Handout 6A - Corporate Risk Management 1. Options 2....

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Corporate Finance © Professor Ho-Mou Wu Corporate Risk Management 1. Options 2. Futures 3. Hedging and Risk Management 4. Application : LTCM 6A-0 Spring 2004
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Corporate Finance © Professor Ho-Mou Wu Spring 2004 Options Options An (European) call option gives its holder a right to buy the underlying asset on a certain date at a prespecified price . An (European) put option gives its holder a right to sell the underlying asset on a certain date at a prespecified price . certain date . expiration date (T) prespecified price . strike price, exercise price (K) . The call or put option contract also has a market price, called option price or option premium (C or P). In general terms, an option is a right to make decision in the future. Such a concept includes the case of real options 6A-1
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Corporate Finance © Professor Ho-Mou Wu Payoffs to European Call and Put Options on Expiration Date Long Call Short Call T S T S $ $ K K Long Put T S $ K payoffs profits payoffs profits profits payoffs $ K T S payoffs profits Short Put 6A-2 Spring 2004
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Corporate Finance © Professor Ho-Mou Wu Why Are Options Used Why Are Options Used 5 . Example 1: Suppose we consider one stock with 100 dollar per share as its price today. Consider its (European) call option with strike price K = 100 and expiration date T (a month from now). The premium of call option is 10 dollar per share, and the interest rate is 1% (for one month) till T . Strategy A. Buy 1 million shares of the stock. Strategy B. Buy 10,000 contracts of call options (each contract covers 1000 shares) on the stock. Strategy C. Buy 1,000 contracts of call options on the stock and invest the remaining 90 million dollar in a safe account with 1% return in a month. 6A-3 Spring 2004
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Corporate Finance © Professor Ho-Mou Wu Example 1 . (Continued) Possible S T (price of the stock at date T ) Final Payoffs of 80 90 100 110 120 130 Strategy A 80m 90m 100m 110m 120m 130m Strategy B 0 0 0 100m 200m 300m = 10 × 10m = 20 × 10m = 30 × 10m Strategy C 90.9m 90.9m 90.9m 100.9m 110.9m 120.9m = 90.9m = 90.9m = 90.9m + 10 × 1m + 20 × 1m + 30 × 1m Why Are Options Used Why Are Options Used 5 . 6A-4 Spring 2004
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Corporate Finance © Professor Ho-Mou Wu Options can be used for hedging or speculation Options can be used for hedging or speculation Profits = Payoffs - Cost $ S T B A C A: full participation in stock market B: offers “leverage”. C: offers “insurance”. -100m -9.1m -10m -20m 80 90 100 110 120 6A-5 Spring 2004
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© Professor Ho-Mou Wu Put Put 5 . Call Parity Call Parity Call . Bond . Put . Stock in terms of portfolio composition . C . T f ) r 1 ( K + P . S 0 in terms of cost at date 0 Payoff on T S T S T S T S T S T K K K K K Bond stock Payoff on T . . . . K
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Handout 6A - Corporate Risk Management 1. Options 2....

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