Chapter 9

Risk Management and Derivatives Market

Risk

is a situation where an action or decision is uncertain shortly.

is unexpected to occur and is always present anywhere and everywhere.

An individual with extra savings may decide to invest in stocks or buy a brand new car. Whatever the
decision is, the individual is facing a certain level of risk.

Should he decided to invest in stocks, the investment made may not result in what is expected to be
because of the presence of risk.

Should he buy a brand new car, the risk of having an accident may cause further costs.

Two types of risks

Pure risk

• gives a threat to individuals, income, and assets or wealth.

• is also associated with every activity and responsibllty. includes fire, theft,or flood which may cause
loss of property or wealth.

• Illness, injury, or death, which can harm or destroy an individual's ability to earn a living, is also a risk.

Speculative risk

• includes financial risk, purchasing power risk, interest rate risk, market risk, and others.

• more on potential monetary losses or gains.

• Indlviduals, public and private corporatons normally take the chance to face this kind of risk in
exchange for receiving financial benefit.

Making either a personal or business decision without knowing its potential risk could lead to a disaster.

True that risk is an uncertainty in the future but somehow risk could be anticipated or prevented. And
because of this, risk has to be managed.

Risk Management

Risk management

is an organized process to deal with risk

helps to identlfy what are the potental risks st may have anatlye them and take neesary precautlonary
acloms to roduce the rtsk. Toacertain esteni, t helps to asure the attalnmentof the overal goals and
objectves

Risk management is indeed full of the connotatlon os concerns and apprehension. It carrics a lot of
unpleasant remtinders from nsurance agents and individuals to be cautious about everything and
anything on actlons and declsions to be made. However, risk management is absolutely a leap of faith
that helps an indtvidual or flrm to be ati peace in whatever decision t may [Link] helps to gain mote
power over future events that can changeaway from life Risk managementeven helps turn uncertainties
into an opportunlsy ifproperly identified and handled.

There are endless ways of applying risk management inthereal world It an be appld to medicine,
engineering, construction, real estate, înformation technology, and otker felis where consegquenceso
uncetainties are present However, in the wotld or finance,k becomes the hot seat of risk rmanagement.
Financial institutions which have been the center of numerous and economic downturns, being
vulnerable to fluctuations such as interest rate and foreign exchange, could have been avolded if better
risk managerment has been inplace before the ourrence.

According to Dan Borge, author of "The Book of Risk","The purpose of riskmanagement isto improve the
future, not to esplain the past" Dan Borge llstrated in his book hat different people have diffrent
approaches to handling risk management. He mentioned that some people adopt the attitude that wha
w ill be willbe - and simply react to evnts as they unfold. Thesepeople referred to by Dan Borge ust go
with the flow. On the other hand, Dan Borge mentioned that some people take a more onstructie
attitude, towand uncertainty, as in the case of scientists cientist belleves that much of life's uncertainty
is due to ignorance, which can be reduced by finding the truth. Scientists attack gnorance by applyinga
sclentific method that dependson logil,observable and repeatable erldence, nd the suspension of
fsodgment untll the evidence IS compeling. Dan Borge also mentloned that a risk mnanager has a
pragmatic attude toward uncertalnty: The future may be uncertain but it is not unimaginable and what I
do can shift the odds in my favor.

The Risk Management Process Thereare ive fundamental steps In the rtsk management process. The
stepsare . isk 1dentificatlon. First, determine what risks threaten the company. While some may seem
contrary to common sense. Identlficatton of rlsks may be accomplished

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in a variety of ways, although most meshode Imvctee cione Inepection of t actlvitles and responsibilittes
of the eomparry The firm mest he atle Mentify whtat are the potential risks they fate atborut to faces S
conluet the operstions The finance manager must he able to Imnmedlately Mdentify what are thene
risks and what arethe postible solutlon to avld such ricks. sor inetance, amanusacterer od the coffe
beans are imported from the U5,thecompatrg then needs dollats to F7 cofelnthe PMllptnesheevily reles
on tmponted coteboeans fremn thets soce offt belr dmportation. Nere,the hllyptine compamryis
exproned to foecicn eachangr risk. To avotld thts kind of risk, the Phillppine Commparry must agree with
another party that would not affect its cash flw because od a possble floctostiom of ts Jllars.

