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Class 14 - o Hedging Take on financial contract that is...

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Ch. 20: Options Ex. Ramsync: o Invest $900M and receive PV of $867M o NPV of $-33M o However, over next 5 years there will be opportunity to grow after exposure to technology Invest $500M and receive PV of $165M But that $165M may increase or decrease a lot over 5 years Derivative: o Financial instrument that derives its value from some underlying asset Oil prices Cattle Foreign exchange rates Stock price o Call option: Gives the right to buy stock at a certain exercise price over a certain period of time o Put option: Gives holder the right to sell stock at certain price… o American option vs. European option: American can be used at any period during life of option European can only be used at end of period Risk management: o Oil consumer (US Air): If oil prices rise US Air is in trouble US Air can purchase a call option
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Unformatted text preview: o Hedging: Take on financial contract that is negatively correlated w/ your underlying position If prices shoot up that’s bad, but you gain on your call option This is like buying insurance • Futures contract: o “I will buy 10,000 barrels of oil from you in 1 year, let’s fix the price right now” o Traded on exchange o Ex. Ramsync: =SDRAM (NPV=-$33M) + MRAM growth opportunity • MRAM must be worth at least $33M • MRAM is a call option • Out of the money: o Don’t want to use option now, but you might sometime in the future • Option pricing using Black Scholes Model: o Inputs: Volatility (% SD) Short term interest rate Time to expiration Exercise price, current price It is worth more than $33M...
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