Topic 7: Derivatives and Risk Management

Topic Learning Outcomes

After this topic, you should be able to:
1. Discuss risk management.
2. Define and demonstrate an understanding of derivatives and their uses.
3. Define options and discuss the option pricing models.
4. Identify and describe the basic features of futures and forwards
5. Discuss calls and puts, options markets, options trading, the role of call and put options in fund raising and
hedging foreign currency exposures with options.

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

Why manage risk?

1. Debt capacity.
• Risk management can reduce the volatility of cash flows, and decreases the probability of bankruptcy.
2. Maintaining the optimal capital budget over time.
• By smoothing out the cash flows, risk management can alleviate the problem when internal cash flows are
low to support the optimal capital budget. These low cash flows are causing firms to slow investment below
the optimal rate or to incur the high costs associated with external equity.
3. Financial distress.
• Risk management can reduce the likelihood of low cash flows and hence of financial distress.
4. Comparative advantages in hedging.
• Many investors cannot implement a tailored hedging program as efficiently as firms can because firms
generally, have lower transactions costs due to a larger volume of hedging activities. There is a problem of
asymmetric information—managers know more about the firm’s risk exposure than outside investors.
5. Borrowing costs.
• The use of derivative instruments called “swaps” can sometimes reduce input cost such interest rate on
debt.
6. Tax effects.
• Companies with volatile earnings pay more taxes than more stable companies due to the treatment of tax
credits and the rules governing corporate loss carry-over.
7. Compensation systems.
• Many compensation systems establish thresholds or ceilings on bonuses, or they reward managers for
meeting targets.

Process for managing risks.

1. Identify the risks that the firm faces.
2. Measure the potential effect of each risk. Segregate risks by potential effect – immaterial, pervasive – and then
focus on the most serious threats.
3. Decide how each relevant risk should be handled. Mitigate risk exposure through one of the following ways:
• Transfer the risk to an insurance company. Often it is advantageous to transfer a risk.
• Transfer the function that produces the risk to a third party.
• Reduce the probability of the occurrence of an adverse event by instituting controls and preventive
measures.
• Reduce the magnitude of the loss associated with an adverse event.
• Purchase derivative contracts to reduce or hedge risks. Financial derivatives can be used to reduce risks
that arise from changes in interest rates and exchange rates.
• Avoid totally the activity that gives rise to the risk.

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.

Strike or Exercise Price

• The price that must be paid for a share of common stock when an option is exercised.
Call Option
• An option to buy a share of stock at a certain price within a specified period.
Put Option
• an option that gives you the right to sell a stock at a specified price within some future period
option writer
• seller of an option

Option Pricing Models

Nearly all option pricing models are based on the concept of a riskless hedge.

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.

Black–Scholes Option Pricing Model (OPM)

• developed in 1973, helped give rise to the rapid growth in options trading
• Derived from the concept of a riskless hedge
• this model calculates the value of an option as the difference between the expected present value of the
terminal stock price and the PV of the exercise price.

OPM Assumptions and Equations

• The derivation of the Black–Scholes model rests on the concept of a riskless hedge. This riskless hedged position
must earn a rate of return equal to the risk-free rate.
Assumptions under OPM:
1. The underlying share of the call option does not give dividends or other distributions during the life of the
option.
2. The short-term risk-free interest rate is known constant during the life of the option.
3. No transactions costs for buying or selling the stock or the option.
4. The purchaser of a security may borrow a fraction of the purchase price at the short-term risk-free interest rate.
5. The call option can be exercised only on its expiration date.
6. Trading in all securities takes place continuously, and the stock price moves randomly.
7. Short selling is permitted. The short seller will receive immediately the full cash proceeds of today’s price for a
security sold short.

The Black–Scholes model three equations:

The value of the option is a function of the following variables:

• stock price
• variance of the underlying stock
• risk-free rate
• option’s time to expiration
• strike price

OPM Example
Given are the following:
Compute equation d1 and d2:

Input d1 and d2 on the current value of call option equation:

Therefore, the Current Value of the call option is $1.686.

Forward and Futures Contracts

Forward contract
• “Tailor-made” contracts representing an obligation to buy or sell, with the amount, rate, and maturity agreed
upon by the parties.
• It has little up-front cost.

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.

Other Types of Derivatives

Swaps
• Two parties agree to exchange obligations to make specified payment streams.
• Types:
o interest rate swap
Allows the trading of one interest rate stream (e.g., on a fixed-rate Philippine Peso instrument)
for another (e.g., on a floating-rate Philippine Peso instrument) where a fee is to be paid to an
intermediary.
This permits firms to change the interest rate structure of their assets or liabilities and achieves
cost savings via broader market access.
 o Currency swaps
more complex than interest rate swaps.
Two parties exchange principal amounts of two different currencies initially. The parties pay
each other’s interest payments and then reverse principal amounts at an agreed exchange rate
at maturity.

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.

Using Derivatives to Reduce Risks

• Derivatives are also can be used to reduce the risks associated with financial and commodity markets.

Security Price Exposure

• Firms are exposed to losses due to changes in security prices when securities are held in investment portfolios.
Risks such as these can often be mitigated by using derivatives. As we discussed earlier, derivatives are securities
whose values stem, or are derived, from the values of other assets.

Commodity Price Exposure

• Commodity price risk
• is the possibility that commodity price changes will cause financial losses for the buyers or producers of
a commodity.
• Groups affected by commodity price risk
o Producers
• Especially on prices of inputs
o Consumers
• Affects their demand
o Governments
• revenue generation: increase in prices causes the government to generate more income
o Exporters
• tariffs on exports causes prices to go up
• Factors affecting commodity prices
o Transportation and storage costs
o Technology
o Politics
o Weather conditions
o Production costs

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

Implications of Derivatives in Hedging and Speculation

• Hedging allows business owners or managers to concentrate on their businesses without having to worry
regarding fluctuations or variability of interest rate, currency, and commodity price.
• Some corporations or businesses can bear the risks in speculating with derivatives, but others are not
adequately knowledgeable about the risks they are taking. Most agreed that a typical corporation should use
derivatives only to hedge risks and not on speculation in an effort to generate higher income.
References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• (n.d.). Retrieved from Investopedia: https://www.investopedia.com/terms/c/commodity-price-risk.asp
• (n.d.). Retrieved from https://thebusinessprofessor.com/lesson/commodity-price-risk-definition/

Other online resources

Risk Management
https://www.investopedia.com/terms/r/riskmanagement.asp
https://www.youtube.com/watch?v=Z0YJI3kXPno

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

Black-Scholes Pricing Model

https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/black-scholes-merton-model/
https://brilliant.org/wiki/black-scholes-merton/
https://www.youtube.com/watch?v=pr-u4LCFYEY