Risk management and stock value maximization'

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Session 9Derivatives and Risk Management

• Risk management and stock value maximization.
• Derivative securities.
• Fundamentals of risk management.
• Using derivatives to reduce interest rate risk.

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Do stockholders care about volatile cash flows?

• If volatility in cash flows is not caused by
  systematic risk, then stockholders can eliminate
  the risk of volatile cash flows by diversifying
  their portfolios.
• Stockholders might be able to reduce impact of
  volatile cash flows by using risk management
  techniques in their own portfolios.

3
How can risk management increase the value of a
corporation?

• Risk management allows firms to
• Have greater debt capacity, which has a larger
  tax shield of interest payments.
• Implement the optimal capital budget without
  having to raise external equity in years that
  would have had low cash flow due to volatility.

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• Risk management allows firms to
• Avoid costs of financial distress.
• Weakened relationships with suppliers.
• Loss of potential customers.
• Distractions to managers.
• Utilize comparative advantage in hedging relative
  to hedging ability of investors.

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• Risk management allows firms to
• Reduce borrowing costs by using interest rate
  swaps.
• Example Two firms with different credit
  ratings, Hi and Lo
• Hi can borrow fixed at 11 and floating at LIBOR
  1.
• Lo can borrow fixed at 11.4 and floating at
  LIBOR 1.5.

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• Hi wants fixed rate, but it will issue floating
  and swap with Lo. Lo wants floating rate, but
  it will issue fixed and swap with Hi. Lo also
  makes side payment of 0.45 to Hi.
• CF to lender -(LIBOR1) -11.40
• CF Hi to Lo -11.40 11.40
• CF Lo to Hi (LIBOR1) -(LIBOR1)
• CF Lo to Hi 0.45 -0.45
• Net CF -10.95 -(LIBOR1.45)

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• Risk management allows firms to
• Minimize negative tax effects due to convexity in
  tax code.
• Example EBT of 50K in Years 1 and 2,
  total EBT of 100K,
• Tax 7.5K each year, total tax of 15.
• EBT of 0K in Year 1 and 100K in Year 2,
• Tax 0K in Year 1 and 22.5K in Year 2.

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What is an option?

• An option is a contract which 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.

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What is the single most important characteristic
of an option?

• It does not obligate its owner to take any
  action. It merely gives the owner the right to
  buy or sell an asset.

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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.

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• Option price The market price of the option
  contract.
• Expiration date The date the option matures.
• Exercise value The value of a call option if it
  were exercised today Current stock price -
  Strike price.
• Note The exercise value is zero if the stock
  price is less than the strike price.

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• Covered option A call option written against
  stock held in an investors portfolio.
• Naked (uncovered) option An option sold without
  the stock to back it up.
• In-the-money call A call whose exercise price
  is less than the current price of the underlying
  stock.

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• Out-of-the-money call A call option whose
  exercise price exceeds the current stock price.
• LEAPs Long-term Equity AnticiPation securities
  that are similar to conventional options except
  that they are long-term options with maturities
  of up to 2 1/2 years.

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Consider the following data
Stock Price Call Option Price 25 3.00
30 7.50 35 12.00 40 16.50
45 21.00 50 25.50 Exercise price 25.
15
Create a table which shows (a) stock price, (b)
strike price, (c) exercise value, (d) option
price, and (e) premium of option price over the
exercise value.

• Price of Strike Exercise Value
• Stock (a) Price (b) of Option (a) - (b)
• 25.00 25.00 0.00
• 30.00 25.00 5.00
• 35.00 25.00 10.00
• 40.00 25.00 15.00
• 45.00 25.00 20.00
• 50.00 25.00 25.00

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Table (Continued)

• Exercise Value Mkt. Price Premium
• of Option (c) of Option (d) (d) - (c)
  
• 0.00 3.00 3.00
• 5.00 7.50 2.50
• 10.00 12.00 2.00
• 15.00 16.50 1.50
• 20.00 21.00 1.00
• 25.00 25.50 0.50

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What happens to the premium of the option price
over the exercise value as the stock price rises?

• The premium of the option price over the exercise
  value declines as the stock price increases.
• This is due to the declining degree of leverage
  provided by options as the underlying stock price
  increases, and the greater loss potential of
  options at higher option prices.

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Call Premium Diagram
Option value
30 25 20 15 10 5
Market price
Exercise value
5 10 15 20 25 30 35
40 45 50
Stock Price
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What are the assumptions of the Black-Scholes
Option Pricing Model?

