...Question: Discuss how an increase in the value of each of the determinants of the option price in the Black-Scholes option pricing model for European options is likely to change the price of a call option. A derivative is a financial instrument that has a value determined by the price of something else, such as options. The crucial idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk" (Ray, 2012). The derivative asset we will be most interested in is a European call option. A call option gives the holder of the option the right to buy the underlying asset by a certain date for a certain price, but a put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The date in the contract is known as the expiration date or maturity date; the price in the contract is known as the exercise price or strike price. The market price of the underlying asset on the valuation date is spot price or stock price. Intrinsic value is the difference between the current stock market price and the exercise price or simply higher of zero. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself. (Hull, 2012). For example, consider a July European call option contract on XYZ with strike price $70. When the contract expires in July, if the price of XYZ stock...
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...Question: Discuss how an increase in the value of each of the determinants of the option price in the Black-Scholes option pricing model for European options is likely to change the price of a call option. A derivative is a financial instrument that has a value determined by the price of something else, such as options. The crucial idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk" (Ray, 2012). The derivative asset we will be most interested in is a European call option. A call option gives the holder of the option the right to buy the underlying asset by a certain date for a certain price, but a put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The date in the contract is known as the expiration date or maturity date; the price in the contract is known as the exercise price or strike price. The market price of the underlying asset on the valuation date is spot price or stock price. Intrinsic value is the difference between the current stock market price and the exercise price or simply higher of zero. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself. (Hull, 2012). For example, consider a July European call option contract on XYZ with strike price $70. When the contract expires in July, if the price of XYZ stock...
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...Chapter 9 Derivatives: Futures, Options, and Swaps Chapter Overview This chapter provides an introduction to derivatives, and examines both their uses and abuses. Reading this chapter will prepare students to: * Explain derivatives. * Understand how derivatives can be used to transfer risk. * Analyze the pricing of derivatives. Chapter Outline I. The Basics: Defining Derivatives A. Derivatives are financial instruments whose value depends on (i.e., is derived from) the value of some other underlying financial instrument or asset (these include stocks or bonds as well as other assets). B. A simple example is an interest rate futures contract, which is an agreement between two investors that obligates one to make a payment to the other depending on the movement in interest rates over the next year. C. Such an arrangement is very different from the purchase of a bond for two reasons: a. Derivatives provide an easy way for investors to profit from price declines, as opposed to the purchase of a bond, which is a bet that its price will increase. b. In a derivatives transaction, one person’s loss is always the other person’s gain. D. Derivatives can be used to speculate on future price movements, but because they allow investors to manage and reduce risk, they are indispensable to a modern economy. E. The purpose of derivatives is to transfer risk from one person or firm to another, providing a kind of insurance...
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...------------------------------------------------- CHAPTER 18 ------------------------------------------------- DERIVATIVES AND RISK MANAGEMENT (Difficulty: E = Easy, M = Medium, T = Tough) Multiple Choice: Conceptual Easy: Risk management Answer: d Diff: E N . Which of the following statements concerning risk management is correct? a. Risk management can reduce the volatility of cash flows, and this decreases the probability of bankruptcy. b. Risk management can reduce the likelihood of low cash flows, and therefore reduce the probability of financial distress. c. Companies with volatile earnings pay more taxes than more stable companies due to the treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. Therefore, our tax system encourages risk management to stabilize earnings. d. Statements a, b, and c are correct. e. None of the statements above is correct. Derivatives Answer: d Diff: E N . Which of the following is an example of a derivative? a. Futures. b. Options. c. Swaps. d. All of the above are examples of derivatives. e. None of the above are examples of derivatives. Options Answer: b Diff: E . An option that gives the holder the right to sell a stock at a specified price at some time in the future is called a(n) a. Call option. ...
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...the idea behind arbitrage is fairly simple, it is quite powerful because the ability to exploit such opportunities is needed for markets to operate efficiently. Arbitrage ensures, for example, that buyers and sellers of foreign exchange can be assured that they are getting the “correct” rates for the currencies they are buying and selling independent of the national foreign-exchange markets they happen to be using. When markets are efficient, the prices of the objects being traded reflect their true value. And having prices reflect true values is important in decentralized economies, such as the United States, since it is the relative prices of various goods, services, and assets that determines how many will be produced, how they will be allocated, and how funds will be invested. If prices did not reflect true value, then the resulting allocation of goods, services, and investment would not be, in general, economically efficient. This Commentary focuses on a particular episode in which the recognition of an arbitrage “opportunity” made financial markets more efficient. It wasn’t a chance to make a profit that got noticed, it was the way the principles of arbitrage could be applied to the problem of correctly pricing options. Once financial economists figured it out, the solution enhanced the efficiency of financial markets because it made options useful as hedging instruments. Such instruments can be used to manage cash holdings only if they are correctly...
