Derivatives and Risk Management


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Reasons that corporations engage in risk management

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.
Reduce the higher taxes that result from fluctuating earnings.
Initiate compensation programs to reward managers for achieving stable earnings.

What is an option?

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.
Most important characteristic of an option:
It does not obligate its owner to take action.
It merely gives the owner the right to buy or sell an asset.

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.
Option price – the market price of the option contract.

How does the option premium change as the stock price increases?

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.

[b]What is corporate risk management, and why is it important to all firms?

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