Chapter On Risk Management and Derivatives

CHAPTER 18
RISK
MANAGEMENT
AND
DERIVATIVES
LEARNING OBJECTIVES
At the end of the chapter, you should be able to;
 Understand the context of risk management
 Define, measure and set out strategies to manage interest rate risk, currency risk,
refinancing risk, market/commodity price risk, credit risk and liquidity risk
 Understand the factors that affect the value of call and put options.
 Apply both the Black-Scholes and Binomial option pricing models
 Understand Put-Call parity, a replicating portfolio, and implied volatility
 Understand how futures contracts and CFDs work
 Explain the mark-to-market process.
 Value a future.
 Explain the use of derivatives for hedging purposes.
 Construct an interest rate swap.
 Understand how to hedge interest risk with floors, caps and collars
 Define and determine the duration of a bond.
 Explain asset securitization.
 Understand how to value convertible securities
 Define the use option pricing models in share based payments
 Understand basic option trading strategies
Financial Management 9e © Carlos Correia  2
Rationale for Financial Innovation
 Tax asymmetries.
 Transaction costs.
 Agency costs
 Risk hedging.
 Increasing the assets’ liquidity.
 Legislative reasons.
 Interest rate volatility.
 Volatility of prices.
 Academic work.
 Accounting reasons.
 Technological advances.
Risk Management Strategies
 External Risk
 Currency risk
 Interest rate risk
 Market risk
 Inflation risk
 Internal Risk
 Liquidity risk
 Credit risk
 Refinancing risk
 Regulatory/legal risk

Types of Risks
 Interest rate risk
 A firm’s exposure to movements in interest rates
 The more debt a firm has, the greater exposure it has to unfavourable rises
and favourable declines of rates
 Fixed and floating rates
• How to mitigate Interest rate risk:
 Matching of duration, term and interest basis if applicable
 A firm should make use of forward rate agreements to fix future interest
rates and interest rate swaps as well as caps, floors and collars
 Refinancing risk
 Risk of loan or bond maturities happening at times of financial distress or
high interest rates
• How to mitigate Refinancing risk:
 A firm should avoid concentrating the refinancing of its loans or bonds – it
should spread out the maturities of such bonds
 A firm should also ensure its sources of financing are widely distributed
Types of Risks continued…
 Liquidity Risk
• Risk that a firm will have insufficient funds to pay its creditors
• To pass the liquidity test, the company should be able to pay its debts as they
become due in the ordinary course of business for 12 months
• How to mitigate Liquidity risk:
• A firm should hold on to cash resources or unused banking facilities to
manage short-term commitments. Use cash flow budgets.
 Currency Risk
• Transaction exposure – arises from purchasing inventory or machinery from
foreign suppliers / borrowing in foreign currency / exports
• Economic exposure – arises from the length of the term of transaction
• How to mitigate Currency risk:
• A firm should monitor and report its exposure and hedge prominent
exposures
• A firm can make use of forward contracts, options, currency swaps and
foreign currency deposits
Types of Risk continued…
 Credit risk
• Risk that the counterparty to any contract will be unable to pay the
firm
• Such failures can negatively impact the firm’s own credit-rating and
cause cash flow interruptions
• How to mitigate credit risk:
• The firm should make use of reports such as the aging analysis of
trade receivables
• The firm should use credit agencies and apply stringent credit
evaluation criteria
• Avoid concentration of exposure

Types of Risk continued…
 Market and Commodity Price risks:
• Risk of unfavourable changes in the price of a major input or output
causing a decrease in profitability
• Market risk also relates to unfavourable fluctuations in the firm’s
share price
• How to mitigate Commodity and Market Risks:
• Use futures, forwards, swaps and options to manage commodity price
risk – for inputs
• Try to use natural hedges – for outputs
• Should a company hedge its outputs?

Types of Risks continued…
General Risks
 Inflation risk
• Risk that inflationary costs will be unable to be passed on to the
firm’s customers
• How to mitigate Inflation risk:
• Focus on cost management and open up operations in low-inflation
countries
 Legal / Regulatory risk
 Basis risk
 Systems and technology risks

Fundamental Derivative Instruments
The three primary instruments are
1. Options
2. Forward contracts
3. Futures.