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...Financial Markets Lecture 6 Overview Futures, Options, Swaps Financial Derivatives Commodity Derivatives 1 Derivatives – Overview • Financial instrument or security whose payoffs depend on another instrument or security • Price of instrument a derivative of underlying security – Farmer who sows a crop in June, faces uncertainty over the price received at harvest time in September – Merchant/ consumer faces a price in September as well – Farmer, merchant negotiate on a price in June for settlement in September • Chicago Board of Trade 1848 • Yodoya rice futures in 1650 • Forwards, Futures, Options, Swaps 2 Derivatives - Definitions • Forwards – involves a contract initiated at one time, performance in accordance with the terms of the contract occurs at a subsequent future time • Futures – type of forward contract with standardized and closely specified contract terms – – – – Traded in organized exchange Standardized, specific quantity, delivery date, mechanism Performance guaranteed by clearinghouse Margins – good faith deposit with the exchange • Option – the right to purchase underlying good at a specific price until a specific date – Calls and Puts • Swaps – Agreement between two or more parties to exchange sequence of cash flows over a period in the future 3 Derivatives - Applications • Price risk elimination • Speculation • Market completeness • Information efficiency • Trading efficiency 4 Derivatives - Markets • Commodity Derivatives:...
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...operated completed differently from previous. Of course, financial market also become more and more complicated in order to associate with change of business structure. Consequently, this had led to rising of financial risk to investors invisibly. Hence, investors would like to speculate and hedge the financial risk as much as possible when do financial decision. Derivative financial instruments such as options, futures and others have been introduced and more commonly used to manage financial risk for improving decision making in this dynamic competitive environment. Options are defined as securities which one party has the right (no obligation) to buy or sell underlying assets with certain price within a certain/specific period of time (Hull, 2012). The option can be either call (right to buy) or put (right to sell) in the form of American options (exercised any time until expiry date) or European options (exercised on expiry date) as either traded options (standard option contracts) or overt-the-counter options (tailor made options). Due to various choices of options, different option pricing models such as Put-Call Parity, Black-Scholes, Cox-Rubenstein Binominal, Risk-Neutral valuation, the Greeks and others has been developed and applied in current financial market. Black-Scholes Option Pricing Model (BS) BS is designed and introduced by Fisher Black and Myron Scholes in 1973 with the assumptions of the market is efficient, returns are lognormal distributed, no...
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...of shares it can be converted to is determined by the issuer of the bond, the corporation. Convertible bonds are an attractive investment. They offer the for potential market appreciation like an equity. They also offer the conservative nature and safety of a bond. A convertible bond pays you interest and gives you the option to convert it to shares of stock. A convertible bond has a face value of $1,000, and the conversion price is $50 per share. The stock is selling at $42 per share. The bond pays $60 per year interest and is selling in the market for $930. It matures in 15 years. Market rates are 10 percent per year. a. What is the conversion ratio? 1000/50=$20 b. What is the conversion value? 20x42=$840 c. What is the conversion premium in dollar and percentage? 930-840=$90 90/840=10.71% What is meant by the exercise or strike price on an option? The price at which a specific derivative contract can be exercised. Strike price is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying security's current market price and the option's strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum...
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...ESSENTIALS of Financial Risk Management Karen A. Horcher John Wiley & Sons, Inc. ESSENTIALS of Financial Risk Management Essentials Series The Essentials Series was created for busy business advisory and corporate professionals. The books in this series were designed so that these busy professionals can quickly acquire knowledge and skills in core business areas. Each book provides need-to-have fundamentals for those professionals who must: Get up to speed quickly, because they have been promoted to a new position or have broadened their responsibility scope • • Manage a new functional area • Brush up on new developments in their area of responsibility • Add more value to their company or clients Other books in this series include: Essentials of Accounts Payable, Mary S. Schaeffer Essentials of Balanced Scorecard, Mohan Nair Essentials of Capacity Management, Reginald Tomas Yu-Lee Essentials of Capital Budgeting, James Sagner Essentials of Cash Flow, H. A. Schaeffer, Jr. Essentials of Corporate Performance Measurement, George T. Friedlob, Lydia L. F. Schleifer, and Franklin J. Plewa, Jr. Essentials of Cost Management, Joe and Catherine Stenzel Essentials of Credit, Collections, and Accounts Receivable, Mary S. Schaeffer Essentials of CRM: A Guide to Customer Relationship Management, Bryan Bergeron Essentials of Financial Analysis, George T. Friedlob and Lydia L. F. Schleifer Essentials of Financial Risk Management, Karen A. Horcher ...
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...multinational company and the impact on its financial statements (second half of 2011), and suggests various hedging strategies using FX options. Udi Sela - Vice President - Numerix - 27 Oct 2011 Since the sub-prime crisis, the markets have witnessed unprecedented levels of volatility across all asset classes. The impact of unpredicted volatility could be significant for the core businesses of corporations across the globe. In response, various hedging strategies were prepared towards the end of August 2011, and subsequently measured the performance of all strategies six weeks later (the beginning of October 2011). The FX Market: Facts and Figures The foreign exchange (FX) market is the most liquid market today, serving a crucial role in facilitating international trade. According to the latest Bank of International Settlements (BIS) survey, published in April 2010, the market’s daily volume is US$4 trillion. This represents a 20% growth rate, as compared to April 2007 when the previous survey was carried out. Over the same period, FX derivatives volume has increased by 9%. Interestingly, the market has become more global as the cross-border trading represents now 65% of all FX trading. Corporations Hedging A new survey shows that 94% of the world’s largest corporations report using derivatives to manage business and macroeconomic risks. Another study recently conducted amongst Fortune 500 corporations reveals that FX and interest rate derivatives are the most widely used instruments...