Unexpected events in the company such as acldents may also respltilnea los of property and ay involve
further loss I f lawsuits or other chaims transpise Property may be lost or damaged as a result of
fire,theft,windstorm, collisiom, or a wide variety of other causes The first step in the risk management
proces is thoroughly examining the situation and Identifying each of the risks that ae poible to occur.

Risk Evaluation. Once the risk have been identifiled, the firm must determine the relative potential of
each risk to cause loss. It should be able to eralzate both the probability of a loss occurring and the
financial impact the loss would have on the firm. The probability or possibility of loss varies according to
how the firm carefully conducts its oeration. The financial impact of a potential loss is difficulkt to
estimate, however, estimating the "best" "worst,"and "most likely* scenarios would help the firm before
deciding on what should be one.
Considerations to Deal with Risk. Next, the firm should carefuly examine the various ways to dealwith
risks and the pros and cons of each method. The potential costs and benefits of each of the following
methods should be considered.

Avoidance of [Link] firm does not have to faceall potenthal risks The firm can avold risk completely by
avolding the actvity that ocasions the risk or by not assurning a responsibility that involves the potential
for loss.

b Loss Prevention and Control. Practicallysome rtsks canot be avokded and the firm may wish to engage
in certain acttvities that involve rilsk xamntine the risks In these situations to determlne if something can
be done to lessen the probabllty or the extent ofthe loss

Retention of Rlsk. When avoldance of risk Is not possile and when Josses cannot becompletely
prevented, the risk can be rstalned or it can be transferres to another party. Risks are usually retalned
when it ls not posble to transfer

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the rlsk to another party that It ts now worth the trouble. Rlsk fnvolves such a remote possibiltsy that
causes Ittle or no concern or the risks ate commonlace and Involve expected eosts or losses that are
normally faced by the firm through the budgettng process can be retained.

d Transfer of RIsk, Risks that cannot be adequately đealr wih bry avoldance, loss prevention, and control,
or retentlon should be transferred to another party if possible. Transfer of risk may be accompIshed by
cotrat, by reponslbltiles of the firm to another patty, or by use of a spclal contract-the Insurance
contract -to transfer the cost of losses to an Insurance company. All of these risk transfer methods
Involve cots that the othfr risktreatment methods do not. Thoe sale and lease-back of property normally
cost more than outright ownership. cost ts also incurred when you want thỹ added responsibility
whthout compenstion for therisk rvoplved Inall, the Insurance contract involves the payment of a
charge, called premium, in exchange for he fnsurance company agreing to pay for oses that Occur. Alt
hough insurance always Involves a cost,it s the most widely used method to transfer risks not dealt with
through avoldance, loss prevention, control, or retention.

5. J entify the Bes Method to Deal with the Rlsk. ach risk should be dealt within a fashion that minimizes
the potentlal cost of loses and provides freedomn from worry and concern over the rlsk o somne extent,
all risk treatment methods involve a cost or compromise on the part of the firm. Each decision involves
both objective and subjective judgments that lead to a unique choice to fit the particular sitwation and
needs of the ompany.

6. Periodic Re-evalwation,. All risk management plans must be re-evaluated and reconsidered
perlodiealy. elng risks are uncertain In the future and they vany from time to time They, therefore, need
a careful assessment and re-evaluation Possible answers to rtsk problemnsalfer from tine to timne and it
neds careful se- evaluation ln aninstancefchangelnenvlronmentand event or instance,forlgn exchange,
interest rates, ollprles, poltes, credit risk, events in other countries, and many more are somseofthe
factors that need to be carefull studled on what ar not look onlyat its present condition but also
forward-looking at lts possible effects the posible effects on the firm's operations from period to period.
The firm c does on the operations of the firm.

Risk management as in the previous discussions varles in different disciplines. However, in this chapter,
the focus of the discussion ls on ffnanclal risk management and therefore dlscusses, possible ways how
to avold isk through derivatives.