What is an Option?
 An option is the right (but not the obligation) to buy or sell at some
date in the future at a predetermined price.
 Call option = right to buy from the writer of the call option (seller)
at a set price [no obligation to buy]
 Put option = right to sell to the writer of the put option (buyer) at a
set price [no obligation to sell]
 The option premium is payable today but the exercise price is
payable on the option expiry date for a CALL option and the
exercise price is receivable on the option expiry date for a PUT
option.
 American = option holder can exercise at any time up to expiry
date
 European = option holder can only exercise on the expiry date and
not at any time before.
 Exercise or Strike Price = the contract price payable by CALL
option holder on expiry and the contract price receivable by the
PUT option holder on expiry.
How are Options Created?
 Company issues options to investors to raise financing
 Option premiums
 Exercise price
 Company issues share options to its employees in the form of share
based payments - usually to senior management.
 Options created by independent parties such as investment banks
(warrants = options listed on the JSE and issued by ABSA, Deutsche
Bank, Investec etc)
 First options market was the Chicago Board Options Exchange
which opened in 1973.
 Organised exchanges are required to ensure liquidity and that
options are tradeable – this is important later for option pricing
models. Are share options issued to employees tradeable?

What is the Difference Between Options
and Futures?
 What is the same?
 Futures contracts and options may both involve the
future delivery of an underlying asset
 What is different?
 A futures contract requires that you buy and take
delivery or enter into an offsetting sale just prior to
delivery.
 An option gives you the right to buy –you are not
required to take delivery and pay the exercise price.
You ©choose.
Financial Management 9e Carlos Correia  13
What are the Payoff Structures for Call and Put
Options just Prior to Expiry?
Call Option Value of Call Option
Exercise Price 9.50 2.50
Payoff = Max(S1- E,0) 2.00

Share Price Payoff
7.00 - 1.50
7.50 -
8.00 - 1.00
8.50 -
9.00 - 0.50
9.50 -
10.00 0.50 -
10.50 1.00 00 50 00 50 00 50 .0
0
.5
0
.0
0
.5
0
7. 7. 8. 8. 9. 9. 10 10 11 11
11.00 1.50 Share Price on Expiry
11.50 2.00
Why is the option worth zero until the share price > 9.50?
You are not going to buy for R9.50 in terms of the option when you can buy for
say, R9.00 in the market. The option only has value on expiry when you can buy
at an exercise price that is below the share price.
What are the Payoff Structures?
Put Option Value of Put Option
Exercise Price 10.50 2.50
Payoff = Max(E-S1,0)
Share Price Payoff 2.00
8.50 2.00 1.50
9.00 1.50
1.00
9.50 1.00
10.00 0.50
0.50
10.50 -
11.00 - -
11.50 -
12.00 -
12.50 - Share Price on Expiry
 Only when the share price falls below R10.50, will the PUT option have
value. If the share price is above R10.50, then you would rather sell in the
market and let your option to sell at R10.50 lapse.

What are the Components of Option
Pricing?
– Intrinsic Value
– Time Value
 Option Value = Intrinsic Value + Time Value
 Intrinsic Value = Share price - Exercise price (at any time
prior to expiry and S>E)
 Option is in the money if S>E
 Option is out of the money if S<E
 Time Value relates to the probability that S>E (for a call

option) by exercise date

What are the Factors that affect Call Option
Values?
 The current share price (underlying asset price)
 The Exercise Price
 Time to expiration
 Volatility of the underlying share price
 The risk-free rate

Call Option Price & the Current Share
Price
 The higher the current share price, the higher the call
option value & the higher the probability that the share
price will be above the exercise price.
 If the share price > exercise price at any time, then S-E =
Intrinsic value
 Share options = no cost to company because as at time of
issue, the intrinsic value = 0 as options often issued at
market value or lower than market value , but there is a
long time to expiry. Do you agree? Why?
 If current share price < exercise price, then the option
will have time value as long as there is a probability that
the share price > exercise price by expiry date.
Call Option Price & the Exercise Price
 The higher the exercise price, the lower the call option
value.
 Value of Call Option on expiry =
 Share Price – Exercise price
 However, (if we ignore time to expiration and volatility
for now), the exercise price is payable at the time of
expiry and the option value =Share price – PV of
Exercise price

The Term to Expiry
 A call option value will be higher, the longer the term to
expiry. Why?
 The time value is mostly about the improving the
probability that the option will be in the money at some
time prior to expiry.
 Executives often receive share options with a high time
value and no intrinsic value.

