C. At stock prices below X, she lets the option
expire worthless, losing the premium. We can see this outcome on the graph as the horizontal line
from the y axis to ST = $50 (X ), at a height of −$5 (−C ).

Long call with X = $50 and C = $5
$25.00
$20.00
$15.00
$10.00
profit from long call
profit or loss
break-even point =
$5.00 (exercise price + premium) = $55 maximim profit =
unlimited
$0.00
$0 $10 $20 $30 $40 $50 $60 $70 $80
maximum loss = exercise price = $5
($5.00)
($10.00)
stock price at option expiration
The graph below shows the revised situation: a call premium of $6 (higher) and an exercise price
of $55 (also higher). The shape of the profit diagram is the same—for example, it still shows
unlimited upside potential—but its intercepts have changed. Now, not exercising means that the
buyers suffers a $6 loss; the loss is higher since the premium was higher. This higher premium
alone would shift the break-even point to the right (bad news for the buyer). However, this shift is
exacerbated by the higher exercise price—now the option won’t be exercised unless ST > $55. The
new break-even point is therefore ($55 + $6) = $61.
Long call with X = $55 and C = $6
$25.00
$20.00
$15.00
$10.00
profit from long call
profit or loss
break-even point =
$5.00 (exercise price + premium) = $61 maximim profit =
unlimited
$0.00
$0 $10 $20 $30 $40 $50 $60 $70 $80
maximum loss = call premium = $6
($5.00)
($10.00)

The graph below summarizes the differences between the two scenarios. The call with the higher X
and higher C (the gray curve) has a much less attractive profit diagram than does the first option: the
lower X means the first option expires in-the-money at a lower ST, helping the buyer start recouping
her investment sooner, and the lower initial cost means that there is less to recoup in any case.
Comparing the long call positions
$25.00
$20.00
$15.00
$10.00
profit or loss
$5.00
profit from long call: X=55, C=6
$0.00
$0 $10 $20 $30 $40 $50 $60 $70 $80
($5.00)
($10.00)
X= $50.00 X= $55.00
premium = $5.00 premium = $6.00
position = LONG position = LONG
ST PAYOFF PROFIT PAYOFF PROFIT

$0 $0.00 ($5.00) $0 ($6)
$5 $0.00 ($5.00) $0 ($6)
$10 $0.00 ($5.00) $0 ($6)
$15 $0.00 ($5.00) $0 ($6)
$20 $0.00 ($5.00) $0 ($6)
$25 $0.00 ($5.00) $0 ($6)
$30 $0.00 ($5.00) $0 ($6)
$35 $0.00 ($5.00) $0 ($6)
$40 $0.00 ($5.00) $0 ($6)
$45 $0.00 ($5.00) $0 ($6)
$50 $0.00 ($5.00) $0 ($6)
$55 $5.00 $0.00 $0 ($6)
$60 $10.00 $5.00 $5 ($1)
$65 $15.00 $10.00 $10 $4
$70 $20.00 $15.00 $15 $9
$75 $25.00 $20.00 $20 $14
$80 $30.00 $25.00 $25 $19
$85 $35.00 $30.00 $30 $24
$90 $40.00 $35.00 $35 $29
$95 $45.00 $40.00 $40 $34
$100 $50.00 $45.00 $45 $39

20-6. This question is very similar to 20-5, and so we will see comparable long profit graphs. In this
question, we will also show the short positions, since it’s not clear which side we’re taking here.
The graph below illustrates the long positions; this graph is comparable to the one we created in
Problem 20-5 above, and to Figure 20.5 in the text. As in Problem 20-5, we see that both long
positions have downsides limited to the call premium, with unlimited upsides. We also note again
that the call with the higher exercise price (shown with the gray line) breaks even at a higher ST,
and that the profit diagram for the call with the higher premium ($4, again shown with the gray line)
is always lower than the profit diagram for the call with the lower premium. (Note that this latter
result is not always true; it is true here since the call with the higher premium has an exercise price
that is not lower than the other option’s.)
Comparing the long call positions
$25.00
$20.00
$15.00
$10.00
profit or loss
$5.00
$0.00
$0 $5 $10 $15 $20 $25 $30 $35
($5.00)
($10.00)
X= $10.00 X= $12.00
position = LONG position = LONG