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Derivatives
meery stabtshment, the funetton ot the fliane manager le ta look tor poetle unrs of fumds and
mnakesuse of threse funds to thoeltm'a advantage. Pinance managers anest the twmds in profects that
hel the lim be pefxtsthatmaximle, profts amd makethebestuse more protablte. It trvolves seleetng
[Link], Nomsescanfumndprofectsbyusmng wtertll Rreoereted
ondethrogiesanecdesnthogs As mentioned, It ls: seen that the tesponstholltes ofthe flnance manager
are of a great aat te the company. Likewlse, the (lnance tanager has to enure that potenttat econemnte
fAxtunations tn the ftrm's ftunds ate nothecatened. Atthis polnt, to help/inancemanagers avold such
llucttatlons, a vasrlety of tolskown, ascerivativrs, and helpmanage the rlsk of such events oceurtng. A
dertvattve ls a contract agreement whose alve epends uopo the prle of oe (urnderlysng scwrlty or
omodity

There-are four tmportant klnds of derlvatlves,they are: Forward contract Future contrac * Opttons a
PutoptIom b. Clloptton 4 Swaps.

Forward Contract

A forward contract Is a stmple derlvatlve Instrument as compared to futures, options, andswaps. A

forward contract Is a contractual agreement made by two partles. One party *gres to buya commodity
or a financtal asset on a date In the future at aflxed price.0on the ebre sdeof the contrac,the selle
agresto dlverthe commoltyor the lnancdal aet *e nroiared directl boetween them, the ers and
condltlons of the contract can be inthe future at a fixed price as agreed wlth the buyer. SInce the partles
In a forward contract reaches the specifled date.A forward contrac s not normally traded tn a formal
exchange Gasomlzed. oth partles in a forward contra are obled to lilthe comtras by the tlme commodity
or financlal ascet. The other party assumes ashort paslon and agreres to One of the partes to a forward
ontraict assumes along poston and agres to buy sll the Bhecommodlty or financlal asset. contractis
agreed upon, the dltvery prlce ls chosen sot hat for both pattles the valu ofehr The speIfled prlcein a
forward contract Is the deltvery prlce. At the tlme the forwar

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contratis era Howeve, the valo of the forward contrac would be dependent on the prilce of the asset
inthe marketon ts maturity date Arthe time the contract was entered into, the value of the contract s
zero but It changes over time resulting again In one of the parties and a loss to another party depending
on the movements fn th prie of the Commodit ot financial asset. A forward contract is settled at a flxed
date in the future as agreed by the parties. The seller [Link] the commodity ort inanclal asset to the
buyer in return for the cash amount equivalent to the delivery price.

A forward cootrast sa ero game The galnof one party ls a loss to another party. For instance,after the
parties agreed to forward the contract fthe price of the commodty or flnanclal asset iacreases by the
timethe contractmatures,the long posltiomn galns and tha short position losses. A risk associated with
the type of derlvative ls that one of the partles maynot able to fulfillits obligation.

At the time the contract is entered into a forward contract, the forward price is equal to the dellvery
[Link], as time passes by, the forward pricechangeswhilethe delivery pric remains to be the
sarne at the tine the ontractivas entered In general,the forward price at any given tirne varies with the
maturity of the contract under consideration; that ts, a forward contract to bury or sella comnmodity or
financial asset in three months is different from a forward contrac to buy or sell a commod ity or
financial asset in six months or nine

Example

Consider the Spot and Forward Foreign Exchange Quotes on Dollars, Decernber 31,2023

Spot 42.1550 30-dayforward 423550 6o-day forward 42,5000 90-day forward 42.6998

On December 31, 2021, a company enters into a long forward contract to buy $1,00,000 @P26998 per
aUss in 90 days. This contract obliges the cmpany to pay P42,699,800 10 buy $1000,000 in 8 days. On
March 30, 202, the exchange rate IS P427SAUsS. By the contract terns, the company wil only pary
P42,699,80 and wil recelve $,00,000 desphte profits P50,200 (P4,2,750,000-P4,3,669,800) since the
dollars Can immedlately be sold for anincrease In the value of dollars gainsthe [Link] company that
took the long postion lost 50,200because the crmpany soblgated to sellthe dollarsat P4.2.6 Insteadof
P42J5 P42,750,000 in thẹ spot market. On the: other hand, the party that ook the short pasition

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Futures contract

Similar to a forward contract,it ls an agreement between two partles to buy or sell a smmoilyor financla|
assetin thes future at a flved prie. Unlike forwandontrsts, futures Contracts are traded through an
organized snd regulated exchange rather than belng regotiated directl betwen two partles. One party to
a contractis oblged to elver the tomnmodity or financlal asset on a date or wlth a range of dates ata
speclfed price an the other party is oblged to pay for the dellvery of the commodityor financlalasets.t.
afstures contract, the partles to a contract do not necesarly be made In prvate or to known parties. The
exchange provldes system that glves the buyer and the seler a Guarantee that the contract wl be
consurmmated. The delvery of the commodity or

