CORPORATE FIANANCE DERIVATIVES, FUTURES & OPTIONS

Presented by:

M. Fareed Mumtaz M. Musharraf Kaleem

The price of jet fuel can greatly affect the profitability of an airline. With rising fuel costs during 2008, fuel became the largest expense for many airlines, accounting for 40 percent or so of operating costs. Southwest airline became an innovator when it when it began to hedge its fuel costs by using variety of sophisticated financial tools to deal with risks associated with volatile fuel costs, including heating oil futures contracts, jet fuel swaps, and call options. During period of rising fuel costs, Southwest was often one of the few profitable airlines, saving millions of dollars through hedging. During late 2008, the cost of jet fuel dropped dramatically, and Southwests hedges did not perform nearly as well. Until 2008, the company had never announced a quarterly loss in 16 years, but, in the fourth quarter it announced a loss of $56 million, in large part due to a hedging loss of $117 million. But Southwest may have gotten off easy. For the same period, UAL Corp. , the parent of United Airlines, lost $933 million and Cathy Pacific lost $ 1 billion on its hedges. In the later discussion, we will explore broadly what derivatives are? Whats hedging and speculation? And what are futures and options?

Why do firms use derivatives?

Derivatives are tools for changing the firms risk exposure.

When the firm reduces its risk exposure with the use of derivatives, it is said to be hedging.

Derivatives can also be used to merely change or even increase the firms risk exposure, known as Speculation.

DERIVATIVE
A derivative is a financial instrument whose payoffs and values are derived from, or depend on underlying variables. Most derivatives are forward or futures agreements (i.e. swaps). An option is a complex form of derivative (i.e. The value of a call option depends on the value of the underlying stock on which it is written.

TYPES OF DERIVATIVES

Forward Contracts

A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

Futures Contracts

A futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a during specified future date, the delivery date. Options An option is a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date.

Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given

Call Option Option Buyer Option Seller

Buys the right to buy the underlying asset at the Strike Price Has the obligation to sell the underlying asset to the option holder at the Strike Price

Put Option
Buys the right to sell the underlying asset at the Strike Price Has the obligation to buy the underlying asset from the option holder at the Strike Price

Illustration on Call Option An investor buys one European Call option on one share of Pakistan

Petroleum Ltd. at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

Illustration on Put Options

An investor buys one European Put Option on one share of Pakistan Petroleum Ltd. at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.

OPTION TERMINOLOGY (For The Equity Markets) Options

Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date. Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.

Call Option - Option to buy. Put Option - Option to sell. American Option - An option which can be exercised anytime on or before the expiry date. Strike Price/ Exercise Price - Price at which the option is to be exercised. Expiration Date - Date on which the option expires. European Option - An option which can be exercised only on expiry date. Exercise Date - Date on which the option gets exercised by the option holder/buyer.

Option Premium - The price paid by the option buyer to the option seller for granting the option.

Thank you
M. Fareed Mumtaz MES M. Musharraf Kaleem KSEW