Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

23. Risk Management: An
    Introduction to Financial
    Engineering

(^822) © The McGraw−Hill
Companies, 2002
HEDGING WITH OPTION CONTRACTS
The contracts we have discussed thus far—forwards, futures, and swaps—are concep-
tually similar. In each case, two parties agree to transact on a future date or dates. The
key is that both parties are obligated to complete the transaction.
In contrast, an option contractis an agreement that gives the owner the right, but not
the obligation, to buy or sell (depending on the option type) some asset at a specified
price for a specified time. Options are covered in detail elsewhere in our book. Here we
will only quickly discuss some option basics and then focus on using options to hedge
volatility in commodity prices, interest rates, and exchange rates. In doing so, we will
sidestep a wealth of detail concerning option terminology, option trading strategies, and
option valuation.
Option Terminology
Options come in two flavors, puts and calls. The owner of a call optionhas the right, but
not the obligation, to buyan underlying asset at a fixed price, called the strike priceor
exercise price,for a specified time. The owner of a put optionhas the right, but not the
obligation, to sell an underlying asset at a fixed price for a specified time.
The act of buying or selling the underlying asset using the option contract is called
exercisingthe option. Some options (“American” options) can be exercised anytime up
to and including the expiration date(the last day); other options (“European” options)
can be exercised only on the expiration date. Most options are American.
Because the buyer of a call option has the right to buy the underlying asset by paying
the strike price, the seller of a call option is obligated to deliver the asset and accept the
strike price if the option is exercised. Similarly, the buyer of the put option has the right
to sell the underlying asset and receive the strike price. In this case, the seller of the put
option must accept the asset and pay the strike price.
796 PART EIGHT Topics in Corporate Finance

FIGURE 23.10

9.75%

(fixed)

9.5%

(fixed)

Prime + 1%

(floating)

Prime + 1%

(floating)

Prime + 1.5%

(floating)

9.5%

(fixed)

Company

A

Swap

dealer

Company

B

Debt market Debt market

Company A borrows at prime plus 1% and swaps for a 9.75% fixed rate. Company B

borrows at 9.5% fixed and swaps for a prime plus 1.5% floating rate.

Illustration of an Interest Rate Swap

23.6

option contract
An agreement that gives
the owner the right, but
not the obligation, to buy
or sell a specific asset at
a specific price for a set
period of time.

call option
An option that gives the
owner the right, but not
the obligation, to buy an
asset.

put option
An option that gives the
owner the right, but not
the obligation, to sell an
asset.