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trader who made a transacton with the futures broker by buying a long pos tion, and selling financlal
asetls guaramtend bh theelearinghous assofated wth thefatures exchange. A as a shortposition.
thlkewthaforward contract, the trader's postlor Is adjusted dally. the ctlivey monch and the eschange
specifhes the delvery perlod during the month Ffor a fotures contraet, the exact dellvery date isnot
specified. However, the contractspeifis, commodites entered in a futures contract, the holder of thre
short-position has been Biven the right to choose the date to deltverthe commodity or
fInancalassetaslongas tlswthla the delivery month.

Futures contractwth seseraldelvery [Link] futures eschange that

ditermfnes the amount of the conmodity and the imits om the amount b ot financlal asset to be
dellvered for one ontract, how the priceof the futures are quoted, which the futures prie moves in any
one day. However, for commodities under the futures contract, the futures exchange also, specifies the
quality fnhe product and the locatiom of the [Link] example, ofcemnanufacturerentered into a
futurec contractin exchange The forures contrasct entails the delivery of 1,00 sascks of ofie beans The
contract ol entered is to deti- the oommoditu for three months (anuary, March, and May) and s
available for 12 months into the future. The fatures exchange wll: spetfy thea quality of the coffee beans
to be delivered and the places where the coffee beans are to be delivered.

To transact in futures contract,the buyer does not haveto pay for the entire amount of the cntrast;
rather, the buyer has to put up an initial margin as a security deposit. The futures exchange is the one to
set up the minimum margin reguirement. Since the futurs contractis marked to market, the value of
whlch Is checked at the end of the day, andany decline in the ralse of the contract s immediately
deducted from the margin accoun, However, the buyer of the contracthas to add moremoney to the
margin asount onethe futures contract falls below the mlnimum margin requirement.

Classes of Futures Contract

in general, there are two classes of futures contracts. They are:

Commadity futures It is an agreement to buy or sella corrodty at a particular date In the future at a
particular price, FExamples of commoditiles traded in the futures exctangeasremeat,whical, ungar,
orange, cofe,cocos, sogar,pol, ssolins, coston,gold,sller,and copper.

Buyers and selrsof commoditles use futures contracts to peg the prlce of the commodity they are buying
or selling which wiltake place inthe future." There are fotecasts regarding the price movement and they
bllve that thls would greatly two parties in the contract the buyer and the slet The partles have dlfreat
affect thetr cash flow and profitablty. The seller of the commodity use futures to

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wck inthe seling price agreced upon desplte a decese In pricelnthe [Link] the buyer locks in the
buylng ptIce dlespite an InceaseIn prlce In the future.

1tthepticeothre undetlytng commodty Increases,thebuyer ofthe futurescontract buys the at a lower prlc
and then akes peo by selling, the conmoldlty at the current prisce. On the other hand,the seller of
thefutures eontract hasto sellthe commodty at a lower ptice as agreedupon with the buryer. Looking a
the other side, If the prtce poes down, the seller ofthe futures makes mnoneybý burving the
comampolity at a lower market prle,and sllng It to the buyer of the futuresat an agreed price.

for instance, on January 202, farmer expectlng to Produce 1,000 sacks of cffe beans by july If the farmers
break-even polnt on a sack of nffoe beanstsP100 per sack and the arner sees thaton July9,2021, the
futurescontract for cofe beans Is Cuently priced at PI50 per sack, It rmlght better off for the farner to
lock In the P120 sales priceper sack.

On July 1, 2021, regardless of price, the farmer dellvers the 1,000 sacks of coffee beans and recelves
P150,000(1,000 x P150). Thls prlce ls locked in. But unless coffe beans are priced at P150 per sack n the
spot market that day, the farmer has elither received less than he could have or more Ifcoffe beans were
prlced at P3o per sack, the farmer recelves a P20 per sick benefit from hedging or P20,000. Likewise, if
the coffe beans were priced at P170 per sack, the farmer lost the opportunity to have anadditional profit
of 20 per sack

