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