How does Volatility affect Option Values?
 Why is volatility in the price of the underlying share so
important to option value?
Exercise Price 52.00
Prices at Expected
Probability
Expiry Value
In first case prices are
Pd 50% 40 20.00 less volatile between
Pu 50% 50 25.00 R40 and R50 - option
EV 100% 45.00 will have no value
Increase in volatility? In second case prices are

Pd 50% 20 10.00 more volatile between
Pu 50% 70 35.00 R20 and R70 - option
EV 100% 45.00
will have value as there is
a 50% chance the option
The Expected Value remains the same
will be in the money
However, with higher volatility in future prices, the option may have value.
 R70 > R52

©
whilst R52< R50
Financial Management 9e Carlos Correia  21
More on Volatility
 Let’s use probabilities to depict the variability in
future prices.
Expected Expected value
Exercise price Share Price Probability
Value of Call of share
6.00 2.00 30% 0.00 0.60
6.00 6.00 40% 0.00 2.40
6.00 10.00 30% 1.20 3.00
1.20 6.00
Expected Expected value

Exercise price Share Price Probability
Value of Call of share
6.00 2.00 10% 0.00 0.20
6.00 6.00 80% 0.00 4.80
6.00 10.00 10% 0.40 1.00
0.40 6.00
 More volatility results in a higher option value.

What About Dividends During the Time to
Expiry?
 The share price will fall as the dividend goes ex-dividend
 This will result in a fall in the value of a call option.
Companies that pay high dividends will reflect call
option values that are lower.
 Investors may exercise prior to expiry to earn dividends
but will lose some time value.

What About Put option Pricing?
 A higher exercise price will result in a higher put option value
 A lower share price will result in a higher put option value. We can
sell using the put and buy for a lower price in the market.
 A longer term to expiry will increase the value of the PUT
 A PUT has a maximum value. A CALL has unlimited potential value.
 How do investors use PUTs? An investor owns 1 million SASOL
shares and wishes to lock in value at R559.65 on 25 Sep 2018. The
investor buys a PUT to sell Sasol at R559.65. The investor still owns
1 million Sasol but now has the right to sell for R559.65. The share
price at 4 Jan 2019 was R431 and this put would be valuable.
 PUT option prices are negatively related to interest rates. Why?

Upper Boundary
 The upper boundary for an option value will be the price of the underlying share.
 Assume that the current share price is R72.00 and the call option price is R0.01.
You would pay close to R72.00 for the option, but you would not pay more as
then you would be able to buy at a lower cost directly in the market.
Upper bound = price of share
Lower bound = Share

price – Exercise Price
 Share Price is worth very little – no chance of attaining Exercise price. Option = 0
 Share price is very high relative to the Exercise price.
 Call option value = Share Price – PV of Exercise
Price
 Parallel lines = certainty about exercising the
option.
©
Diff = PV of exercise price rather than 25
Financial Management 9e Carlos Correia 
What is PUT-CALL Parity?
 If two portfolios offer the same payoff in the future, then they will have the
same price today.
 P = C – S +E/(1+r)
 Put price equals the call price less the share price plus the PV of the
Exercise price.
Portfolio Value today Payoff for Scenario 1 Payoff for Scenario 2
Share price > Exercise price Share price < Exercise price
X C + E/(1+r) (S1 - E) + E = S1 0+E=E

Y P+S 0 + S1 = S1 (E - S) + S =E
 As these two portfolios have the same payoffs, they will be priced the same.
 European options but American options are close. Empirical evidence =
violations of put-call parity not enough to cover transaction costs.
 We can determine the price of a PUT once we have determined the price of
a CALL.

Replicating portfolio
 Current share price: R50 and you have a call option to buy at R50
within 1 year and interest rate is 8%. Possible share prices at
expiry in 1 year’s time is either R60 or R40

Replicating portfolio
 Structure a portfolio of shares and debt so that you have
the same pay-offs in a year’s time.
 Value of portfolio = 0.50(R50) – R18.52 = R6.48 = value of call

option
 How did we know to buy 0.5 shares?
 Change in price of call = R10 and change in price of share is R20.
So 10/20 = 0.5

Determining delta
 So how did we know that we needed to acquire 0.5 of a share?
This is referred to as delta (Δ).
 How did we determine the borrowing amount (B)?
 We can also use simultaneous equations to determine delta (Δ) and
B as follows:

How did we determine the debt?
 We can solve for the debt (B) as follows:
 40(0.5) – 1.08B = 0
 20 = 1.08B
 20/1.08 = B = R18.51852

Black-Scholes Option Pricing Model
 Formula 19.1 Solution for computing European call option values
31
Financial Management 9e © Carlos Correia
What are the Assumptions of Black &
Scholes?
 Constant risk-free rate
 Investors can borrow and lend at the risk-free rate
 Constant variance in relation to price movements
 Share is continuously traded
 Normal distribution of share returns
 No transaction costs
 No taxes
 Short selling
 No dividends or rights issues
 European option

Applying Black-Scholes
 Price on a 3 month call option = R0.18
 Exercise Price = 2.55
 Current share price = 2.50
 Risk-free rate = 10%
 Standard deviation of annual returns = 30%
 What is the value of the call option?

Example 18.1 Valuation of a Call Option
250
ln  0 . 1  0 . 5 0 . 3 2
0 . 25
d  255
1
0 .3 0 . 25
 0 . 10965
250
ln  0 . 1  0 . 5 0 . 3 2
0 . 25
d  255
2
0 .3 0 . 25 0.50 + 0.0438
  0 . 04035
F r o m t a b le s fo r t h e s t a n d a r d n o r m a l d is t r ib u t io n f u n c t io n ( T a b le E ) :
N d  1 0 . 5438
N d 2   0 . 4840
0.50 -0.016
 255 
Value of option  250  0.5438   0 . 1  0 . 25  0 . 484 
 e 

= 1 5 .6 c e n ts  34
Using Table E

Black-Scholes in Excel
 Example 1: A company’s share price is R2.50 and the option has an exercise price
of R2.55. The volatility as measured by the standard deviation is 30%. The time
to expiry is 3 months (0.25 of the year) and the risk-free rate is 10%. What is the
value of the option? Use Excel.

 Example 2: A company’s share price is R25.50 and the option has an exercise
price of R25.50. The volatility as measured by the standard deviation is 30%.
The time to expiry is 3 months (0.25 of the year) and the risk-free rate is 10%.
What is the value of the option? Use Excel.
A B C D E F G H
1 Black-Scholes Option Pricing Model
2
3 Share Price 25.50 Enter the current share price
4 Exercise Price 25.50 Enter the option's exercise or strike price
2
5 Standard deviation 30.0% Enter the standard deviation. Variance = stdev
6 Time to expiry 0.25 Enter as a fraction of a year
7 Risk-free rate 10.0% Enter the annualised risk-free rate
8
9 d1 0.24167 (LN($C$3/$C$4)+($C$7+0.5*$C$5^2)*$C$6)/($C$5*$C$6^0.5)
10 d2 0.09167 $C$9-$C$5*($C$6)^0.5
11 0.09167 (LN($C$3/$C$4)+($C$7-0.5*$C$5^2)*$C$6)/($C$5*$C$6^0.5)
12 N(d1) 0.59548 NORMSDIST($C$9)
13 N(d2) 0.53652 NORMSDIST($C$10)
14
15 Value of Call Option 1.841 C = SN(d1) - Ee-rtN(d2)

16 $C$3*$C$12-$C$4*EXP(-$C$7*$C$6)*$C$13
17 Value of Put Option 1.212 P=C-S+Ee-rt
18 Management 9e $C$15-$C$3+$C$4*EXP(-$C$7*$C$6)
Financial © Carlos Correia  37
 Example 2:
Intrinsic Value = 0
A B C
 104
105 1.0000
NORMSDIST
84.134%
 Time Value = 1.84 106
107
108
0.0000
0.24167
0.09167
50.000%
59.548%
53.652%
A B C D E
Black-Scholes - Cumulative
P-Ee-rt Value
110 another view Probability
111 C = SN(d1) 25.500 0.595 15.185
-rt
112 Ee N(d2) 24.870 0.537 13.343
113 0.630 1.841
114
115 Exercise Price 25.50
Periods per
116 year
n
117 PV factor 365 0.9753 1/(1+r)
118 Present value of Exercise Price 24.870
119
-rt
120 Continuous Discounting becomes e
-rt
121 e 0.9753
Applying Excel to our previous example 1
A B C D E F G H
1 Black-Scholes Option Pricing Model
2
3 Share Price 2.50 Enter the current share price
4 Exercise Price 2.55 Enter the option's exercise or strike price
2
5 Standard deviation 30.0% Enter the standard deviation. Variance = stdev
6 Time to expiry 0.25 Enter as a fraction of a year
7 Risk-free rate 10.0% Enter the annualised risk-free rate
8
9 d1 0.10965 (LN($C$3/$C$4)+($C$7+0.5*$C$5^2)*$C$6)/($C$5*$C$6^0.5)
10 d2 -0.04035 $C$9-$C$5*($C$6)^0.5
11 -0.04035 (LN($C$3/$C$4)+($C$7-0.5*$C$5^2)*$C$6)/($C$5*$C$6^0.5)
12 N(d1) 0.54366 NORMSDIST($C$9)
13 N(d2) 0.48391 NORMSDIST($C$10)
14
15 Value of Call Option 0.156 C = SN(d1) - Ee-rtN(d2)