Financial Futures. It is a contract to buy or to sell a specific financial instrument at aspecified price in the
future. Examples of financlal futures are treasury bilsans bonds, notes, certificates of deposits, stock
indexes, and foreign currencles,. Compared to commodity futures, the flinanclal future s also used bythe
buyer and seller to avofld the risk of 1osing the valueof helr financlal [Link] value on
the nterest rate or foreign exchange lin hemarket besause of its inheren is alittle blt complicated,
especlally for financial Instruments that rely on thelr Characteristics where the narket yalue of the
ontracts moves In an oposite direction. Let us say treasury bonds The yva|ue or the bonds changes
when the interest rate n the market Increases or decreases. When the Interest rate gos up, the value of
the bonds decreases On the other hand, when the prevalling Interest fate gos down,the valueofthe
bonds Increaes nlike commodlty futures, t has adirectrelaionship. Thus, when the prlcels above
thepriceagreed upon,the buyer of the futures wilbenefit, and the seller of the utures lose.

For example, FLT Corporaton would like t bulld anew manufacturtng plant ata costof P50 millin. To
flnance the manufactur tng plant, the corporation will sue

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a 10-year bond that carries an interest rate of 8% 1f tssued today However, based on thelr 5-year
strategicplan, tt wil be bullt after a year .The problem posed by thls ls that the Board o Directors s
expecting that the interest rate will go up in a year because of an Increasing Inflatlon rate. And 1f they
walted or a year,the Board of Directors may be correct and thiecompany will have to pay a higher
Interest .On the other hand,tr bonds are Issued now, they have to pay the Interest or 8%for the money
they need in a year. Or, Issued the bonds todat, and placed them ln short- term security that would
givea lower returnthan8% anduse them after ayet.

To answer the roblem faed by FLF Corporatlon, the corporatlon has to buy a 1. year Treasury Note (T-
note) Interest rate future. Financlal futures are based ona Nypothctical 0-year T-mote with a 6% seml-
annual coupon, I[ the nterest rate ln the rmarket goes up, the valuę of he hypothetical T-note will go
down and if the Interest rate goes down, the value ofthe hypothetical T-note will o up.-Therefore, the
corpfration an sell 10-year r-note future whlch will be dellvered Ina yeart hedge its position. Should the
nterest rate goes up, the corporation has to pay more than s% for its isved bond. However, thr
corporation earns son its future position for slling the T-note ata higher price when the interest rate ls
lower. On the other hand, if the interest rates go down, the corporation will pay a lower interest rate for
its issued bond but loseits futue positlon.

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Options. Anoption is a contract by which the burer of an option pay the seller a premlum for the right to
beuy or sel, but not the obligation,s specific mdertying act ataspectie peta specifle future [Link]
underlying asets ncluode stocks, stock Indices, foreign curtacles, debt instruments, commoldites, and
futures contracts. The price in the option contract ls knOwn as the: exerctse prioe or the strike price; the
date In the contrac Es known as the espiration date, esercise date, ormaturty rdate, options started ir an
or ganized exchangr in 1973 and now gaining popularity all over the world, A huge aroune 2 optlons are
now traded over thecounter among financial finstitutions,

There are two kind of options: the American optlon and ther oher one is European American optlons can
be exercised at any tlmne up to the exniration date. Ualke Europen options, it is exercesed on its
expiration date (Holl, 199s) American option has a greater nurbes of tranactions as compared to the
Furopean option in an exchange-traded in the world despite being more complex than the Eiropean
optio(Chisholm,300), Howere, ove-the- counter options areften European, becsuse the buyers do no
wan to puy more premtums for the ability to buy or sell before the option expires. ome of the properties
of the American options care fromn European options.
In options as Compared to futures and forward contracts,the holder of the optian contrect sives the
right to buy or slthe underlying aset. The holder does not have to exercise his right to buy or selifthe
moverent of the price of the underlying asset went unfavorable to the holder of the option. Whereas
the holder of a future or forward contractis obliged to buy or sellth underlying asset. However,
oncentered into an option contrac, a cost is charged in the fotm of a premium whlch is none as
compared to future and forward contracts. An individual who owns the underlying asset which is also
the subject of th option is Called a covered option while an option not backed up by an underlying asset
s called the [Link] there are two types of options, one s the calloption and the other is
the put opt option.