$0 $0.00 ($2.00) $0 ($4.00)
$5 $0.00 ($2.00) $0 ($4.00)
$10 $0.00 ($2.00) $0 ($4.00)
$12 $2.00 $0.00 $0 ($4.00)
$17 $7.00 $5.00 $5 $1.00
$22 $12.00 $10.00 $10 $6.00
$27 $17.00 $15.00 $15 $11.00
$32 $22.00 $20.00 $20 $16.00

We will now look at the short positions’ profits for these two options. The graph below shows that
these profits are the mirror images of the long positions we just saw. Now, the call with the higher
premium and the higher exercise price (the gray line) dominates the other: A higher premium
means more money for the call writer to keep regardless of ST, and a higher exercise price means
that ST must finish higher before the call is even exercised against the writer. We can also see that
the profits to both of the short positions are very different from those of the long positions: The
upside is limited to the call premium received, but the downside is unlimited.
Comparing the short call positions
$10.00
$5.00
$0.00
$0 $5 $10 $15 $20 $25 $30 $35
($5.00)
profit or loss
($10.00)
profit from short call: X=12, C=4
profit from short call: X=10, C=2
($15.00)
($20.00)
($25.00)
X= $10.00 X= $12.00
position = SHORT position = SHORT

$0 $0.00 $2.00 $0 $4.00
$5 $0.00 $2.00 $0 $4.00
$10 $0.00 $2.00 $0 $4.00
$12 ($2.00) $0.00 $0 $4.00
$17 ($7.00) ($5.00) ($5) ($1.00)
$22 ($12.00) ($10.00) ($10) ($6.00)
$27 ($17.00) ($15.00) ($15) ($11.00)
$32 ($22.00) ($20.00) ($20) ($16.00)

20-7. Since we are paying the premium in this case, we know that we have a long put position. This is a
bearish position: Our profit is higher when the stock price at date T (ST) is lower. Now, the option
is exercised when (ST < X), receiving a payoff equal to (X − ST). Thus, for example, if the stock
price at date T is $30, then we exercise our put, forcing our counterparty to pay us $45. We therefore
receive a payoff of $15, which, after we account for our $5 premium, leaves us a profit of $10.
This long put breaks even when our date-T payoff just equals our $5 premium paid—that is, when
(X − ST) = $5, or ST = $40. The maximum profit occurs when ST = $0; in that case, the long put
holder’s payoff is $45, and her profit is $40. The maximum loss occurs when the option expires
worthless: When (ST > X), the put buyer loses the premium of $5.
Note that the profit diagram below is comparable to the diagram shown in Figure 20.7 in the text.
Long put with X = $45 and P = $5
$40.00 maximim profit =

(exercise price - premium)
= $40
$30.00
$20.00 profit from long put

profit or loss
$10.00
break-even point =
(exercise price - premium) = $40
$0.00
$0 $10 $20 $30 $40 $50 $60 $70 $80
maximum loss = put premium = $5

($10.00)
X= $45.00
premium for put = $5.00
position = LONG
ST PAYOFF PROFIT
$0 $45.00 $40.00
$5 $40.00 $35.00
$10 $35.00 $30.00
$15 $30.00 $25.00
$20 $25.00 $20.00
$25 $20.00 $15.00
$30 $15.00 $10.00
$35 $10.00 $5.00
$40 $5.00 $0.00
$45 $0.00 ($5.00)
$50 $0.00 ($5.00)
$55 $0.00 ($5.00)
$60 $0.00 ($5.00)

