ch 18 - Derivatives and Risk Management Chapter 18 Motives...

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Unformatted text preview: Derivatives and Risk Management Chapter 18 Motives for Risk Management Derivative Securities Using Derivatives Fundamentals of Risk Management 18-1 Why might stockholders be indifferent to whether a firm reduces the volatility of its cash flows? Diversified shareholders may already be hedged against various types of risk. Reducing volatility increases firm value only if it leads to higher expected cash flows and/or a reduced WACC. 18-2 Reasons That Corporations Engage in Risk Management Reduced volatility reduces bankruptcy risk, which enables the firm to increase its debt capacity. By reducing the need for external equity, firms can maintain their optimal capital budget. Reduced volatility helps avoid financial distress costs. Managers have a comparative advantage in hedging certain types of risk. Reduced volatility reduces the costs of borrowing. Reduced volatility reduces the higher taxes that result from fluctuating earnings. Certain compensation schemes reward managers for achieving stable earnings. 18-3 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. Its important to remember: It does not obligate its owner to take action. It merely gives the owner the right to buy or sell an asset. 18-4 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: option contracts market price. 18-5 Option Terminology (Contd) 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 investors portfolio....
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ch 18 - Derivatives and Risk Management Chapter 18 Motives...

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