Explain the characteristics of options and swaps and

compare their use as hedging tools for firms.

- Financial Options give the holder the right to
undertake a specified transaction on the maturity
date
o But there is no obligation. The option holder
can choose not to exercise the option
o A Call (Put) Option gives the right to buy (sell)
the asset
o We restrict attention to options that can only be
exercised on the maturity date (European
Options)
Uses of options:
Additional flexibility in firms hedging programs,
compared with forwards, futures or swaps
Combining limited downside with upside potential
(asymmetric payoff for holder).
Used for hedging or insuring an open position e.g.
foreign exchange exposure.
In corporate finance applications
- We need to know what inputs affect the option value,
and how the option value is expected to change over
time.
- Managers will need this type of information in order
to decide when it will be optimal to exercise options

Swaps:
Traditionally, the exchange of one security for another to
change the maturity (bonds), quality of issues (stocks or
bonds), or because investment objectives have changed.
Recently, swaps have grown to include currency swaps and
interest rate swaps.
If firms in separate countries have comparative advantages
on interest rates, then a swap could benefit both firms. For
example, one firm may have a lower fixed interest rate,
while another has access to a lower floating interest rate.
These firms could swap to take advantage of the lower rates.

Payoffs on holding options

- European Style
Call: Max (ST X, 0) Put: Max (XST,0)
Including premium, P (initial price of the option):
Call: Max ( ST X-P,-P) Put: Max (XST-P,-P)