7 Derivatives and Risk Management
7 Derivatives and Risk Management
Be Engaged
Look:
Think:
1. What will you feel when you do the same activity as the man who cross the rope on the cartoon above?
2. How important is balancing in this type of activity?
3. Do companies and firm do balance in trying times and circumstance? Cite real life examples.
Let’s Discuss
1. Risk management
2. Reasons to manage risk
3. Overview of derivatives
4. Options
5. Introduction to Option pricing models
• The Black-Scholes Option Pricing Model
6. Forwards and futures contracts
7. Other types of derivatives
8. Using derivatives to reduce risks
Risk management
• In business parlance, it involves identifying events that could have adverse financial consequences and taking
actions to prevent and/or mitigate the effects caused by those events
• Its scope has broadened to include responsibilities as controlling the costs of key inputs or protecting against
changes in interest rates or exchange rates through dealings in the interest rate or foreign exchange markets
Derivatives
Derivatives
• Securities whose values are determined by the market prices or interest rates of other assets.
• not used by corporations to raise funds but rather serve as a useful tool for managing certain aspects of the
firm’s risk.
derivative security
• or simply “Derivatives”
• A security that is neither debt nor equity but derives its value from an underlying asset that is often another
security
Natural Hedges
• Situations in which aggregate risk can be reduced by derivatives transactions between two parties known as
counterparties.
Options
• An instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price
on or before a set expiration date.
• probably the most popular type of derivative security.
• A standardized contract providing the right to buy or to sell an amount of the currency, at a particular price,
during a specified time period;
Options Markets
There are two ways of making options transactions:
• making a transaction through one of 20 or so call and put options dealers with the help of a stockbroker
• the organized options exchange.
Options Trading
• motive for purchasing call options
o the expectation that the market price of the underlying stock will rise by more than enough to cover the
cost of the option, thereby allowing the purchaser of the call to profit.
Riskless Hedge
• 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.
OPM Example
Given are the following:
Compute equation d1 and d2:
Futures Contract
• Standardized contracts offered on organized exchanges
• Similar to forward contract but less flexible because of standardization
• Can eliminate downside risk
• key differences with forward contract:
o Futures contracts are “marked to market” on a daily basis
that gains and losses are recorded, and money must be put up to cover losses. This greatly
reduces the risk of default that exists with forward contracts.
o Futures contracts are generally standardized while forward contracts are generally negotiated between
two parties and are not traded after they have been signed.
o Physical delivery of the underlying asset is never taken under futures contract i.e. the two parties simply
settle with cash for the difference between the contracted price and the actual price on the expiration
date.
Structured Notes
• A debt obligation derived from another debt obligation.
Inverse Floaters
• A note in which the interest rate paid moves counter to market
• if interest rates in the economy rose, the interest rate paid on an inverse floater would fall, lowering its cash
interest payments. At the same time, the discount rate used to value the inverse floater’s cash flows would rise
along with other rates.
• 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.
Futures
• used for both speculation and hedging.
a. Speculation
• involves betting on future price movements
• futures are used because of the leverage inherent in the contract.
b. Hedging
• done by a firm or an individual to protect against a price change that would negatively affect profits
• A hedge can be:
o long hedges
where futures contracts are bought in anticipation of price increases
o short hedges
firms or individuals sells futures contracts to guard against anticipated price declines
o natural hedge
If two parties have mirror-image risks, they can enter into a transaction that
eliminates risks
o Perfect Hedge
Any gains on the futures contracts would exactly offset losses.
In reality, it is virtually impossible to construct this type of hedge
Swaps
• effects of Standardized contracts for swaps
1. Standardized contracts decrease the effort involved in arranging swaps at the same time decrease
transactions costs; and
2. This led to a secondary market for swaps that will increase the liquidity and efficiency of the swaps
market
Derivatives
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/derivatives/
https://www.thestreet.com/investing/options/futures-vs-options-14781578
https://www.youtube.com/watch?v=3bPRN_GhHiY