reduce both the risks and costs of borrowing by using swaps, and (vi) to
reduce the higher taxes that result from fluctuating earnings.
- Derivatives are securities whose values are determined by the market price
or interest rate of some other security.
- A hedge is a transaction which lowers risk. A natural hedge is a
transaction between two counterparties where both parties’ risks are
reduced.
- Options are financial instruments that (i) are created by exchanges rather
than firms, (ii) are bought and sold primarily by investors, and (iii) are of
importance to both investors and financial managers.
- The two primary types of options are (i) call options, which give the
holder the right to purchase a specified asset at a given price (the exercise,
or strike, price) for a given period of time, and (ii) put options, which give
the holder the right to sell an asset at given price for a given period of
time.
- A call option’s exercise value is defined as the current price of the stock
less the strike price.
- The Black-Scholes option Pricing Model (OPM) can be used to estimate
the value of a call option.
- A futures contract is a standardized contract that is traded on an exchange
and is “marked to market” daily, but where physical delivery of the
underlying asset usually does not occur
- Under a forward contract, one party agrees to buy a commodity at a
specific price and a specific future date and the other party agrees to make
the sale. Delivery does occur.
- A structured note is a debt obligation derived from another debt
obligation.
- A swap is an exchange of cash payment obligations. Swaps occur because
the parties involved prefer someone else’s payment stream.
- In general, risk management involves the management of unpredictable
events that have adverse consequences for the firm.
- The three steps in risk management are as follows: (i) identify the risks
faced by the company, (ii) measure the potential impacts of these risks,
and (iii) decide how each relevant risk should be dealt with.
