Chapter 18

Derivatives and Risk Management

Options

• A right to buy or sell stock

–at a specified price (exercise price or "strike" price)

–within a specified time period

• The price of an option is called the "premium.”

Options to Buy Stock

• Call– Option to buy created by investors

• Warrants – Option to buy created by a

corporation

Option to Sell Stock

• Put– Option to sell stock at a specified

price within a specified time period

The Intrinsic Value of an Option

• Depends on the value of the underlying stock

• Is derived from the underlying stock

–hence the name "derivatives”

The Intrinsic Value of an Option to Buy Stock

• The difference between

–the price of the stock and

–the strike (exercise) price

In, Out, & At the Money Options

• An "in" the money call option: price of the stock exceeds the exercise price (positive intrinsic value)

• An "out" of the money call option: exercise price exceeds the price of the stock

• An "at" the money call option: exercise price equals the price of the stock

The Intrinsic Value of an Option

The Intrinsic Value of an Option

• An option cannot sell for less than its intrinsic value

• An option sells for its intrinsic value on the expiration date

Options & Leverage

• Options are purchased for their potential leverage

• Percentage return on option may exceed the percentage return on the underlying stock

The Time Premium of an Option

• Price of the option minus its intrinsic value

• Prior to expiration, an option sells for a time premium

• At expiration there is no time premium

The Time Premium of an Option

Chicago Board Options Exchange

• The first secondary market in options

• Option prices are reported in the financial press

• The "open interest:” number of contracts in existence

Profits & Losses to Buyers of Calls

• Maximum potential loss is the cost of the option

• Unlimited possible profits

Profits & Losses to Buyers of Calls

Profits, Buying Stock & Calls

• Calls

–limited loss

• Stock

–large possible loss

• Unlimited profit potential to either long position

Profits, Buying Stock & Calls

Writing Options

• Options are created ("written") by investors who either

–own the underlying stock: “covered” option writing

–do not own the underlying stock: “naked” option writing

Covered Call

• To write a covered call: buy the stock and sell the option

• Combines a long in the stock and a short in the option

• Covered call takes advantage of the disappearing time premium

• Profit is limited

Profit / Loss

• Profit/loss profile for covered call writing

Naked Call

• To write a naked call, sell the call

• The maximum possible profit is the sale price

• Since the writer does not own the stock, unlimited risk of loss if the price of the stock rises

Naked Call

Profit / Loss Compared

• When the buyer profits, the naked writer sustains a loss

• When the naked writer profits, the buyer sustains a loss

• The profit/loss on buying a call or writing a naked call are mirror images

Profit / Loss Compared

Puts

• An option to sell stock –at a specified price –within a specified time period

• Buy a put in anticipation of the stock's price declining

• Sell a put in anticipation of the stock's price remaining stable or rising

Put’s Intrinsic Value

• A put's intrinsic value rises as the price of the stock declines

Profit / Loss: Buying a Put

• Profit/loss profile for buying a put

Profit / Loss: Writing a Put

• Profit/loss profile for writing a put

Profit / Loss

• Once again the profit/loss profiles from buying a put and writing a put are mirror images

Profit / Loss

Stock Index Options

• Put and call options based on –an index of stock prices – instead of a specific stock

• Avoid the risk of selecting individual securities

• Capture movements in the market as a whole

Stock Index Call

• Buying a stock index call–a long position in the market–anticipates a market increase

• Selling a stock index call–a short position against the market–anticipates a market decline

Stock Index Put

• Buying a put is made in anticipation of a market decline

• Both buying a stock index put or selling an index call is made in anticipation of lower stock prices

Futures

• A formal agreement (contract) for

–the delivery (seller) or

–receipt (buyer) of a commodity

• Participants in futures markets are either

–speculators

–hedgers

Futures Contracts

• Contracts establish a futures price

• The current (spot) price may be

–Lower

–Higherthan the futures price

Positions

• Speculators buy or sell contracts in anticipation of price changes

• The long position anticipates price increases

• The short position anticipates price decreases

Open Interest• Number of contracts in existence

Closing a Futures Contract

• Close a position in a futures by entering into the opposite position

• A contract to sell "offsets" a contract to buy

• A contract to buy "offsets" a contract to sell

Futures and Leverage

• Futures offer large profits and losses

• The source of the leverage: the small margin requirement

• The margin requirement is a small percentage of the value of the contract

Margin

• Margin: a good faith deposit required of both

–the long position and

–the short position

Marking to the Market

• Futures positions are "marked to the market" daily

• Funds are transferred between accounts

Maintenance Margin

• A second margin requirement

• If funds in the account fall below the maintenance margin requirement, the investor receives a "margin call”

• Failure to meet the margin call results in the position being closed

Hedgers

• Buy and sell contracts to offset existing positions

• Are growers and other users of commodities

• Wish to reduce the risk of loss from price fluctuations

Hedgers

• Pass the risk of loss to the speculators

• Take the opposite positions of the speculators

• Forego the possibility of a large return to obtain future price certainty

Financial and Currency Futures

• Financial futures

–contracts for the future delivery of a financial asset

• Currency futures

–contracts for the future delivery of a currency

Stock Index Futures

• Based on an index of stock prices

• Speculators buy and sell stock index futures in anticipation of changes in stock prices

• Portfolio managers use stock index futures to hedge against movements in stock prices

Risk Management and Currency Futures Contracts

• Establishes a future price

• Manages exchange rate risk

Hedging Strategies

• If receiving a future payment, enter contract to sell the currency

• If making a future payment, enter contract to buy the currency