Chapter 1 • Introduction
time is above the exercise price specified in the option contract, the exporter will
ignore the option contract and sell the euros for sterling in the open market. Here the
option will be worth nothing. On the other hand, were the sterling value of a euro in
two months’ time to be below the option contract exercise price, the exporter will exer-
cise its option and sell the euros to the seller of the option contract according to the
terms of that contract. In this case the option will be worth, at the exercise date, the dif-
ference between what the exporter would receive under the option contract and the
current market sterling value of those euros.
Why should the exporter want to enter into such an option contract? Who would
sell the exporter such a contract and why? A UK business with a debt in a currency
other than sterling is exposed to risk. The value of one currency, relative to that of
another, tends to fluctuate, more or less continuously, according to supply and de-
mand. Entering into the option contract eliminates risk as far as the exporter is con-
cerned. The exporter is guaranteed a minimum amount (the exercise price) for the
euros. In fact the risk is transferred to the other party (the ‘counterparty’) in the option
contract. This is exactly the same principle as insurance. When we pay a premium to
insure one of our possessions against theft, we are paying a counterparty (the insur-
ance business) to bear the risk. If the object is not stolen we do not claim; if the sterling
value of the euro turns out to be above the option contract exercise price, the exporter
does not exercise the option. In both cases a sum has been paid to transfer the risk.
The exporter is under no obligation to transfer the risk; it can bear the risk itself and
save the cost of buying the option. This is a commercial judgement.
The seller of the currency option (the counterparty) might well be a foreign ex-
change dealer or simply a business that grants currency options. This business enters
into the option contract because it makes the commercial judgement, taking account of
possible movements in the sterling/euro rate between the contract date and the exercise
date, that the price it charges for the option is capable of yielding a reasonable profit.
This is rather like the attitude taken by an insurance business when setting premiums.
Many types of derivative are concerned with transferring risk, but not all.
Derivatives pervade many areas of business finance and we shall consider various
derivatives, in context, at various stages in the book.
According to a survey, 90 per cent of the world’s 500 largest businesses regularly
use derivatives to help manage risks (International Swaps and Derivatives Association
2003). El-Masry (2006) surveyed 401 UK businesses and found that derivatives were
more likely to be used by businesses that are (1) large, (2) public companies and (3)
involved in international trade.1.9 Private equity funds
Another remarkable development, particularly since around the turn of the century, is
the rise of private equity fundsand their ownership of a large portion of the world’s
private sector businesses. A private equity fund pools finance from various investors
(very rich private individuals and the institutions). The fund then uses the finance to
buy private sector businesses, often ones that were stock market listed. These busi-
nesses are then managed by the fund. The types of business that tend to be the targets
for private equity funds are those that are seen to be underperforming under their pre-
vious senior management. A common action by the new management has been to
increase the extent that the businesses are financed from borrowing, rather than
equity. The effect of a listed business being taken over by a private equity fund is for‘