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Finance Textbook Notes – Chapter 11: Managing Total Risk With Derivative Securities

  1. Strategic risk is the cash flow variability produced by changes in the firm’s economic environment. By reducing cash flow volatility, managers can also reduce associated costs like financial distress, taxes and agency costs.
  2. Hedging is a means of reducing strategic risk, which in turn can reduce agency costs, taxes and the cost of financial distress, all of which can increase firm value.
  3. Comparison of pairs of derivative concepts.
    • Speculation is taking above average risk with the expectation of receiving substantial returns. Speculators willingly assume large risk. Hedging is a tool for reducing strategic risk in hopes of improving the timing or consistency of cash flows and minimize downside exposure while creating large upside potential.
    • Primary assets are the primitive financial or physical assets that are exchanged in the marketplace like stock, bonds, and real estate. Derivatives are securities that derive their value from some underlying primitive security.
    • Long position – you are in it for appreciation. Hoping the value of the asset will rise so you can sell it in the future (or buy and sell in the case of an option). A short position is the exact opposite – hoping for the value of an asset to fall.
    • A spot price is the price today in the cash market. The futures price is some price in the future in the futures market.
    • A put option is an option to sell a security at a certain striking price. Put holders have a short position. If the price of a stock drops below the striking price, the option has value and the holder is in the money (because they can sell at a higher price). A call option is an option to buy a security at a certain striking price. Call holders have long positions, hoping that the price of a security will rise above its striking price, when the holder can buy below market value and be in the money.
    • European options can only be exercised on the maturity date. American options can be exercised at any time prior to maturity.
    • A futures contract is a contract to buy and sell an asset at a futures price on a certain delivery date. Futures can be closed out before their maturity and are traded on exchanges. Forward contracts are obligations to buy and sell an asset at a forward price on a delivery date. They are not traded on exchanges, are used primarily in the foreign exchange markets and cannot be close out prior to maturity. Futures are privately negotiated and are therefore not liquid.
  4. The profit on a futures vs. forward contract is not identical. Futures are marked to market each day and can be closed out prior to maturity. Their value, and therefore the potential profit or loss, varies from day to day. Forward profit/loss is determined only at maturity.
  5. The cost of forwards and futures as hedges is not an explicit payment, but an opportunity cost. Parties can hedge downside losses but also limit upside potential if the value of the asset rises above the forward or future price. The forgone upside is an opportunity cost that is the implicit cost of hedging with these contracts.
  6. Standardization in the futures market makes them liquid. By providing a standardized set of rules for trading futures contracts in an organized exchange that acts as a clearinghouse and honors the contracts, they can be bought and sold prior to maturity at the prevailing market price. This standardization facilitates the smooth operation of the secondary market. It also lowers transactions costs.
  7. Options are rights to buy (call) or sell (put) shares of a primitive security on or before a specified date at a stated striking price. Unlike futures and forwards, options are not commitments. Options derive their value from the underlying primitive asset, but do not affect the value of the primitive asset.
  8. A holder of a call option has a long position and is hoping for the value of the underlying asset to increase above the striking price. A holder of put option has a short position and is hoping for the value of the underlying asset to decrease below the striking price. The payoff to the holder of a call option at exercise is the difference between the prevailing price (higher) in the market and the strike price (lower) less the cost of the option. The payoff to the holder of a put option at exercise is the difference between the prevailing market price (lower) and the strike price (higher) less the cost of the option.
  9. The manager would also need to know the prevailing market price of the primitive security (stock), as well as the standard deviation of its returns. The manager could then calculate the price of the call (with Black-Scholes) and use the call-put parity principle to infer the price of the put.
  10. Because of a limited time frame, the value of a call option can never be worth more than the value of the underlying asset. The same holds true for the value of put option vs. the value of a short position in the underlying asset.