Derivatives and Corporate Risk Management Flashcards
Basic principles and concepts related to managing risks effectively.
Fundamentals of risk management
Contracts for the future purchase or sale of a financial asset at a price set today.
Futures
Motivations for corporations to manage risks effectively.
Reasons for engaging in risk management
The price at which the security can be bought or sold in an option contract.
Exercise (or strike) price
A call option with an exercise price lower than the current stock price.
In-the-money call
A call option with an exercise price higher than the current stock price.
Out-of-the-money call
Risks associated with a firm’s input costs.
Input risks
Risks associated with environmental pollution.
Environmental risk
Risk inherent in financial markets due to price fluctuations.
Financial risk exposure
Exchanging cash payment obligations between parties to manage financial risk.
Swaps
A security whose value is derived from other assets, used to manage financial risk exposures.
Derivative
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Securities whose value is derived from an underlying asset.
Derivative securities
Utilizing derivative securities in financial strategies.
Using derivatives
Whether a firm’s reduction of cash flow volatility concerns stockholders.
Stockholders concerns
A contract granting the holder the right to buy or sell an asset at a predetermined price within a specified time.
Option
An option to buy a specified number of shares of a security in the future.
Call option
The date an option matures.
Expiration date
An option to sell a specified number of shares of a security in the future.
Put option
The market price of an option contract.
Option price
The value of an option if exercised today (Current stock price - Strike price).
Exercise value
An option written against stock held in an investor’s portfolio.
Covered option
An option written without the stock to back it up.
Naked (uncovered) option
The price of an option over its exercise value.
Option premium
Long-term Equity AnticiPation Securities, long-term options with maturities up to 2 1/2 years.
LEAPS
Assumptions including no dividends, no transaction costs, known risk-free rate, and continuous time trading.
Black-Scholes Option Pricing Model assumptions
Managing unpredictable events that could harm a firm’s operations.
Corporate risk management
Risks offering only the prospect of a loss.
Pure risks
Risks offering the potential for gain or loss.
Speculative risks
Risks related to the demand for a firm’s products or services.
Demand risks
Risks linked to the loss of a firm’s productive assets.
Property risks
Risks arising from financial transactions.
Financial risks
Risks resulting from human actions.
Personnel risk
Risks connected with product, service, or employee liability.
Liability risks
Risks typically covered by insurance.
Insurable risks
Identifying risks, measuring their impact, and deciding how to handle each relevant risk.
Steps of corporate risk management
Strategy to guard against price changes that could negatively impact profits.
Hedging
Buying a futures contract to protect against price increases.
Long hedge
Used to reduce input price risk by allowing future purchases at today’s price.
Commodity futures markets
Selling a futures contract to protect against price declines.
Short hedge