16 $C$3*$C$12-$C$4*EXP(-$C$7*$C$6)*$C$13
17 Value of Put Option 0.143 P=C-S+Ee-rt
18 $C$15-$C$3+$C$4*EXP(-$C$7*$C$6)

The Binomial Option Pricing Model
 The BOPM is an alternative approach to value options.
 The binomial model assumes only two possible values for the
underlying stock price over any finite period.
 The price of the share can only be two numbers
 Realistic solutions if we select a large number of short time periods

Binomial Model - Example
 Call option
 Exercise price 12.20
 Current share price 12.00
 Risk-free rate 1.0% per month
 Share price will rise by 4% or fall by 1/1.04
 Up/down factor = eσ√∆t [ ex. σ = 13.59%, t=1/12]

Binomial Model
 What is the probability (p) of the up factor so that we achieve a
return equal to the risk-free rate?
 We can solve for p:

Binomial Model
0.58 0.94
p = 0.6176471
12.00 x 1.04 =
12.48
0 1 2 3
Binomial Tree
13.498
12.979
12.480 12.480
12.00 12.000
11.538 11.538
12.00/1.04 = 11.095
11.538 10.668
13.498 – 12.20 =
1.29836
Expected pay-offs
[(1.29836 x 0.6176)+(0.28 x (1-0.6176)]/(1.01) = 1.298368
0.89999 0.899992
As 11.538 <
0.615195 0.28 12.20, payoff
0.415852 0.171229 => 0
0.104712 0
Value of Option 0
0
Workings: Future Share Prices
 1st month:
12.00 x 1.04 = 12.48 or 12.00/1.04 = 11.538
 2nd month:
12.48 x 1.04 = 12.979 or 12.48/1.04 = 12.00 or 11.538 x 1.04 =
12.00 or 11.538/1.04 = 11.095
 This creates a lattice of share prices

Workings: Expected Payoffs
 Time 3
 13.498 – 12.20 = 1.29836
 12.48 – 12.20 = 0.28
 As 11.538 < 12.20, payoff => 0
 Time 2
 [(1.29836 x 0.6176)+(0.28 x (1-0.6176)]/(1.01) =
0.89999

Hoadley – Binomial

Option value

The Greeks
Delta
 What is delta?
 This is the degree to which an option price will move given a
small change in the underlying share price.
 An option with a delta of 0.5 will change value by one cent for
every two cent movement in the underlying share.
 A deeply out-of-the-money call will have a delta very close to zero
 A deeply in-the-money call will have a delta very close to 1. (Go to
the pay-off diagram to see why)
 The delta of a European call on a non-dividend paying stock is:
 Delta = N(d1) (see Black-Scholes formula above for d1)
 Call option deltas are positive and put deltas are negative. Why?
 The put option price is inversely related to the underlying share price.
Put delta = (call option delta – 1). The delta is also known as the
hedge
Financial ratio
Management 9e ©
Carlos Correia  48
The Greeks
 Vega: The change in option price for a one percentage point
change in volatility.
 Theta: The change in option price for a one day reduction in the
time to expiration. This is measures time decay.
 Gamma: This measures how the delta changes for small changes
in the underlying share price. Therefore this reflects the delta of
the delta.
 Rho: This refers to the change in option price for a one

percentage point change in the risk-free interest rate.