20-8. As in Problem 20-7, the profit diagram for this put, assuming a long (purchased) position, will look
similar to Figure 20-7 in the text. The maximum loss for a long position is the premium paid—here,
$1. The maximum profit for a put occurs when ST = $0, so that the payoff is (X − ST) = $5, and the
profit equals (payoff − premium) = ($5 − $1) = $4. This is a bearish position, doing better when ST is
lower.
Long put with X = $5 and P = $1
$5.00
maximim profit =
$4.00 (exercise price - premium)
= $4
$3.00
$2.00
profit from long put
profit or loss
$1.00 break-even point =

(exercise price - premium) = $4
$0.00
$0 $2 $4 $6 $8 $10
maximum loss = put premium = $1
($1.00)
($2.00)
Since it’s not clear that we are taking the long position here, let’s also look at the short (written) put
position. As always, this profit is the mirror image of that for the long position. The short put does
best when the option expires worthless. In that case, the payoff to the position is $0 (since the buyer
does not exercise), and the writer gets to keep the full premium received. However, when the stock
price at date T is less than the exercise price, the buyer exercises, and the writer suffers a negative
date-T payoff. The worst this can be is when ST = $0, making the writer’s “profit” [(ST − X) + P] =
[($0 − $5) + $1] = −$4.
X= $5.00 X= $5.00
Short put with X = $5 and P = $1 premium = $1.00 premium = $1.00
position = LONG position = SHORT
$2.00

$1.00
$0 $5.00 $4.00 ($5.00) ($4.00)
maximim profit = premium = $1 $1 $4.00 $3.00 ($4.00) ($3.00)
$2 $3.00 $2.00 ($3.00) ($2.00)
$0.00
$3 $2.00 $1.00 ($2.00) ($1.00)
$0 $2 $4 $6 $8 $10 $4 $1.00 $0.00 ($1.00) $0.00
break-even point = $5 $0.00 ($1.00) $0.00 $1.00
($1.00) (exercise price - premium) = $4 $6 $0.00 ($1.00) $0.00 $1.00
profit from short put
profit or loss
$7 $0.00 ($1.00) $0.00 $1.00

$8 $0.00 ($1.00) $0.00 $1.00
($2.00) $9 $0.00 ($1.00) $0.00 $1.00
$10 $0.00 ($1.00) $0.00 $1.00
($3.00)
($4.00) maximum loss = (exercise price - put premium) = $4
($5.00)

20-9. If Minelli wants to lock in the price of its critical raw material, copper, then it can take a long position
in a forward contract for copper, with a delivery date in one month and a delivery price of $3/lb.
Since Minelli wants to buy copper, it takes the forward position that requires it to take delivery of
copper at a certain price—that is, the long position. Think of it this way: Minelli wants to hedge
the price of copper. Since its structural position in copper (its need to use copper to manufacture
ceiling fans) does poorly when copper prices rise, it wants to hedge this exposure using another
position that does well when copper prices rise. Look again at Panel A of Figure 20.2 in the text to
see that it is the long side of a forward that profits when the price of the underlying asset rises.
Of course, just because Minelli wants a 1-month copper forward with a delivery price of $3
doesn’t mean that there will be a counterparty willing to take the other side of that contract. If
there isn’t, then Minelli might be forced to compromise on one or more of its desired contract
elements. Minelli might also see if there is an exchange-traded futures contract that would serve
its purposes. The Comex in New York trades a copper futures contract, which on 5/14/10 settled at
$3.1270/lb. for June 10th delivery. This contract covers 25,000 pounds of high-grade copper. As
noted above in Problem 20-4, using a futures contract would mean that Minelli would be forced to
accept these standardized contract terms, as well as put up margin; however, it would not suffer
the counterparty risk it would face with a forward.
20-10. We can use the Black-Scholes model to value this option, as was done in Checkpoint 20.3 in the text:
 $20   0.16  90
ln   +  0.04 + 2  ∗ 365
d1 =    
$18
= 0.6794
90
0.16 ∗
365
90
d2 = 0.6794 − 0.16 ∗ = 0.4808
365
C = $20 ∗ (0.7516) − $18 ∗ e −0.04∗0.25∗ (0.6847) = $2.83
We can summarize the intermediate steps this way:

given:
S0 = $20.00
X= $18.00
annualized variance = 0.16
days to option maturity = 90
annual risk-free rate = 4%
find: comments
T= 0.2466 = 90/365 time to expiration
S0/X = 1.1111 If this ratio > 1, the call is in-the-money.
ln(S0/X) = 0.1054 LN Terms in yellow boxes are Excel paste functions.
variance/2 = 0.0800
[risk-free rate + variance/2]*T = 0.0296
square root of variance = 0.4000
square root of T = 0.4966
(square root of variance)*(square root of T) = 0.1986
d1 = 0.6794
N(d1) = 0.7516 NORMSDIST If d1> 0, N(d1) > 0.5.
d2 = 0.4808
N(d2) = 0.6847 NORMSDIST
-rT = -0.0099
-rT
e = 0.9902 EXP This is a PV factor, which assumes continuous compounding.
S0*N(d1) = $15.03 (1)
-rT
X*e *N(d2) = $12.20 (2)
C= $2.83 (3) (1) - (2) = (3)
intrinsic value = $2.00 This is what the call would be worth if exercised today;
it's > 0, since this call is in-the-money (it would otherwise be $0).
time value = $0.83 This is the remainder of the call's value: C - intrinsic value.

Note that we used the Excel function NORMSDIST to find the probabilities. The “S” in the
middle of this function’s name stands for “Standard normal,” the normal distribution whose mean
is 0 and standard deviation is 1.
When the exercise price rises to $25, the value of the call will fall. There will be no intrinsic value,
since the option is out-of-the-money; all of the call’s value will be time value.
given:
S0 = $20.00
X= $25.00
find:
T= 0.2466 = 90/365
S0/X = 0.8000
ln(S 0/X) = -0.2231 LN Note that the ln term here is negative, since S0/X < 1.
variance/2 = 0.0800
d1 = -0.9745
d2 = -1.1731
-rT = -0.0099
-rT
e = 0.9902 EXP
S0*N(d1) = $3.30 (1)
-rT
X*e *N(d2) = $2.98 (2)
C= $0.32 (3) (1) - (2) = (3)
it's = 0, since this call is out-of-the-money.
time value = $0.32 In this case, this is the all of the call's value.
When the variance rises, there is more upside potential for any option, and premiums rise. This is true
for both puts and calls: No matter which side is your winning side, there is a better chance of reaching
it when the variance is higher. Of course, there’s also a greater chance of ending up on the losing
side—but when that happens, option buyers get to walk away. The worst outcome from having the
stock end up out-of-the-money—less than X for a call, or greater than X for a put—stays at the cost of
the premium paid. So if the upside potential increases, but the worst-case outcome stays the same,
more volatility must be good!
given:
S0 = $20.00
X= $18.00
find:
T= 0.2466 = 90/365
S0/X = 1.1111
ln(S0/X) = 0.1054 LN
variance/2 = 0.1600
d1 = 0.5506
d2 = 0.2697
-rT = -0.0099
-rT
e = 0.9902 EXP
S 0*N(d1) = $14.18 (1)
-rT
X*e *N(d2) = $10.81 (2)
C= $3.37 (3) (1) - (2) = (3)
it's > 0, since this call is in-the-money (it would otherwise be $0).
time value = $1.37 This is the remainder of the call's value: C - intrinsic value.

