1Managerial FinanceLecture 17Financial OptionsClass 16. Summary•Risk management allows firms to move cash flows between different states of the worldNeed to be clear about:what is the riskthe firm is worried about?Need to be clear about: the firm is worried about? Why?What is the frictionthat makes risk management valuable?•If hedging is valuable, how should it be implemented?Forwardsare bindingagreements between buyers and sellers to buy or sell assets in the futureOptionsgive the buyer the right but not the obligationto purchase or sell assets in the future: generally more flexible if the transaction2or 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 riskyou seek to avoidNot hedging is an alternative: hedging all risks is rarely desirable
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2Option Pricing and Early Exercise Decisions•Put-call parity:Relationship between Europeancall and put prices: helpful in bt i itlllhf thikobtaining 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 modelFlexible model•Used to value anyoptionSpecial case: Black-Scholes option pricing•One formula for pricing European style options3Portfolio insurance•You own $10,000 shares of H.J. Heinz CompanyThe stock price is $50 per shareYou think HNZ has upside potential Yet, you want protection against a price declineWhat can you do?4