ch18 - CHAPTER18 DerivativesandRisk Management...

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    18-1 CHAPTER 18 Derivatives and Risk  Management Derivative securities Fundamentals of risk management Using derivatives
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    18-2 Are stockholders concerned about  whether or not a firm reduces the volatility  of its cash flows? Not necessarily. If cash flow volatility is due to  systematic risk, it can be eliminated  by diversifying investors’ portfolios.
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    18-3 Reasons that corporations  engage in risk management Increase their use of debt. Maintain their optimal capital budget. Avoid financial distress costs. Utilize their comparative advantages in  hedging, compared to investors. Reduce the risks and costs of borrowing. Reduce the higher taxes that result from  fluctuating earnings. Initiate compensation programs to reward  managers for achieving stable earnings.
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    18-4 What is an option? A contract that gives its holder the  right, but not the obligation, to buy (or  sell) an asset at some predetermined  price within a specified period of time. Most important characteristic of an  option: It does not obligate its owner to take  action. It merely gives the owner the right to buy  or sell an asset.
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    18-5 Option terminology Call option – an option to buy a specified  number of shares of a security within some  future period. Put option – an option to sell a specified number  of shares of a security within some future period. Exercise (or strike) price – the price stated in the  option contract at which the security can be  bought or sold. Option price – the market price of the option  contract. 
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    18-6 Option terminology Expiration date – the date the option matures. Exercise value – the value of an option if it were  exercised today (Current stock price - Strike  price). Covered option – an option written against stock  held in an investor’s portfolio. Naked (uncovered) option – an option written  without the stock to back it up.
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    18-7 Option terminology In-the-money call – a call option whose  exercise price is less than the current price of  the underlying stock.
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