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Lect 17 221 web - Managerial Finance Lecture 17 Financial...

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1 Managerial Finance Lecture 17 Financial Options Class 16. Summary Risk management allows firms to move cash flows between different states of the world Need to be clear about: what is the risk the firm is worried about? Need to be clear about: the firm is worried about? Why? What is the friction that makes risk management valuable? If hedging is valuable, how should it be implemented ? Forwards are binding agreements between buyers and sellers to buy or sell assets in the future Options give the buyer the right but not the obligation to purchase or sell assets in the future: generally more flexible if the transaction 2 or sell assets in the future: generally, more flexible if the transaction may not occur The choice of risk management tool should focus on the specific risk you seek to avoid Not hedging is an alternative : hedging all risks is rarely desirable
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2 Option Pricing and Early Exercise Decisions Put-call parity: Relationship between European call and put prices: helpful in bt i i t ll l h f th i k obtaining put or call values whenever one of them is known Time value of options and early exercise decisions: Should options be exercised early? If so when? Option pricing models: General model : binomial option pricing model • Flexible model Flexible model Used to value any option Special case : Black-Scholes option pricing One formula for pricing European style options 3 Portfolio insurance You own $10,000 shares of H.J. Heinz Company The stock price is $50 per share You think HNZ has upside potential Yet, you want protection against a price decline What can you do? 4
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