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RISK MANAGEMENT
• Credit risk
• No suitable instrument
• Lack of knowledge
• Accounting / legal issues
• Transaction costs
• Resistance by Board / upper management
VOCABULARY
• Agricultural commodities
– Wheat, corn, soybeans
– Farmer (supplier) can lock in sales price before
harvest (short futures)
– Consumer (user) can lock in purchase price
(long futures)
• Other commodities
– Metals, petroleum
• Financial assets
– FX, stock market indices, interest rates
EXAMPLE
• Ann agrees to buy from Bill one barrel of
oil, five months from now, for $20
– Ann is in the “long” position
– Bill is in the “short” position
• If the price of oil is $25 five months from
now, who pays to whom, and how much?
d1 = [ln(S/X)+(r+0.5s2)t] / st0.5
d2 = d1 - st0.5
PURPOSES OF DERIVATIVES
• Speculative
– Highly risky
– Highly leveraged
– Very volatile
• Hedging
– Combine with other securities
– Hedge (minimize) risk from other securities
HEDGING
• Protective put
– Own stock (long position)
– Own put (long position)
• Covered call
– Own stock (long position)
– Sell call (short position)
• Straddle
• Spread
PROTECTIVE PUT
+ =
PROTECTIVE PUT EXAMPLE
ST : 30 25 20 15
Premium: -0.75 -0.75 -0.75 -0.75
Put Payoff: 0 0 2.50 7.50
=== === === ===
Overall: 29.25 24.25 21.75 21.75
COVERED CALL
• Investor purchases stock
• Investor also sells (writes) a call option on the
stock
+ =
COVERED CALL EXAMPLE
ST : 30 35 40 45
Premium: 2 2 2 2
Call Payoff: 0 0 -5 -10
=== === === ===
Overall: 32 37 37 37
STRADDLE
• (Long) Straddle: buy both a call and a put
on a stock
• Each option has the same exercise price and
expiration date
• Believe stock will be relatively volatile
• Worst-case: no movement in stock price
SPREAD
• Combination of options
– Two or more calls, or
– Two or more puts
• Vertical spread: simultaneous sale and purchase
of options with different exercise prices
• Horizontal spread: sale and purchase of options
with different expiration dates
INTEREST RATE OPTIONS
• Futures
– Standardized
– Exchange-traded
– Short horizons
• Swaps
– Custom tailored between counterparties
– Little regulation; potential for privacy
– Term flexibility
INTEREST RATE SWAPS
• Originally:
– Unique contracts
– Had to search for counterparty
– Investment banks were dominant intermediaries
• More recently:
– More standardized and liquid
– Intermediaries accept contract, then lay off risk
– More highly capitalized firms -- e.g., commercial
banks