Lecture "Fundamentals of finance management - Chapter 18: Derivatives and risk management" has contents: Derivative securities, fundamentals of risk management, using derivatives. | CHAPTER 18 Derivatives and Risk Management Derivative securities Fundamentals of risk management Using derivatives Are stockholders concerned about whether or not a firm reduces the volatility of its cash flows? Not necessarily. If cash flow volatility is due to systematic risk, it can be eliminated by diversifying investors’ portfolios. Reasons that corporations engage in risk management Increase their use of debt. Maintain their optimal capital budget. Avoid financial distress costs. Utilize their comparative advantages in hedging, compared to investors. Reduce the risks and costs of borrowing. Reduce the higher taxes that result from fluctuating earnings. Initiate compensation programs to reward managers for achieving stable earnings. 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. Most important characteristic of an option: It does not obligate its owner to take action. It merely gives the owner the right to 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 – the market price of the option contract. Option terminology Expiration date – the date the option matures. Exercise value – the value of an option if it were exercised today (Current stock price - Strike price). Covered option – an option written against stock held in an investor’s portfolio. Naked (uncovered) option – an option written without the stock to back it up. Option terminology 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 | CHAPTER 18 Derivatives and Risk Management Derivative securities Fundamentals of risk management Using derivatives Are stockholders concerned about whether or not a firm reduces the volatility of its cash flows? Not necessarily. If cash flow volatility is due to systematic risk, it can be eliminated by diversifying investors’ portfolios. Reasons that corporations engage in risk management Increase their use of debt. Maintain their optimal capital budget. Avoid financial distress costs. Utilize their comparative advantages in hedging, compared to investors. Reduce the risks and costs of borrowing. Reduce the higher taxes that result from fluctuating earnings. Initiate compensation programs to reward managers for achieving stable earnings. 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. Most important characteristic of an option: It does not obligate its owner