• The stock underlying the call option provides no
  dividends during the call options life.
• There are no transactions costs for the
  sale/purchase of either the stock or the option.
• kRF is known and constant during the options
  life.

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• Security buyers may borrow any fraction of the
  purchase price at the short-term risk-free rate.
• No penalty for short selling and sellers receive
  immediately full cash proceeds at todays price.
• Call option can be exercised only on its
  expiration date.
• Security trading takes place in continuous time,
  and stock prices move randomly in continuous time.

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What are the three equations that make up the OPM?

• V PN(d1) - Xe -kRFtN(d2).
• d1 .
• s t
• d2 d1 - s t.

ln(P/X) kRF (s2/2)t
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What is the value of the following call option
according to the OPM?Assume P 27 X 25
kRF 6t 0.5 years s2 0.11

• V 27N(d1) - 25e-(0.06)(0.5)N(d2).
• ln(27/25) (0.06 0.11/2)(0.5)
• (0.3317)(0.7071)
• 0.5736.
• d2 d1 - (0.3317)(0.7071) d1 - 0.2345
• 0.5736 - 0.2345 0.3391.

d1
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N(d1) N(0.5736) 0.5000 0.2168
0.7168. N(d2) N(0.3391) 0.5000 0.1327
0.6327. Note Values obtained from Table A-5 in
text. V 27(0.7168) - 25e-0.03(0.6327)
19.3536 - 25(0.97045)(0.6327) 4.0036.
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What impact do the following para- meters have on
a call options value?

• Current stock price Call option value increases
  as the current stock price increases.
• Exercise price As the exercise price increases,
  a call options value decreases.

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• Option period As the expiration date is
  lengthened, a call options value increases (more
  chance of becoming in the money.)
• Risk-free rate Call options value tends to
  increase as kRF increases (reduces the PV of the
  exercise price).
• Stock return variance Option value increases
  with variance of the underlying stock (more
  chance of becoming in the money).

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What is corporate risk management?

• Corporate risk management is the management of
  unpredictable events that would have adverse
  consequences for the firm.

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Definitions of Different Types of Risk

• Speculative risks Those that offer the chance
  of a gain as well as a loss.
• Pure risks Those that offer only the prospect
  of a loss.
• Demand risks Those associated with the demand
  for a firms products or services.
• Input risks Those associated with a firms
  input costs.

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• Financial risks Those that result from
  financial transactions.
• Property risks Those associated with loss of a
  firms productive assets.
• Personnel risk Risks that result from human
  actions.
• Environmental risk Risk associated with
  polluting the environment.
• Liability risks Connected with product,
  service, or employee liability.
• Insurable risks Those which typically can be
  covered by insurance.

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What are the three steps of corporate risk
management?

• Step 1. Identify the risks faced by the firm.
• Step 2. Measure the potential impact of the
  identified risks.
• Step 3. Decide how each relevant risk should be
  dealt with.

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What are some actions that companies can take to
minimize or reduce risk exposures?

• Transfer risk to an insurance company by paying
  periodic premiums.
• Transfer functions which produce risk to third
  parties.
• Purchase derivatives contracts to reduce input
  and financial risks.

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• Take actions to reduce the probability of
  occurrence of adverse events.
• Take actions to reduce the magnitude of the loss
  associated with adverse events.
• Avoid the activities that give rise to risk.

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What is a financial risk exposure?

• Financial risk exposure refers to the risk
  inherent in the financial markets due to price
  fluctuations.
• Example A firm holds a portfolio of bonds,
  interest rates rise, and the value of the bonds
  falls.

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Financial Risk Management Concepts

• Derivative Security whose value stems or is
  derived from the value of other assets. Swaps,
  options, and futures are used to manage financial
  risk exposures.
• Futures Contracts which call for the purchase
  or sale of a financial (or real) asset at some
  future date, but at a price determined today.
  Futures (and other derivatives) can be used
  either as highly leveraged speculations or to
  hedge and thus reduce risk.

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• Hedging Generally conducted where a price
  change could negatively affect a firms profits.
• Long hedge Involves the purchase of a futures
  contract to guard against a price increase.
• Short hedge Involves the sale of a futures
  contract to protect against a price decline in
  commodities or financial securities.

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• Swaps Involve the exchange of cash payment
  obligations between two parties, usually because
  each party prefers the terms of the others debt
  contract. Swaps can reduce each partys
  financial risk.

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How can commodity futures markets be used to
reduce input price risk?

• The purchase of a commodity futures contract
  will allow a firm to make a future purchase of
  the input at todays price, even if the market
  price on the item has risen substantially in the
  interim.