Futures & Forward Contracts
 A forward contract is a commitment to buy an asset on a
specified future date at a specified price. It is written
specifically to satisfy the needs of the parties.
 A future is the same in principle except that it involves
the trading of standardized contracts on a formal
exchange.

Pricing of Futures & Forward Contracts
Ft ,T  St (1  r )  D(1  r )
 If the dividend is assumed to occur at the end of the period then we

deduct D and not D(1+r)
 Price of ALSI future
 See example 18.2 where we apply the futures pricing formula to
value the ALSI March 2019 contract in August 2018.

Contracts for Difference (CFDs)
The future of Futures?
 What are CFDs?
 This is a contract that enables you to obtain the price movements on an
underlying share. If you are long, you pay interest and you receive the
dividend. The provider of CFDs buys the underlying shares to avoid exposure,
receives interest and pays across any dividends received.
 We think that investors will invest in CFDs rather than futures in the future.
Why?
 Why do we think that CFDs will be popular? There is NO expiry date and
there is transparency. If you buy a BHP Billiton CFD, you pay say a 5%
margin and then you pay interest on the balance. You receive any dividend
flow. As the price moves, you either have to make further margin payments or
you receive money if the price movement is in your favour. Dividends and
interest are explicit. In the pricing of futures, these are implicit. What would
you prefer?

CFD example
 t

Risk-reducing Techniques
 Natural hedges – operational hedging
 Hedging with futures, forwards, and options
 Hedging with interest rate swaps
 Duration and immunization

Natural Hedges
 Hedging involves the offsetting of a position in the spot market
with an opposite position in the derivatives market.
 Natural hedging occurs when opposite positions are taken in the
market through the normal course of business. Fluctuations are
thus automatically set off against each other.
 Given the intricate and interdependent nature of many
transactions, coupled with the complexities of group corporate
structures, a careful analysis of the situation may reveal natural
hedges which were not clear at first glance. Ex. Input price of
alumina is highly correlated to output price of aluminium. For
aluminium producers this represents a natural hedge for a major
input cost.

Hedging with Futures, Forwards, &
Options
 Hedging with futures or forward contracts is
designed to fix the price at some time in the
future.
 By contrast, hedging with options has the effect
of protecting the seller from a fall (or the buyer
from a rise) in the price.

Hedging with a Forward Contract
 Refer to the example in the textbook.
 Farmer sells futures contract – a short hedge. Farmer fixes the price he will
receive
 Mango ade buys sugar futures – a long hedge. The company fixes the price it
will pay for sugar.
 Farmer and Mango ade will probably not deal with sugar on the
exchange but will close out their positions and take the gain or loss
and set off this off against the cost and revenue in the spot market.

Hedging with Interest Rate Swaps
 One party agrees to swap commitments on a notional
amount for commitments held by another party.
 A Ltd is paying a fixed interest rate and B Ltd is paying a
floating interest rate. A Ltd and B Ltd agree to swap
obligations using a separate contract, so that A Ltd will
pay a floating rate to B Ltd and B Ltd will pay a fixed rate
to A Ltd
 The floating rate borrower may want to hedge against fluctuating interest
rates.
 One borrower may not be able to raise the particular debt package required
on terms as favourable as those obtained by the other party.

Interest rate swap with a bank
 Initial borrowings = R100m. Co. A Notional amount = R100m
 Settlement of net cash flows
JIBAR
Co. A Bank
FIXED RATE
JIBAR
Original bank
Notional amt Pays Receives Swap Quarter

Fixed rate JIBAR settlement
Year 1 100,000,000 9.0% 7.5% -1.5% -375,000
Year 2 100,000,000 9.0% 10.0% 1.0% 250,000

Duration & Immunization
 Change in interest rates -> greater change in the value of longer-
term debt than that of short-term debt
 Example 18.5: Duration volatility of debt
 The current market rate is 15%:
 Value for both bonds = R1000
 If the interest rate rises to 18%, then the value of the 1-year bond
falls to R974.58 [1150/1.18]
 The value of the 5-year bond will fall to R906.18
 The debt with the longer duration is more sensitive to interest rate
changes.
 Interest rate risk is also affected by the level of the coupon rate.

Duration
 Firms that borrow and lend funds can hedge against interest rate
volatility by ensuring the term of the debt matches.
 The duration of the debt is not the stated term of the debt.
 Although the period of the debt may be stated in terms of its
maturity date, the total cash flows from the debt do not occur at
the maturity date but during the course of that period.
 The true duration of the debt is the weighted average of the PV of
the cash flows over the period of the debt.
 The total duration is the weighted average of each portion of the
debt for the time that it exists.

