CHAPTER 18
Derivatives and Risk
Management
Derivatives: Forward, futures,
options
Put call parity, Black Scholes
Formula
Other derivatives: swaps, rights,
warrants
Hedging with derivatives
18-1
What is a derivative?
A derivative is a financial
contract between two parties to
transact an asset at a fixed price
at a future date.
It derives value from other assets
or events.
18-2
Definitions
Buyer: one who buys the derivative.
Writer: one who sells the derivative.
Long position: the position of the
buyer.
Short position: the position of the
writer.
Expiry date: the date when cash
flows would be exchanged.
18-3
Definitions
Underlying asset: the asset to be
transacted.
Strike price (or exercise price): the
transaction price of the underlying
asset at the expiry date.
Counter parties: the opposite
party in the derivative contract
18-4
The Forward Contract
A financial contract which allows
the buyer to buy a specific asset
at a specific price on a specific
future date.
The seller has to sell to the buyer
that asset at that price and at
that future date.
Delivery date: expiry date.
18-5
The Forward Contract
Payof
Payof:
the
profit
brought
about
by the
contrac
t.
18-6
The Forward Contract
Payof
Payof:
the
profit
brought
about
by the
contrac
t.
18-7
The Futures Contract
Similar to forward contracts
Specifications standardized:
underlying asset, contract size,
expiry date.
Traded in exchanges
Many types: e.g. commodity,
interest rates, equity, FX etc.
18-8
Features of Futures
Contract
Margin account:
Initial margin
Maintenance margin
Margin call
Mark to market:
Delivery price is updated at the end
of every trading day
Gains and losses are updated into
margin account.
18-9
What is an option?
A contract that gives its holder the
right, but not the obligation, to
buy (or sell) an asset at some
predetermined price within a
specified period of time.
Its important to remember:
It does not obligate its owner to take
action.
It merely gives the owner the right to
18-10
buy or sell an asset.
Option terminology
Call option an option to buy a specified
number of shares of a security within
some future period.
Put option an option to sell a specified
number of shares of a security within
some future period.
Exercise (or strike) price the price stated
in the option contract at which the
security can be bought or sold.
Option price option contracts market
price.
18-11
Option terminology (cont)
Expiration date the date the option matures.
Exercise value the value of an option if it
were exercised today (Current stock price Strike price).
In-the-money call a call option whose
exercise price is less than the current price of
the underlying stock.
Out-of-the-money call a call option whose
exercise price exceeds the current stock price.
18-12
The Call Option Payof
(long position)
18-13
The Call Option Payof
(short position)
18-14
Determining option
exercise value and option
premium
Stock
Strike
Exercis Option Option
price
price
e value
price
premiu
m
$25.00
$25.00
$0.00
3.00
3.00
30.00
25.00
5.00
7.50
2.50
35.00
25.00
10.00
12.00
2.00
40.00
25.00
15.00
16.50
1.50
45.00
25.00
20.00
21.00
1.00
50.00
25.00
25.00
25.50
0.50
18-15
Call Option Intrinsic Value
and Time Value
Intrinsic Value: the value of the call
option if exercised now
Time value (or premium): the
diference between the value of
the call option and the intrinsic
value
18-16
Call Option Intrinsic Value
and Time Value
18-17
Relationship of Call Value
with other Factors
Factor Change: An increase in
Call Value
Change
Relationship
spot price of the underlying asset
Increase
Positive
time to expiry date
Increase
Positive
strike price
Decrease
Negative
risk-free interest rate
Increase
Positive
the return volatility of the
underlying asset
Increase
Positive
18-18
The Put Option Payof
(long position)
18-19
The Put Option Payof
(short position)
18-20
Relationship of Put Value
with other Factors
Factor Change: An increase in
Call Value
Change
Relationship
spot price of the underlying asset
Decrease
Negative
time to expiry date
Increase
Positive
strike price
Increase
Positive
risk-free interest rate
Decrease
Negative
the return volatility of the
underlying asset
Increase
Positive
18-21
Put Call Parity
Relates the call price and the put
price with the strike price and the
spot price
P = K exp(-rT ) - S + C
Arbitrage opportunities exist if put
and call prices violate the
relationship
18-22
The Black-Scholes option
pricing model
2
T
ln(S/K) rRF
2
d1
T
d 2 d1 - T
C S[N(d1 )] - Ke
P Ke
- rRF T
- rRF T
[N(d 2 )]
[N(-d 2 )] - S[N(-d1 )]
18-23
Use the B-S OPM to find the option
value of a call option with S = $27, K
= $25,
rRF = 6%, T = 0.5 years, and 2 =
ln($27/$25
) [(0.06 0.11 )] (0.5)
0.11.
2
d1
(0.3317)(0
.7071)
0.5736
d2 0.5736- (0.3317)(0
.7071) 0.3391
From AppendixC in the textbook
N(d1 ) N(0.5736) 0.5000 0.2168 0.7168
N(d2 ) N(0.3391) 0.5000 0.1327 0.6327
18-24
Solving for option value
C S[N(d1 )] - Ke
-rRF T
[N(d 2 )]
C $27[0.7168] - $25e
C $4.0036
-(0.06)(0.5)
[0.6327]
18-25
Swaps
The exchange of cash payment obligations
between two parties, usually because each
party prefers the terms of the others debt
contract.
An interest rate swap is a financial
contract based on a notional amount,
whereby the buyer of the contract pays a
fixed interest based on the notional
amount periodically to the seller, and the
seller of the contract pays a floating rate
interest based on the same notional
amount periodically to the buyer.
18-26
Other Types of Derivatives
Rights and Warrants: like call
options allowing the holder to buy
stocks at a strike price.
The Shares as a Call Option: shares
have a limited liability, hence it is
like a call option.
18-27
The Need to Hedge
Better debt capacity and cost.
Smoother budget funding.
Reduced cases of extreme
financially-poor performance.
Better comparative advantage
in hedging.
Beneficial tax efects.
18-28
An Approach to Risk
Management
Identify the situations when the firm would
make a lossquantify the loss.
Find a hedging instrument that rewards when
the loss-making situations occurquantify the
rewards.
Compute the satisfactory quantity of hedging
instrument to purchase.
Purchase the satisfactory quantity of the
hedging instrument.
Monitor the cash flows necessary to maintain
the hedge.
18-29
Why Derivatives are Good Hedging
and Speculating Instruments
Good speculating instrument:
built in leverage magnifies
investment risk and return.
Good hedging instrument: built in
leverage allows little overhead
cost to get into hedge position.
18-30