The table below summarizes our work from Problem 20-10. As X rises, C falls, but as volatility
rises, C rises.
scenario X variance C
1 $18.00 0.16 $2.83
2 $25.00 0.16 $0.32
3 $18.00 0.32 $3.37
20-11. This problem, like 20-10, uses the Black-Scholes model on three different scenarios. Here, however,
we will not only increase the variance (which, all else equal, will increase the value of the call),
but we will decrease the time to expiration (which will decrease the value of the call). We start
with the initial case, as summarized below:
 $25   0.09  90
ln   +  0.04 +
2  365
*
di =  $20  
= 1.6386
90
0.09 *
365
90
d2 = 1.6386 − 0.09 * = 1.4896
365
C = $25*(0.9494) − $20*e -.04*.25 *(0.9318) = $5.28
given:
S0 = $25.00
X= $20.00
find:
T= 0.2466 = 90/365
S0/X = 1.2500
ln(S0/X) = 0.2231 LN
variance/2 = 0.0450
d1 = 1.6386
d2 = 1.4896
-rT = -0.0099
-rT
e = 0.9902 EXP
S0*N(d1) = $23.73 (1)
-rT
X*e *N(d2) = $18.45 (2)
C= $5.28 (3) (1) - (2) = (3)
intrinsic value = $5.00
time value = $0.28

Note that the d values here are much larger than they were in the initial scenario for problem 20-10,
which also means that the N(d) values are higher. This option is fairly deeply in-the-money (i.e.,
current price above exercise price), which boosts the numerator of the d1 term; it also has a lower
variance, which, while slightly decreasing the second term in the numerator of d1, also lowers the
value of the denominator significantly.
Now, we decrease the time to expiration. This both increases the present value of the exercise price
(which the call buyer would pay on exercise), and decreases the amount of time for the volatility
to work its magic. Both effects of a shorter T decrease the call’s value.
given:
S0 = $25.00
X= $20.00
find:
T= 0.0822 = 90/365
S 0/X = 1.2500
ln(S0/X) = 0.2231 LN
variance/2 = 0.0450
d1 = 2.6757
d2 = 2.5897
-rT = -0.0033
-rT
e = 0.9967 EXP
S0*N(d1) = $24.91 (1)
-rT
X*e *N(d2) = $19.84 (2)
C= $5.07 (3) (1) - (2) = (3)
time value = $0.07
Note that, relative to the initial scenario, the intrinsic value has not changed. All of the decrease in
the call’s value comes from the lower time value.

Finally, we increase the stock’s variance. As noted earlier, this will increase the call premium.
given:
S0 = $25.00
X= $20.00
find:
T= 0.2466 = 90/365
S0/X = 1.2500
ln(S0/X) = 0.2231 LN
variance/2 = 0.0750
d1 = 1.3077
d2 = 1.1154
-rT = -0.0099
-rT
e = 0.9902 EXP
S0*N(d1) = $22.61 (1)
-rT
X*e *N(d2) = $17.18 (2)
C= $5.43 (3) (1) - (2) = (3)
time value = $0.43
Again, it’s not the intrinsic value that changes, but the time value.
The chart below summarizes our results. As T falls, C falls, but as volatility rises, C rises.
(days)
scenario T variance C
1 90 0.09 $5.28
2 30 0.09 $5.07
3 90 0.15 $5.43

20-12. This question is similar to the example in the text that is summarized in Figure 20.10. Our firm has
an obligation to make floating-rate payments. However, the swap means that the company will
receive from its swap counterparty the floating-rate payments that it needs to service its loan. In
exchange, the firm will pay its swap counterparty a fixed rate of 6.4%. Our firm is thus party to
two arrangements: the loan with its lender, and the swap with its swap counterparty. We can
visualize the situation like this:
SWAP floating floating