Duration – Example 18.6
 Assume a company is paying a coupon rate of 15%, and the par
value is R1000. Assume the Yield to Maturity is 15%.
 The duration of the debenture is 3.8550 years, even though the term
of the debenture issue is 5 years. The duration of a bond and
therefore its risk is affected by both the term and the coupon rate. A
high coupon and short term means lower risk. This calculation is
called Macauley Duration.
 What happens in our example if we reduce the coupon to 5% but
the YTM stays at 15%? 62
Duration
 The duration of the debenture will increase. Why? A high coupon
means we can reinvest a higher proportion of cash flows at the new
interest rate, whilst a low coupon means that we are less able to do
this.
 For a zero coupon bond/debenture, the term is equal to the duration

of the bond/debenture.
Immunization
 If company issues the debentures at a coupon of 15%,
and then lends the funds on a 5 year basis but which is
repayable in instalments over 5 years, then the durations
will differ as the latter will have a duration of 2.63 years.
 How do we achieve immunization?
 Changes in interest rates will change durations and

companies will need to continually monitor durations to
minimise risk.
 Immunization is VERY important for banks and financial
institutions
Comparison of durations
 Borrow at 15% payable in 5 years time and lend at 15%, repayable
in annual installments.
 What happens if the interest rate falls to 10%?

Duration
 If interest the interest rate falls to 10% and we have structured the
following repayments of the loan, then there will be little impact on
the NPV of the differential cash flows because the durations are
almost equal.

Modified duration
 Modified duration = approximate impact that a change in interest
rates will have on the value of a bond
 Dmod = Macauley duration/(I +YTM)
 % change = -Dmod x change in interest rates
 Dmod = -3.855/1.14 = -3.3816
 If interest rate change = -1%, then value up by 3.38%
 67
Hedging Interest risk with Floors, Caps
and Collars
 Caps
• Caps can be used to set the maximum interest rate that will be paid
on borrowings
• If the interest rate goes above the Cap rate, then the bank (the
counter party) will reimburse the firm for the additional interest rate

and Collars
 Floors
• Used to ensure interest income does not fall below a certain rate
• Investor pays a premium for this option as the bank will pay over
the difference should the market interest rate falls below the
minimum rate

and Collars
 Collars
• Combination of a cap and a floor
• The company sells a floor to investors
• Banks can organise a zero cost collar for the firm so that the cost
of the premium payable for the cap is set off by the premium
receivable for the floor

Collar cash flows
 Collar

and Collars
 Advantages of Collars:
 Flexibility
 Relative certainty in terms of the cost of borrowing
 Protection from upward spikes in the interest rate
 Shape of the Yield curve – firms will benefit from borrowing on a floating
rate basis but can avoid the associated volatility
 Lower cost than a long-term fixed rate loan
 Zero cost collar
 Disadvantages of Collars:
 Loss of some of the benefit from falling interest rates
 Uncertainty regarding taxation
 May be costly to cancel a Collar before the conclusion of the contract

 What risks do
companies hedge?
 What instruments do
companies use to
hedge?
 Forwards = forex
 Swaps = interest rate
risk

Securitisation
 Asset securitisation is the conversion of an organization’s
illiquid assets into liquid assets. This is achieved by
repackaging existing income-yielding assets into tradable
securities, secured by the assets (for example, non-
negotiable debt) into negotiable instruments.
 The main participants are:
 The originator. The seller of the asset – for example
the bank.
 The issuer. The buyer of the assets, who issues the
negotiable debt.
 The investor. The original buyers, and subsequent
traders, in the negotiable debt

Securitisation
 Example: Woolworths securitisation of its card debtors
 Few securitisations have occurred in South Africa since the global financial crisis