To simplfy the dlscusson ofoptlon , llthe exercses wil be in the European option

CalOption

Itglves the holder the right to buy the underlylng asset at a certaln price or execis price orstihe prlce
within epelile pertlod f ti an Aamerican opton,lt anbe exercised on or brefore the expiratfon date. While
Iflt sa Ffuropean optlon,It an be exercised on it expiration date. A call optfo IS bought ir therea an
expectation that the porice of thte underlying assetlsexpectod to lncresemore than the esercise price.
Hlowever, on the part of theseller of the call opton 1s called the optlon [Link] sellrof the calloption
expects that theesercdseprlce s Mgherthan theprice of the underlyIng asset by the tlme it expires

stanhexerciseprilelsmote calloptonand a shortcalloptlon s selingthe calloptlon. than the curent stock

price, acalloptlon Is sal to be out- In the money '(Brtgham and1touston,20t4). t-the-money. when the
exercdaeprlcels below the aurrent priee of tre stosk, the optlon ks

Forexample tf an investor buys a Furopean calloptton on WEB stock withan expiratlon aseof janary
31,2021and with an execiseprkce of r700 per [Link] lowvestor has the right to buy, the stock at P700
per share o Janoaty 31,[Link] dos ned nol o sercise theclloptlon belng glven only therlgbt to
bluy the stock Thehnrvestor wl ay exercise his right to buy If the prlce of the stock increases tnore than
the ezercise price om Januarv 3, 202. The proflt obtalned from exescistng the cl optlon 1s the dilference
terweethe price of th stok on thee explratlon date and the exercdse price lessthe premnfum paid on tho
elloptiom. However, If the price of the stock Is less than the exerdse price, the investor rwilllet the
caloptlon expire since exercising hls right to buy ls no longer profitable, Wbcther an investor ererciseror
not is rpgh tobwyche stock, spremfurm has toboepald or theroption.

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cPut Option

Itgives the holder the right to sell the underiying asset by a certain date for a certain price. The buyer of
the put option is expecting that the price of the underlying asset w ill o dowm shortly. t is normally one
by locking in a certain price in the fature that will secure the selling price of the underlying asset. If a
farmer who is expecting to harvest his farm pofoced insix months but he also expectsthat the price of
the armproduced wil decrese ithe Same time, he woulds enter iInto a contractto buy a put option gtving
him the risht t sell the farm Produced ata higher price However, f the price of farm prodwuced goes
Nigler than he exercise price, the buyer o the put opton I letheput option epire on 'sexpiration date. Jus
like the buyer of the call option, the buyer of a put option has to ay fa the optfon prem lum of hls farm
produced. ust ikethe Call ption,a put option moy "her bebought or sold

For example...

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To summartze options, there are four baslc option positions, they are T A long positlon Iin a European
calloption is mas ,- ,o 2 A short position in a European calloption is-max(S,-X, 0), 3 1ong position in a
European put option is max(x-Sp 0). b A short position in a uropean put Option-mar (x -s 0).

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fectors that Affect the Option Price

The changing option prices for call nd put re fficted bythe ollowtng

Stock Price
Call [Link] thepriceof thestock ncreases,the vale the callopton lncresses becuse of the gatn potential
of buying the stock at tstrikeprke andslng the stock ata hiagher price.-The chance of galnlng ofsets the
lospotenthl.

Put Optlion. As the priceofthe stockdecreases thevalsef the putoption ncrses As the ralue of the stock
decreases the buyer of the put optlon has a bettfr poltion to exercise the right to sl t has a better
chaunce of gaining and whas to be compensated by a higher price of the optlon

Strike Price

Callptfon. As the strike price lacreses, dre o he oplion dectases the chanse o exercising the right to buy
becomes smaller. Thws, the dlferee lostng ls getting higher and has to be reflected through a declining
calloptm between the stock price and th tieprlses ntrowrandtherefore thechanget

Po Opton. As the stxile Ptice Increases, the value of the option increases If the stike price is
gettinghigherthan thestockprice, the chance of exercising the right to sell salso higher, Because
ofthls,the putoption becomes higher.

Pertod

Caloption. the expfraton period is longer, it ha a bigger chance that the stock pricernay increase
sharplyabovethe exercise price. For thls reason, the price of the optiom ish ghes.

Put Option. Just like the all pton, / haexpiraton period is longer,it has a high probabillty chat the priceo
the stock wil go lower than the exercise [Link] f the stock price foes lower, the buyer of thẹ put
option has a higher chance to exercise the right to sell Thus, the put option is higher.

