Intermediate Financial Management, 5th Ed.

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Nov 10, 2013 (4 years and 3 days ago)

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Appendix 5
-

1

If volatility is due to systematic risk, it
can be eliminated by diversifying
investors’ portfolios.



Why might stockholders be indifferent
to whether or not a firm reduces the
volatility of its cash flows?

Appendix 5
-

2


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.

Reasons Risk Management Might
Increase the Value of a Corporation

Appendix 5
-

3


Reduce the higher taxes that result
from fluctuating earnings.


Initiate compensation programs to
reward managers for achieving stable
earnings.



Appendix 5
-

4

An option is 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.



What is an option?

Appendix 5
-

5


It does not
obligate

its owner to
take any action. It merely gives the
owner the
right
to buy or sell an
asset.

What is the single most important

characteristic of an option?

Appendix 5
-

6


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 Terminology

Appendix 5
-

7


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.

Appendix 5
-

8


Covered option
: A call option
written against stock held in an
investor’s portfolio.


Naked (uncovered) option
: An
option sold without the stock to
back it up.


In
-
the
-
money call
: A call option
whose exercise price is less than
the current price of the under
-
lying stock.

Appendix 5
-

9


Out
-
of
-
the
-
money call
: A call
option whose exercise price
exceeds the current stock
price.


LEAPS
:
Long
-
term Equity
AnticiPation Securities are
similar to conventional options
except that they are long
-
term
options with maturities of up to
2 1/2 years.

Appendix 5
-

10

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.

Consider the following data:

Appendix 5
-

11

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

Appendix 5
-

12

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

Table (Continued)

Appendix 5
-

13

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.

Appendix 5
-

14

Call Premium Diagram

5 10 15 20 25 30 35 40 45 50

Stock Price

Option
value

30

25

20

15

10

5


Market price

Exercise value

Appendix 5
-

15


The stock underlying the call option
provides no dividends during the call
option’s life.


There are no transactions costs for
the sale/purchase of either the stock
or the option.


k
RF

is known and constant during the
option’s life.

What are the assumptions of the

Black
-
Scholes Option Pricing Model?

(More...)

Appendix 5
-

16


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 today’s 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.

Appendix 5
-

17

V = P[N(d
1
)]


Xe

-
k
RF
t
[N(d
2
)].


d
1

= .






s

t

d
2

= d
1



s



What are the three equations that

make up the OPM?

ln(P/X) + [k
RF

+
(
s
2
/2)]t

Appendix 5
-

18

What is the value of the following

call option according to the OPM?

Assume: P = $27; X = $25; k
RF

= 6%;

t = 0.5 years:
s
2

= 0.11

V = $27[N(d
1
)]


$25e
-
(0.06)(0.5)
[N(d
2
)].


ln($27/$25) + [(0.06 + 0.11/2)](0.5)





(0.3317)(0.7071)




= 0.5736.

d
2

= d
1



(0.3317)(0.7071) = d
1



0.2345



= 0.5736


0.2345 = 0.3391.

d
1

=

Appendix 5
-

19

N(d
1
) = N(0.5736) = 0.5000 + 0.2168




= 0.7168.

N(d
2
) = 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
.

Appendix 5
-

20


Current stock price
: Call option
value increases as the current
stock price increases.


Exercise price
: As the exercise
price increases, a call option’s
value decreases.

What impact do the following para
-

meters have on a call option’s value?

Appendix 5
-

21


Option period
: As the expiration date
is lengthened, a call option’s value
increases (more chance of becoming in
the money.)


Risk
-
free rate
: Call option’s value
tends to increase as k
RF

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).

Appendix 5
-

22

Corporate risk management relates
to the management of unpredictable
events that would have adverse
consequences for the firm.

What is corporate risk management?

Appendix 5
-

23

All firms face risks, but the lower
those risks can be made, the more
valuable the firm, other things held
constant. Of course, risk reduction
has a cost.

Why is corporate risk management

important to all firms?

Appendix 5
-

24


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 firm’s products or
services.


Input risks
:
Those associated with a
firm’s input costs.

Definitions of Different Types of Risk

(More...)

Appendix 5
-

25


Financial risks
:
Those that result from
financial transactions.


Property risks
:
Those associated with loss
of a firm’s 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 that typically can
be covered by insurance.

Appendix 5
-

26

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 handled.

What are the three steps of

corporate risk management?

Appendix 5
-

27


Transfer risk
to an insurance
company by paying periodic
premiums.


Transfer functions
that produce
risk to third parties.


Purchase derivative contracts to
reduce input and financial risks.

What are some actions that

companies can take to minimize

or reduce risk exposure?

(More...)

Appendix 5
-

28


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.

Appendix 5
-

29


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.

What is a financial risk exposure?

Appendix 5
-

30


Derivative
:

Security whose value stems or
is derived from the values of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.


Futures
:
Contracts that 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.

Financial Risk Management Concepts

(More...)

Appendix 5
-

31


Hedging:
Generally conducted where
a price change could negatively affect a
firm’s 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.

(More...)

Appendix 5
-

32


Swaps
:
Involve the exchange of cash
payment obligations between two
parties, usually because each party
prefers the terms of the other’s debt
contract. Swaps can reduce each
party’s financial risk.

Appendix 5
-

33


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

How can commodity futures markets

be used to reduce input price risk?