DERIVATIVES AND RISK MANAGEMENT
Using Derivatives to Manage Risk
Explain why finance theory, combined with well-diversified investors and “homemade hedging,” might suggest that risk management should not add much value to a company.
List and explain some reasons companies might actually employ
risk management techniques
What is a “natural hedge”? Give some examples of natural hedges.
How does a nonsymmetric hedge differ from a natural hedge?
Name an example of a nonsymmetric hedge.
List three reasons the derivatives markets have grown more rapidly
than any other major market in recent years.
What is an option? A call option? A put option?
Define a call option’s exercise value. Why is the actual market price
of a call option usually above its exercise value?
What are some factors that affect a call option’s value?
Underwater Technology stock is currently trading at $30 a share. A
call option on the stock with a $25 strike price currently sells for $12.
What are the exercise value and the premium of the call option?
($5.00; $7.00)
Describe how a risk-free portfolio can be created using stocks and
options.
How can such a portfolio be used to help estimate a call option’s
value?
What is a forward contract?
What is a futures contract? What are the key differences between
forward and futures contracts?
What is the difference between the initial margin and the maintenance margin on a futures contract?
Suppose you buy a March futures contract on a hypothetical 15-year,
6 percent semiannual coupon bond with a settlement price today of
109 9/32.
You post the initial margin required for this transaction
($1,553 per $100,000 contract).
What nominal yield to maturity is implied by the settlement price? If interest rates fall to 4.5 percent,what return would you earn on one futures contract?
If interest rates rose to 5.5 percent, what is the return on one futures contract? (5.11%, 448%, 271.66%)
Briefly describe the following types of derivative securities:
(1) Swaps.
(2) Structured notes.
(3) Inverse floaters.
Define the following terms:
(1) Pure risks.
(2) Speculative risks.
(3) Demand risks.
(4) Input risks.
(5) Financial risks.
(6) Property risks.
Explain how a company can use the futures market to hedge against
rising interest rates.
What is a swap? Describe the mechanics of a fixed-rate to floating-
rate swap.
Explain how a company can use the futures market to hedge against
rising raw materials prices.
How should derivatives be used in risk management? What problems can occur?