Binomial Option Pricing of a Hedged Position

An individual who bought stocks is facing the probability of having the price go upor to go down. No
matter how autious an individualis in choosing the right stock to buy, it may result in whatever is
unexpected. To avoid this ocuence, the indivldual may own two related financial asset - a stock and a
call option on the same stock. In this way, the individual may set up a risk-free hedged position. A risk-
free hedged position is a hedge where the buyer of the stocks simultaneously shors a calloption on the
same stock In this way, whatever s the price moverment of the stock, will be offset by the shor call
option. To Nlustrate this oncept, let us assume that APM, In. bought stocks of SSI. The firm is afraid to
incur a loss sfthe priceof the stock wll ove against the firm's expectations To avold such ocurrences, the
firm may sell acalopton simultaneously with the stocks If the priceof the stock goes up,the lrm wil an on
the upward movement of the price but loseon sling the aloptlon beausethe buyer th ecllopton
willexercise theright to buy at the lower price. However,lf the priceo the stock goes down,the firm losses
on th price moverent of thestock butearnsfrom sllig the calloptlon, and the buyer of the al optfon will It
exercsethe lght to buy.,Based on thellwstration, Individuals can set up riskesfreposition by holding two
flnanchal asts, Regardlessof how the stock price wilk behave,the value ofthe portfllowould bethe sarne,
Insert pics and discussions

Black-Scholes Option Model

The Black-Scholes model was developed by Fischer Black and Myron Scholes in 1973 to ralbe European
options. t is widely used by options traders around the world for being simple. The model was
constructed by Black and Scholes to create a riskless portfolio that consists of non-dividend-paying
stock. To remain risk-free, the hedged portfolio has to be rebalanced continuously

In their article "The Pricing of Options and Corporate Llabilities", they can develop a Precise model to
determine the equilibrium of the value of an option, They were able to observe that the concepts of
pricing an option can also be 'sed to value other contingent caims. The Black-Scholes model plays an
important role In valulng contingent claims and Kentifying overvalued and undervalued options In the
market.

The Black-Scholes model used the following, assumptions In computing the value ofthe option:

Onty European options are consldered. That ls, It can only be exercised at the expiration date

37

S 6.6-7.7

2. herets o transactlon cos tin auying and slling both the stockand options. The market ts efficlent, The
short- -term interest rate Is knowm and constant througpho the 1fe of the [Link] borrower and
lender use the shott-tetm Interest rate. The underlying stock does not pay dltvidends 6, No estrictions
on short-selling and the short-seller Imrnediately receive the proceeds of the security sold. 7 The
probability estribution of stock returns is normal and iS distributed with constant variance.

Insert pics and discussions here

Swap
A swapis an agrement between two partles to exchange a series ofcash fows In the haure A swap
market is an over-the- counter dea makilng It rlskythat one of the partls aight default in fulfllig ts
oblgations swrap contractsare custonleed by the specinc Beeds of the parties. In general, swaps are
used to manage risk about the Interest rate, currency rate, equity returmn, or commodity price. In this
type of derivative, one of the Nries agres to pay the other party a cash low equal to a predetermined
fixed rate on a notional 1principal for several years. At the same time, the other party agres to pay at a
fating ate on the same notional prinelpal for the same perlod. A typical example of this kind of
derivattve is when one company issued bonds to raise capltal to finance its Iovestment. The bondholder,
being an Investor, espects payment of interest at regular [Link] the interest rate pegs on the
lssuance of bonds s a loating ate, and the lssuing company cannot give an assurancetofull ther obligatton
due to fluctuating nterest rate, teissuer may enter into an interest swap agreement to lock n its interest
expense. To lock Ihthe nterestexpense,the suer of the bond may pay or swapaflxed interest payment for
wnother payment that Is tled to the level of the Interest [Link] effect, ifthe floating interest rate on the
bonds Increases, its Cash low som the swop agreenent wllalsosIbcrese ofibetingits interest rate
exposure,

The term lengthfor buyers and shor for sellers are the common term used for forwards, the futures, and
opfons. However, for swap contracts, terms long and short are not used. The prefered terms used are
the lating-(varlable ratepayer and the lxed-ratepoyer ina sap, the floting-rate payer is the one who buys
and the flxed-rate1 pager lsthe one who wells.

have multiple Payments, which means payments are mnade In [Link] the time a swap Technically, a
swap may have a single paymnent. However, most of the swaps traded contract has bese entered, the
swap has Zero Thls ls true In all types of swaps except for currency swaps that pay the notlonal principal
to he other party, but th amounts eachangedare equlvalent In a currency swap, the currencles are In
two different currenctee

