Session 20.

Introduction to Risk
Management
PGP, IIM INDORE
Calls and Puts
Call Option
The holder has the right to buy an asset at specified price on or before
exercise date

Put Option
Holder has the right to sell asset at specified price on or before exercise date

Same degree of risk

Calls and Puts
Option Obligations
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Calls, Puts, and Shares
Derivatives
Financial instrument created from another instrument

Option Premium
Price paid for option
Exercise Price (Strike Price)
Price at which security is to be bought or sold
American option
Can be exercised any time up to expiration date
European option
Can only be exercised on expiration date
Options
In-the-Money
Exercising the option would result in a positive payoff.
Call option exercise price is lower than the stock price

At-the-Money
Exercising the option would result in a zero payoff (i.e., exercise price equal
to spot price).

Out-of-the-Money
Exercising the option would result in a negative payoff.
Options on Hindustan Unilever
Stock, October 2013
HUL Position Diagram, Call
Profit Diagram for HUL
HUL Position Diagram, Put
Selling Options
The seller (or writer) of an option has an
obligation.
The seller receives the option premium in
exchange.
Payoff to Seller of HUL Call
Payoff to Seller of HUL Put
Profit Diagram for HUL
Forward Contracts
A forward contract specifies that a certain
commodity will be exchanged at a specified time in
the future at a price specified today.
Its not an option: both parties are expected to hold up their end of the
deal.
Futures Contracts
A futures contract is like a forward contract:
It specifies that a certain commodity will be
exchanged at a specified time in the future at a
price specified today.

A futures contract is different from a forward:

Futures are standardized contracts trading on
organized exchanges through a clearinghouse.
Since traded on an exchange: liquid market in
futures
Why manage risk?
Why Manage Risk?
Does risk management create value?
Risk: Exposure of a firms earnings, cashflows, or market value to
external factors such as interest rates, exchange rates, commodity
prices, and other factors
Various types of mitigating risk:
Insurance
Hedging
Diversification
Does risk management create
value?
Extending the logic applied in M&M Propositions on Capital Structure
and Dividend policy
One could show that risk management is irrelevant (under certain
assumptions)
Therefore, corporate risk management (hedging, diversification, etc.) should
not affect firm value, since investors can do the same equally well.
Does risk management create
value? Contd.
However, there are certain imperfections that make risk management
relevant
Financial Distress
Investment policy: Firms involve in cash flow hedging and ensure steady
stream of internally generated funds required to make necessary
investments
Transaction costs and barriers to entry
Asymmetric Information
Due to lack of developed capital markets in certain countries, diversification
may provide access to internal capital market
Additional Concepts
Types
Equity derivatives : Options and futures in stock and indices
NSE and BSE Equity derivatives segment
In stock options, the buyer has a right not an obligation
In stock futures, both the buyer and the seller are obliged to buy/sell the
underlying stock

Currency Futures
Interest rate futures, i.e., Bond futures
Commodities: Metals, agricultural products, oil, weather
MCX (Multi-commodity exchange), NCDEX (National Commodity and
Derivatives Exchange), etc.