Managing Financial Risk with Options

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Managing Financial Risk with Options

• Chapter 14

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Reasons for Preferring Options

• Loss is limited to amount paid for premium
• Options are flexible to configure and readjust as
  desired
• Options are widely available over-the-counter and
  on organized exchanges
• Options protect against adverse effects but allow
  the retention of benefits from favorable moves

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Ways to use Options

• To Hedge
• To Take a View
• To Reduce Costs
• To Realize Competitive Advantage

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Risks to Hedge with Options

• Interest rate risk
• Rates may increase and borrowing costs more
• Rates may fall and decrease earnings
• Foreign exchange rate risk
• Commodity price risk
• Monetizing imbedded options
• Applying options as a competitive tool

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Interest Rate Risk

• Hedging floating rate debt
• Risk is that rates may increase
• Interest rate caps protect against interest rate
  increases

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Hedging Interest Rate Risk

• Interest Rate Cap
• Payment Realized When Interest Rate Exceeds Some
  Target
• Determining Factor Can be Interest Rate or Bond
  Price
• Swap - Alternate Vehicle

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Cap Premiums

• As Call Options on Forward Interest Rates
• More Expensive as Yield Curve Steepens
• More Expensive as Rate Volatility Increases

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Interest Rate Risk

• Hedging floating rate assets
• Risk is that rates may decrease
• Interest rate floors protect against rate
  decreases

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Floors

• Put Option on Interest Rate
• To Hedge Natural Long Exposure
• Income Received from Floor Instrument when
  Interest Rate Falls
• Receive Fixed Percent Less Floating Rate
  Designated

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Options can also increase yields or decrease costs

• Options can be sold and the premium received can
  increase the yield on an investment or decrease
  the cost of funding the firm

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Options can be Combined to Produce Special
Benefits

• Collars result from combining caps and floors
• Zero cost collars result when the purchased cap
  premium exactly matches the sold floor premium
• Result of a zero cost collar is effectively
  limiting the maximum and minimum debt costs

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Collars

• Buy a Cap
• Sell a Floor
• Costless Collar - Zero Cost Collar
• Match Amount Received for Floor to Amount Paid
  for Cap

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Page 339 Example Extension

• LIBOR at 4
• Un-hedged
• Eff. Rate 5
• Sold Futures
• Eff. Rate 8.1
• Puts Bought
• Eff. Rate 4.4

• LIBOR at 10
• Un-hedged
• Eff. Rate 11
• Sold Futures
• Eff. Rate 8.1
• Puts Bought
• Eff. Rate 8.4

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Foreign Exchange Rate Risk

• Usually applied to transaction exposure
• Can hedge exposure fully
• Can use partial hedges at different exchange rates

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Hedging Receivables

• Purchase Put options

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Hedging Payables

• Purchase Call options

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Commodity Price Risk

• Energy prices
• Metal prices
• Major ingredient prices
• Grains
• Meal, oil, etc.

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Sources of Commodity Price Risk

• Fixed price sales with major commodity input
  needs
• Energy costs by transportation companies
• Metal costs of finished product manufacturers

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Monetizing Imbedded Options

• Characteristics of options may be imbedded within
  a position the firm holds
• Firm can sell an option with identical
  characteristics if it perceives the price
  obtained exceeds the options value
• Callable corporate debt is an example
• It contains out of the money interest rate option
• If interest rates decline firm can exercise

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Options as a Tool

• Creative use of options allows firms to enhance
  their competitive position
• Buy options and offer the benefits of them to
  customers
• Some options may not be economically feasible for
  customers to buy
• Some customers may lack sophistication of using
  options

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Strategic Dimensions of Risk Management

• Relating Policies to Sales and Marketing
• Price Goods in Local Currency
• Helps make sales effort competitive
• Protecting Operating Margin
• Lock in a floor protecting against strengthening
  dollar
• Establish risk tolerance level

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Commodity Price Risk

• Long term contracts to supply goods at a fixed
  price
• Travel companies
• Silver producing - developer
• Spread Benefits
• Allow range to be targeted
• Cost of protection can be limited
• Can match hedging needs outlook

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Burns McBride Example

• Gave customers option on heating oil for winter
  months. By passing along benefits they were able
  to offer customer a limited cost for heating fuel.

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