OUR FIRM LENDER
COUNTERPARTY
fixed
The chart below illustrates that payments between the firm and its swap counterparty. Every six
months, our firm pays its counterparty the fixed coupon shown in column E, which is found as
(6.4%/2) ∗ ($20M). (The $20M is the notional principal—the amount on which the payments are
based; we divide by 2 to account for the semiannual nature of the payments.) In return, our firm
receives the floating-rate payments shown in column D. These are found by multiplying the $20M
notional principal by the appropriate periodic rate. This rate is found as (LIBOR + 50 bp spread)/2.
Note that when the (LIBOR + 50) rate is less than the fixed 6.4%, our firm must pay its
counterparty, but when (LIBOR + 50) > 6.4% (as happens in all but the first period, according to
our LIBOR assumptions), our firm receives a cash inflow.
Notional Principal = $ 20,000,000

6.4%
× $20 million
2
LIBOR + 50 bp
6-Month floating rate Floating Rate Fixed Rate Net Swap Cash Flow
Year LIBOR Rate on loan Coupon Coupon Fixed for Floating
(A) (B) (C ) (D) (E) (F)
- 5.44% 5.94%
0.50 7.20% 7.70% $594,000 $640,000 ($46,000)
1.00 6.40% 6.90% $770,000 $640,000 $130,000
1.50 5.92% 6.42% $690,000 $640,000 $50,000
2.00 6.24% 6.74% $642,000 $640,000 $2,000
2.50 6.88% 7.38% $674,000 $640,000 $34,000
3.00 7.20% 7.70% $738,000 $640,000 $98,000
3.50 7.36% 7.86% $770,000 $640,000 $130,000
4.00 6.72% 7.22% $786,000 $640,000 $146,000
4.50 6.08% 6.58% $722,000 $640,000 $82,000
5.00 $658,000 $640,000 $18,000
6.58%
× $20 million
2

A firm might enter into a swap contract in order to match its revenues and expenses. For example, if
it receives fixed-dollar revenues from a sales contract, it might prefer to match those fixed receipts
with fixed-dollar loan payments. If there is some impediment to their simply taking out a fixed-rate
loan, then a floating-rate loan plus a fixed-for-floating swap may be a good alternative.
One sort of “impediment” that might make this loan-plus-swap arrangement work is a relatively
high cost of borrowing in the fixed-rate market. For example, say our firm’s credit quality led
lenders to offer a floating rate of LIBOR + 50, or a fixed rate of 7%. If we use the initial LIBOR
rate from the problem, this implies choosing either a floating rate that starts at (5.44% + 0.50%) =
5.94%, or a fixed rate of 7%. Now, assume that a potential counterparty, with a different credit
profile, can borrow fixed at 6% or floating at LIBOR. They would like to borrow in the floating-
rate market. However, they note that they can borrow in the fixed-rate market 100 bp more
cheaply than our firm, and in the floating-rate market 50 bp more cheaply—they have a larger
relative advantage in the fixed-rate market. Say they borrow $20M at 6% then enter into a swap
with our firm. This swap calls for our firm to pay them 6.4%, and to receive (LIBOR + 30) in
return. (This is illustrated in the picture below.) Our firm therefore pays 6.4% to the swap
counterparty (receiving (LIBOR + 30) in return), plus (LIBOR + 50) to their lender. The net cost
is = (6.4% + 20 bp) = 6.6%, which is less than they would have paid had they simply borrowed in
the fixed-rate market at 7%. The counterparty gets 6.4% fixed payments from our firm, which is
sufficient to make its loan payments, with 40 bp left over. Its net cost, after paying the 6% on its
own loan, is [6.4% − 6% − (LIBOR + 30)]  LIBOR − 10, which is cheaper than they could
borrow in the floating-rate market. Everyone wins!
fixed: 6.4% SWAP

OUR FIRM COUNTERPARTY
net: 6.6% net: LIBOR-10

floating:
LIBOR+50
fixed : 6%
LIBOR +30
floating:
LENDER LENDER
In short, a firm may enter into a swap agreement because it has a relative advantage in one
borrowing market, but it wants to borrow in another. Borrowing in its relatively cheaper market,
then swapping into the cashflow type it really wants, may allow it a net benefit.

