Spreadsheet Model for Derivatives
A derivative is a security whose values are determined by the market price or interest rate of some other
Derivatives are a primary aspect of risk management, because they offer financial planners and risk
managers an opportunity
to hedge business risk.
The term risk management can mean many things, but in
business it involves identifying events that could have adverse financial consequences and taking actions to
prevent and/or minimize the damage caused by such events.
Effective risk management allows managers to
control the costs of key inputs and protecting against changes in interest rates and exchange rates.
Derivatives can include options (whose values depend upon the prices of some underlying stocks or other
financial assets), interest rate futures, exchange rate futures, and swaps (whose values depend on interest
rate and exchange rate levels), and commodity futures (whose values depend on commodity prices).
An option is a contract which gives its holder the right to buy (or sell) an asset at a predetermined price within
a specified period of time.
Option contracts, though often quoted in terms of single shares, usually are
contracts for a 100 shares.
A call option describes a situation in which one investor may sell to someone the
right to buy his/her shares of a stock over some interval of time.
In this scenario, the writer of the call option
(the party that surrenders the right to exercise) is said to hold a short position on the option.
party that has purchased this right to buy is said to hold a long position on the option.
price that the stock may be purchased for is called the strike, or exercise, price.
When an investor "writes"
call options against stock held in his/her portfolio, this is called a "covered call".
When the call options are
written without the stock to back them up, they are called "naked calls".
When the exercise price is
below the current market price, the call option is said to be "in-the-money".
Likewise, when the exercise
price exceeds the current market price, the call option is said to be "out-of-the-money".
For instance, if you
believed that the price of stock was primed to rise, a call option would allow you to capture a profit off of the
rise in price.
A put option allows you to buy the right to sell a stock at a specified price within some future period. If you
happened to believe that the price of a stock was ready to fall, a put option would allow you the opportunity to
turn a profit out of that decline.
cases of both call and put options, the profit or loss made on an
options transaction is determined by the value of the underlying asset, the strike price of the option, and the
price of the option.
FOR A CALL, AT EXPIRATION