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CF Lect 9

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9 views15 pages

CF Lect 9

Uploaded by

jesusfrjimenez
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Corporate Finance

Lecture 9: Derivatives

Joacim Broth 2024


Derivatives
• A derivative is a security, whose value is determined by the change in value
of another asset

• Tailor-made or standardized (traded)

• Used by companies to control currency, interest or other risks (tailor-made)

• Used by investors to control risks or to increase returns (standardized)

• Several types, include options, futures and swaps


A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different
financial instruments.

• Can be extremely complex, incorporating many different underlying assets


Examples of use (1)

• A paper mill buys cellulose pulp and is worried


about price increases. To reduce the risk of
increasing raw materials costs, they make a
forward contract on pulp

• The profit/loss on the forward contract will


compensate any increase/decrease of the actual
cost. The risk (up and down) is eliminated
Examples of use (2)
• A construction company has a loan of 5 MEUR
• The interest rate on such a big loan is almost always variable
• To protect against interest rate increases, the company makes an
interest rate SWAP with the bank, thereby elimintating e.g. 70% of
the interest rate risk
• The risk reduction comes at a significant cost

In plain words (instead of trying to use difficult financial words that


confuse, it is simply explained:
Part of the loan/loans is paid with a variable interest rate, and on
another part you pay a slightly higher interest rate, but it is fixed for the
duration of the agreement and therefore does not follow the ups and
downs of the interest rate.
Examples of use (3)

• A company buys a software system from the US


for 1.000.000 USD, to be paid after 3 months

• To protect against a weakening of the EUR, an


interest rate forward is made, locking the
EUR/USD price at a certain rate. Whatever the
rate eventuelly is, the cost in EUR to the
company is fixed
Examples of use (4)
• A start-up wants to employ a CEO but cannot afford
a high salary

• The CEO gets an option to subscribe to shares after


2 years, at today´s share price

• Any increase in share price will benefit the CEO but


if the company fails, he will not loose anything

• Profit from these options is probably taxed as salary


income
Options
• An option is a right to do something (or not do it)

• Whenever you have an option, it has some value


because even if it today seems worthless, it may in the
future become valuable
– the right to buy Apple shares for 160 $
– the right to mine gold in Lapland

• A lot of real-life transactions have an element of option


– the option not to do an investment
– the option to abstain on a loan
– the option to use a dollar today and not tomorrow
Calls and puts
• A call option gives the owner a right to buy stocks at
a specified exercise price (”strike price”) on, or
before a specific date

• A put option gives the owner a right to sell stocks at


a specified exercise price on or before a specific
date

• Buying options is risk-free (because you can choose


not to use it)
Buying and selling options
• Buying options is risk-free (because you can choose
not to use it)

• The seller of an option cannot refuse to sell if the


buyer of the option requests it

• Therefore there are significant risks in selling


options

• To compensate for those risks, the buyer pays a


premium to the seller
The profit and loss on options
• The buyer of options will never make a loss on the actual
options

• But the buyer has paid the premium, which can be a loss

• The seller will never make a profit on the options

• But the seller hopes that the premium remains his profit

• On the actual options, the buyer’s profit is equal to the


seller’s loss
How are options valued ?
• The value of the option on the strike day is clear. But how to value them
before (i.e. the value of the premium)?

• Premiums are determined by supply and demand – the different investor’s


expectations about the future

• Factors affecting the price


– the price of the stock
– the exercise price (the future estimated agreed price for the stock)
– interest rates
– time to expiration
– volatility of stock price (up and downs)

• The Black & Scholes formula


– Quantifies the factors affecting the option value
– Gave the guys a Nobel price
Beyond the scope of this course…but ask ChatGPT etc. for have an explanation
The trading of options
• In real life, the buy/sell transaction implied by the option
is often never carried out (standardized options)

• the options exchange calculates the profits/losses an


settle them directly with the parties

• the buyer pays the premium up front

• the seller pays any losses when they materialize


– the seller must not walk away so the exchange will require
collateral to cover any losses
– the requirement changes with the price of the underlying security
Futures and forward contracts
• A contract, binding both parties, to complete a transaction on a future date
at a predetermined price
– Futures are standardized, exchange-traded and mainly used for speculation
– Forwards are tailor-made, one-to-one contracts. Default risk!

• Example: you have to pay 100.000 USD after 3 months to pay for a
computer system
• you do a forward with your bank to buy dollars after 3 months at a fixed rate of 1,20
• whatever happens to the FX rate, your rate is 1,20

• Example: you have little cash but want to get rich on the stock market.
Buy futures (warrants) that pay off hugely if the market goes up, but if it
does not then you loose it all pure speculation !!!!
Benefits and risks
• Benefits
– Excellent tools for risk reduction
• Currency forwards
• Commodities forwards
– Can create huge profits with little capital

• Risks
– Contracts can be very complex
– Assymetric risks
– If Delta is high => high losses possible
Benefits and risks
– Assymetric risks:

• Buying a call option: The risk is limited to the premium you


paid (your maximum loss), while the potential profit is
theoretically unlimited if the price of the underlying asset
increases significantly.

• Selling a call option: The opposite applies here – the


potential profit is limited to the premium you received when
selling the option, but the potential loss can be very large if
the price of the underlying asset rises sharply.

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