20-13. This question is very similar to 20-12. Thus, we won’t repeat our discussion from that problem.
The numbers work out like this:
Notional Principal = $ 20,000,000

8%
× $20 million
2
LIBOR + 100 bp
6-Month floating rate Floating Rate Fixed Rate Net Swap Cash Flow
Year LIBOR Rate on loan Coupon Coupon Fixed for Floating
(A) (B) (C ) (D) (E) (F)
- 6.80% 7.80%
0.50 7.20% 8.20% $780,000 $800,000 ($20,000)
1.00 8.00% 9.00% $820,000 $800,000 $20,000
1.50 7.40% 8.40% $900,000 $800,000 $100,000
2.00 7.80% 8.80% $840,000 $800,000 $40,000
2.50 8.60% 9.60% $880,000 $800,000 $80,000
3.00 9.00% 10.00% $960,000 $800,000 $160,000
3.50 9.20% 10.20% $1,000,000 $800,000 $200,000
4.00 8.40% 9.40% $1,020,000 $800,000 $220,000
4.50 7.60% 8.60% $940,000 $800,000 $140,000
5.00 $860,000 $800,000 $60,000
8.60%
× $20 million
2
Note that, once again, only for the first period is the fixed rate greater than the (LIBOR + 100)
floating rate; therefore, our fixed-for-floating firm receives cash inflows from the swap for all but
the first period.
(Please see the answer to question 20-12 for an answer to part (b).)

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Chapter 20

Corporate Risk Management

forward contract Long position in forward contract

$55 ($10) ($5) ($5)

©2011 Pearson Education, Inc. Publishing as Prentice Hall

$45 $20 $10 $10

forward contract Forward contracts are zero-sum games

$45 ($20) $20 $0

$10 $10 $10

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Gains and losses from hedging

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©2011 Pearson Education, Inc. Publishing as Prentice Hall

Long call with X = $50 and C = $5

stock price at option expiration

Long call with X = $55 and C = $6

stock price at option expiration

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Comparing the long call positions

stock price at option expiration

ST PAYOFF PROFIT PAYOFF PROFIT

©2011 Pearson Education, Inc. Publishing as Prentice Hall

Comparing the long call positions

stock price at option expiration

ST PAYOFF PROFIT PAYOFF PROFIT

©2011 Pearson Education, Inc. Publishing as Prentice Hall

Comparing the short call positions

stock price at option expiration

ST PAYOFF PROFIT PAYOFF PROFIT

©2011 Pearson Education, Inc. Publishing as Prentice Hall

Long put with X = $45 and P = $5

$40.00 maximim profit =

$20.00 profit from long put

maximum loss = put premium = $5

stock price at option expiration

©2011 Pearson Education, Inc. Publishing as Prentice Hall

Long put with X = $5 and P = $1

$1.00 break-even point =

stock price at option expiration

ST PAYOFF PROFIT PAYOFF PROFIT

$7 $0.00 ($1.00) $0.00 $1.00

($4.00) maximum loss = (exercise price - put premium) = $4

stock price at option expiration

©2011 Pearson Education, Inc. Publishing as Prentice Hall

We can summarize the intermediate steps this way:

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©2011 Pearson Education, Inc. Publishing as Prentice Hall

intrinsic value = $5.00

time value = $0.28

©2011 Pearson Education, Inc. Publishing as Prentice Hall

intrinsic value = $5.00

time value = $0.07

©2011 Pearson Education, Inc. Publishing as Prentice Hall

intrinsic value = $5.00

time value = $0.43

©2011 Pearson Education, Inc. Publishing as Prentice Hall

SWAP floating floating

Notional Principal = $ 20,000,000

©2011 Pearson Education, Inc. Publishing as Prentice Hall

fixed: 6.4% SWAP

net: 6.6% net: LIBOR-10

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Notional Principal = $ 20,000,000