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Chapter 21 IM 10th Ed

Chapter 21 IM 10th Ed - CHAPTER 21 Risk Management CHAPTER...

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CHAPTER 21 Risk Management CHAPTER ORIENTATION The purpose of this chapter is to look at futures, options, and currency swaps and explain how they are used by financial managers to control risk. CHAPTER OUTLINE I. Futures and options can be used by the financial manager to reduce the risks associated with interest rates, and exchange rates, and commodity price fluctuations. A. A futures contract is a contract to buy or sell a stated commodity (such as soybeans or corn) or a financial claim (such as U.S. Treasury bonds) at a specified price at some future specified time. 1. A futures contract is a specialized form of a forward contract distinguished by: (l) an organized exchange, (2) a standardized contract with limited price changes and margin requirements, (3) a formal clearinghouse and (4) daily resettlement of contracts. a. An organized exchange provides a central trading place and encourages confidence in the futures market by allowing for effective regulation of trading. b. Standardized contracts lead to greater liquidity in the secondary market for that contract, which in turn draws more traders into the market. c. The futures clearinghouse serves to guarantee that all trades will be honored. This is done by having the clearinghouse interpose itself as the buyer to every seller and the seller to every buyer. d. Under the daily resettlement process, maintenance margins must be maintained. 2. For the financial manager financial futures provide an excellent way of controlling risk in interest rates, foreign exchange rates, and stock fluctuations. 11
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B. There are two basic types of options: puts and calls. A call option gives its owner the right to purchase a given number of shares of stock or some other asset at a specified price over a specified time period. A put gives its owner the right to sell a given number of shares of common stock or some other asset at a specified price over a given time period. 1. The popularity of options can be explained by their leverage, financial insurance, and investment alternative expansion features. a. The leverage feature allows the financial manager the chance for unlimited capital gains with a very small investment. b. When a put with an exercise price equal to the current stock price is purchased, it insures the holder against any declines in the stock price over the life of the put. This is the financial insurance feature of options and can be used by portfolio managers to reduce risk exposure in portfolios. c. From the point of view of the investor, the use of puts, calls, and combinations of them can materially increase the set of possible investment alternatives available. 2. Recently, five new variations of the traditional option have appeared: the stock index option, the interest rate option, the foreign currency option, the Treasury bond futures option, and leaps. a.
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Chapter 21 IM 10th Ed - CHAPTER 21 Risk Management CHAPTER...

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