Risk Management with Derivatives Flashcards
What are the finacial risks faced by corporations?
- Commodity price risk
- Interest rate risk
- Credit risk
- Foreign exchange risk
What are tools often used for hedging?
- Forwards contracts
- Futures
- Options
- Swaps
What is a forward contract?
An agreement to buy/ sell an asset at some date in the future at a price agreed today. There is an obligation to carry out the contract.
What is a futures contract?
It is a more standarised form of a forward agreement.
Differences between forwards and futures
1) A future seller can choose to deliver the underlying asset on any day during the delivery term. Foward can only be on the date.
2) Future contracts are traded on the exchange.
3) The prices of futures contracts are marked to the market daily while forward prices are fixed on the day of the agreement.
What does marked to market mean?
The value for the contract is adjusted daily to reflect current market prices. Your profit/ loss is credited/debited to your margin daily.
What are options?
It gives the owner the right not he obligation to sell or buy an asset at a fixed price on or before the given date.
What is the excerise price?
This is the pre-specified fixed price for the underlying asset to be bought
What is the spot price
The market price of the underlying asset
How does long/short positions work for options?
If you hold the long position you have the right to exercise the option which is buying or selling the underlying asset.
If you hold the short position you have the obligation to buy/ sell the underlying asset if the buyer exercises the option.
Difference between European/ American option
European can only be exercised on expiration while American can be exercised at any time.
Terminology for making profit/loss on options
Profit = in the money
Loss = out of the money
Break even = at the money
What are derivatives used for?
1) To hedge against the risk of loss and default
2) To speculate on the economic variables
What are swaps?
The arrangement between two counterparts to exchange cash flows over time.
Advantages of options as CEO compensation
- Options align executives’ interests to that of the shareholders.
- Options allow the company to lower the executive’s base pay.
- Options put an executive’s pay at risk, rather than guaranteeing it regardless of the
performance of the firm. This gives the manager/executive the incentive to work harder.
Disadvantages of options as CEO compensation
- Options align executives’ interests to that of ONLY the shareholders, and not other
stakeholders. - Options increase the upper limit of the executive’s pay, and may encourage risk-taking
behaviors of the executives. - Options put an executive’s pay at risk, rather than guaranteeing it regardless of the
performance of the firm. This gives incentives to the managers to manipulate earnings or
stock prices
What is a protective put?
You buy a share and a put option of that share.
What is an option combination?
Call and put options with different strike prices can be bought and sold simultaneously along with the stocks and bonds in a combination.
What are some combinations of options and stocks/bonds?
Share + Short put = guarenteed payout of 50 or higher
Short call + Zero coupon bond = guarenteed payout of 50 or higher
Put call parity
C+Ke^−rT = P+S
P(put) - P(call) = PV(exercise price) - P(underlying share)
