of the future outlay to exercise declines, and therefore option valueincreases.-σ is also positively related to option value. Anyrandom movement inthe underlying security price is more likely to help than harm optionvalue.-As T increases, option value increases; reflect the increased oddsthat the security will experience some increase in price, the longerthe time until maturity.Applications of Option Valuation-The equity of a firm with debt in its capital structure is actually a call optionifinterest and principal are paid to creditors, shareholders own the underlyingassets of the firm; if interest and principal are defaulted, creditors will end upwith the assets.-If the So/X ratio is high, the option is well in the money, which implies a lowproportion of debt in the company’s capital structure. If low the company haslots of debt.-An increase in σ means that the operating assets of the firm are more risky.-Specific actions taken by geared companies can shift wealth fromdebtholders to shareholders.Agency-Many economists think that an efficient market for company take-oversis animportant solution to the agency problem of manager-shareholder conflict.-Any solution to an agency problem requires that there be an overall gain insolving the problem, which is allocated in such a way that the agent has anincentive to participate in the solution.Derivatives-Any financial security whose return or outcome set is derived from someother assets value or return outcome.-Simple derivatives can be very dangerous when misapplied.Participation in Derivative Markets-These should be careful control and oversight of those responsible forcommitting firms to positions in derivative markets.-Someone in the organisation should understand enough about these marketsto appreciate the risks inherent in a proposed commitment.-The potential benefits of participating in derivative markets are very large formany organisations.-The most common type of transaction is derivative markets is the hedging ofrisk.-Properly used, derivatives serve to reduce risk.The Types of Derivatives-Interest Rate: forward contracts, futures contracts, options, swaps. 43
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