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...the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of riskaverse investors. The main function of derivatives is that they allow users to meet the demand for costeffective protection against risks associated with movements in the prices of the underlying. In other words, users of derivatives can hedge against fluctuations in exchange and interest rates, equity and commodity prices, as well as credit worthiness. Specifically, derivative transactions involve transferring those risks from entities less willing or able to manage them to those more willing or able to do so. Derivatives transactions are now common among a wide range of entities, including commercial banks, investment banks, central banks, fund mangers, insurance companies and other non-financial corporations. Participants in derivatives markets...
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...and the gains realized in cash because the investments were subject to lock-up agreements.2 Enron’s Chief Financial Officer (CFO) and others realized it was likely these investments would experience significant drops in value before they could be sold, but the investments could not be hedged commercially. Therefore, the CFO designed transactions that would, from an accounting point of view, keep the anticipated losses out of Enron’s income statement. This paper explains Enron’s hedging transactions with special purpose entities (SPEs) that allowed the company to overstate its true economic profit.3 The paper first provides an overview of risk management and explains how particular derivatives used by Enron and other companies help manage risk. The paper then analyzes Enron’s unique hedging schemes and provides insights with respect to their structure as well as the motivation for their creation. In addition, this section of the paper describes how the SPEs were used to keep losses out of Enron’s financial statements, how investors in the SPEs were provided with massive financial returns on modest investments, and why Enron’s declining stock price ultimately exposed the questionable activities of the CFO and others. The third section of the paper addresses specific, improper accounting employed by Enron, including consolidation rules. Finally, the paper discusses the Financial Accounting Standards Board Exposure Draft on the Proposed Interpretation that would change the consolidation...
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...relative to the financial institution’s capital position and financial condition or have not been identified to the extent that the situation represents an unsafe and unsound banking practice. Determination of whether the institution’s risk-management system can measure and control its risks is of particular importance. The primary components of a sound risk-management process are a comprehensive risk-measurement approach; a detailed structure of limits, guidelines, and other parameters used to govern risk taking; and a strong management information system for monitoring and reporting risks. These components are fundamental to both trading and nontrading activities. Moreover, the underlying risks associated with these activities, such as market, credit, liquidity, operations, and legal risks, are not new to banking, although their measurement can be more complex for trading activities than for lending activities. Accordingly, the process of risk management for capitalmarkets and trading activities should be integrated into the institution’s overall riskmanagement system to the fullest extent possible using a conceptual framework common to the financial institution’s other business activities. Such a common framework enables the institution to consolidate risk exposure more effectively, especially since the various individual risks involved in capital-markets and trading activities can be interconnected and may transcend specific markets. The examiner...
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...Derivatives Michael Bloss Associate Professor and Director MSc IF for Derivatives - Nürtingen-Geislingen University Introduction Michael Bloss Investment Advisor and Assistant Vice President Commerzbank AG Associate Professor and Director of the Master Programme "International Finance" Derivatives HfWU – Nürtingen-Geislingen University Director of the European Institute of Financial Engineering and Derivatives Michael Bloss contact information Michael.Bloss@HFWU.de Michael.Bloss@EIFD.de Michael Bloss Agenda for this course Derivatives exchanges Options Pricing Strategies Future Pricing Strategies Strategies and the pricing of options on futures Commodity and foreign exchanges futures Synthetic combinations and trading strategies Margining Risk controlling OTC derivatives SWAP OTC options Exotic options … Michael Bloss Derivatives to be in use in FE and portfolio management Case study … Literature list SET BOOKS: Derivatives by Bloss/Ernst/Häcker ISBN: 978-3-486-58632-9 Oldenbourg Verlag – München Michael Bloss Literature list Title Options, Futures & other Derivatives Derivate ISBN 978-0-131499-08-9 Author John C. Hull 978-3-486-58354-0 Michael Bloss, Dietmar Ernst Michael Bloss, Dietmar Ernst, Joachim Häcker Derivatives 978-3-486-58632-9 Michael Bloss cursive = English Version bold type = set book I have a request! Please tell me, if you don't understand me !!! Michael Bloss Lecture 1 Derivatives market ...
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...A/cs. That is something risk management struggles with, say the experts. In Richard Meyers’ estimation, risk managers or traders do not socialize enough. “It’s all about visibility,” he said. Meyers, chairman and CEO of Richard Meyers & Associates, a talent acquisition and management firm in New Jersey, relates the story of a firm that decided to adopt an Enterprise Risk Management (ERM) strategy. Instead of appointing its risk manager to head ERM, the company brought in someone else. Why? Time has come when organizations across the world have to do deep amendments in their Enterprise Risk Management (ERM) policies covering foreign exchange hedging programs, diversification in derivatives portfolio, Enterprise risk management policies and deeper and deeper understanding towards financial models. With this background paper would...
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