CS C

Tisantial Warkets

Each date where- one of the parties makes payments is called the settlement date (also known as the
payment date). The time between settlement Payment dates Is called the settlement pertod. On a gtven
settlement date, the floating rate payer wll make payment to the fixed ratepayer. in return, the fised-
rate payer also makes payment to the floating Tatepayer. The parties in a swap typlcallyagree to
exchange only for the net amount owed by one party to another party. This practice in a swap contract
is called netting. It ls very rare to see that an exchange wtp take place between two partles. The
expiration date of a swap contract is called the termination date
Several leading futures exchanges created futures contracts on swaps. The contract allows the
participants to hedge and speculate o" the rates that witt reign in the swap market in the future.

London Interbank Offer Rate (LIBOR)

The floating rate in many interest rate swap agreements is the London Interbank Offer Rate (LIBOR). The
L1BOR is the interest rate offered by banks on deposits from other banks in Eurocurrency markets.
LIBOR rates are determined by trading among banks and it continuously changes as the economic
conditions also hange. The LIBOR is considered a prime rate or reference rate of interest to be charged
for floating-rate loans in the domestic financial market. At times, the LIBOR is also used as a reference
rate for loans in the international market.

Interest Rate Swap

The most common interest rate swap is plain vanilla. It is the exchange of a fixed-rate loan for a floating
rate loan. The life of the swap can range from 2 years to over 15 years.

The reason for this exchange is to take benefit of comparative advantage. Some companies may have a
comparative advantage in fixed-rate markets,while other companies have a comparative advantage in
floating rate markets. When companies borrow, they look for a lower costof borrowing, However, this
may lead to a company borrowing flxed whenit wants floating or borrowing floating when t wants to be
fixed. This is where a swap comes in A swap has the effect of transforming a flxed-rate loan into a
floating rate loan or vice versa,

Insert the cut examples here

Users of Derivatives

1 ealers. Big banks and security houses have dealers whose derivattve contracts are sold and bought. For
large f inancial institutions that operate derivative transactions isa highly specialized affair. They hire
highly skilled people to tallk to the clients to discuss things about their needs. The experts help to bring
together all possible solutions to meet the client's requirements by comblning forwards, futures, swaps,
and options. RIsk assoclated faced by the flirm offering the customized product using derivatives are
managed by the traders. On the other hand, the risk manager takes care of the overall level of risk. I
necessary, the quants analyst as called by investment houses Is a device the tools to prlce new products.
2 Speculators. These are people or firms who wish to take a position in a market. Practically, they are
betting whether the price of the commoditles and financial assets in the key market wll go up or will go
down. The key market varlables are the interest rate, stock market indices, and currency exchange rates.
Forward contracts, for instance, are used for speculation A speculator yho thinks thatthe dollars
wllappreclate about peso can speculate bytaklng a long Postion in a forward contract on dollars. f the
speculator belleves that the price of the dollars

fiaascidt Rertets

in 90 days 1s P45 10 1 dollar and the forward price in days ls P43 to a [Link] & speculatot made an
easy proflt bry bouying the dollars at P43 per dollar and: selllngit at P45

There E difference between speculating using torward rnarkets and speculating, by burying the
underlying asset In the spot market (Hull, 1977. Buying, the underlying asset in the spot market requlres
immedlate payment to the total value of the underlying asset bought. However, under the forward
contract, the underlying asset does not require any payment not until the forward contract [Link]
effect, It only shows that speculating forward markets prorides more leverage than speculating using the
spot market. 'The option ls also used to speculate.

, Aarbltrageurs. These people are in business to take advantage of the dlscrepancy in pricing between
two different markets. Arbitrage ls a way to produce a profit that ls risk-free due to mlspricing of the
commodity or financlal asset Before, there were two stock exchanges in the Phlippines. One Is located in
Manlla and the other one Is in Makati. If one stock, let's say, ACR Is traded on Manlla Stock Exchange at
P230 per share and the same stock 1s also traded on Makati Stock Exchange at P2.50, what the
arbltrageur willdo s buy ACR at P230 per share on Manlla Stock Exchange and sell t at Makat1 Stock
exchange at P2.50. The arbltrageur from thls transactlon, generated a profit of Po.20 per share