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FINE 5200
1. Sources of Risk
What are risks?
o The known knowns
o The known unknowns
o The unknown unknowns
Reports that say that something hasn't happened are always interesting to me,
because as we know, there are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some
things we do not know. But there are also unknown unknowns -- the ones we don't
know we don't know. And if one looks throughout the history of our country and
other free countries, it is the latter category that tend to be the difficult ones.
Donald Rumsfeld (U.S. Secretary of Defense, 2001-2006), at the Department
of Defense news briefing, February 12, 2002.
Examples of known unknowns and unknown unknowns in the corporate
world?
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c) Natural hedge
Hedging by changing business practices, without any use of derivatives:
o Vertical integration (managing exposure to prices)
o Localize both revenues and expenses (managing currency exposure)
d) Benefit of hedging with derivatives
Both long-run and short-turn exposure
Cost effective
Flexible
e) Choice of derivatives:
Forward contracts
Futures contracts
Swaps
Options
Others
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Example 1
Consider a three-month forward contract on 100 ounces of gold.
The investor takes a long position in the forward contract.
The delivery/forward price is $1,200 per ounce.
Determine the investors payoff in three months if the gold price ends up in a range
between $1,150 and $1,250.
What if the investor had a short position in the forward contract instead?
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Example 2
Suppose an investor just bought a three-month call option on 100 shares of Stock
XYZ.
The strike price of the option is $50 (per share).
Determine the investors payoff in three months if stock price ends up in a range
between $25 and $75.
What if the investor bought a put option instead?
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Warrants
Convertible bonds
Corporate incentives (employee stock options)
Others
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4.1. Warrants
Warrants are similar to call options:
o Exercise price
o Maturity
o Number of shares per each warrant
Warrants are also different from exchange traded call options:
o They are sold by the company, not other investors.
o They are usually sold as sweeteners in a package of loans, bonds, common
stock or preferred stock.
o Most warrants are detachable so that they can be sold or exercised irrespective
of the original package they are bundled together.
o When warrants are exercised, investors pay the strike price to the company and
the company gives investors new shares (dilution of ownership).
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Example 3
(Example 25.8 / p.743)
Buckeye Industries has a zero-coupon bond issue with a face value of $100, due in
one year.
The value of Buckeyes assets is currently worth $109.
Jim Tressell, the CEO, believes that the assets in the firm will be worth either $92 or
$138 in one year.
The risk-free rate is 6% (EAR).
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