Convertible Securities
 Convertible bonds and preference shares are issued to
reduce borrowing costs
 The right to convert these securities allows a lower interest
or preference dividend rate
 Valuation involves a bond / preference share valuation and a
call option valuation
 Extreme points:
 Share price is very low relative to the conversion price -
unlikely to convert - value as a bond/pref.
 Share price is very high relative to the conversion price –
highly likely that conversion will occur – use converted
value
Share Based Payments
Valuation of Share Options & IFRS2
 Statement “Standard option pricing models cannot be used to determine the value of
employee stock options (ESOs).” Why?
 vesting requirements,
 forfeiture of unvested and out-of-the-money options when employees leave the
company,
 non-tradability of ESOs (usually resulting in earlier exercise), blackout periods,
 other considerations
 These factors make ESO valuation more complex than standard option valuation.
 Employee share options have a much longer time to expiry than traded options. Often
ESOs are 5-10 years whilst traded share options are for a few months. During this long
time period there could be a changes in interest rates, share volatility and dividend
yields. In particular, the underlying share volatility may change significantly from its
value at the ESO grant date. This will be particularly so for high growth companies.
 The possible changes in these key variables can have a significant effect on ESO
valuation and therefore on ESO expense. However, the long time to expiry is often
positive.
 Employees will tend to exercise early. Why? Diversification of personal wealth

Is it possible to manage the ESO expense?
How?
 Understate volatility?
 Understate the expected life (firm is not required to use
time to expiry)?
 Understate the risk-free rate? (but this is external)
 Overstate expected dividend rates?
 Overestimate forfeiture rates?
 Estimate the dilution effect

What Does IFRS2 Require?
 Measurement basis
 Historical cost
 Intrinsic value: S - E
 Minimum value : S – Ee-rt
 Fair value
 Share options should be measured in terms of their fair
value

IFRS 2
 Application of option pricing models to employee share options
 Vesting period, during which the share options are not
exercisable
 Non-transferability of options
 Conditions to vesting
 Forfeitures
 Option term is significantly longer
 Dilution

Executive Share options are Long-term.
What does this do to the Value?
• Assume executive is issued with share option at market value.
Intrinsic value = Zero.
• Yet if we extend out the term to expiry from 3 months to 7 years, see
what happens to the “zero” value options. Executive share options are
long-term. What does this do to the value?
A B C A B C
3 Share Price 25.50 3 Share Price 25.50
4 Exercise Price 25.50 4 Exercise Price 25.50
5 Standard deviation 30.0% 5 Standard deviation 30.0%
6 Time to expiry 0.25 6 Time to expiry 7
7 Risk-free rate 10.0% 7 Risk-free rate 10.0%
8 8
9 d1 0.24167 9 d1 1.27878
10 d2 0.09167 10 d2 0.48505
11 0.09167 11 0.48505
12 N(d1) 0.59548 12 N(d1) 0.89951
13 N(d2) 0.53652 13 N(d2) 0.68618
14 14
Value of Call Option
15Management 9e
Financial © Carlos Correia
1.841 15 Value of Call Option 14.249 81
More on Volatility
 Historical
 Analyse daily, weekly and monthly estimates over the
expected option time frame
 Look for trends over time
 Consider omitting any past periods not expected to
recur
 Consider comparable companies
 Implied
 Look at market expectations used for listed options
 Review assumptions used to price any other
derivative securities (e.g. convertible debt)
 Consider comparable companies

Straddles & Strangles
 A straddle is the simultaneous purchase of a Call option and a
Put option with the same strike price and same expiry date. What
is the potential profit for an investor?
 A strangle will mean differing exercise prices
 The investor requires the market to be volatile

Option Trading Strategies
 Bullish call spread – buying a call with a low exercise price and
selling a call with a high exercise price.

Straddles
 Buy a call option & a put option with the same exercise
price & expiry date (long straddle)
Share price Call profit at Put profit at Total
at expiration expiration expiration Profit/Loss
7 -500 4,500 4,000
8 -500 3,500 3,000
9 -500 2,500 2,000
10 -500 1,500 1,000
11 -500 500 0
12 -500 -500 -1,000
13 500 -500 0
14 1,500 -500 1,000
15 2,500 -500 2,000
16 3,500 -500 3,000
17 4,500 -500 4,000
 Write a call and a put option at the same exercise price

(short straddle)
2,000
1,000
0
Profit/Loss
7 8 9 10 11 12 13 14 15 16 17
-1,000
-2,000
-3,000
-4,000
-5,000
Share price
JSE Volatility Index (SAVI)
The Fear Index
 Graph of volatility index (SAVI) versus Top 40 Index

The End
Risk
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CHAPTER 18

Financial Management 9e © Carlos Correia  4

Financial Management 9e © Carlos Correia  7

Financial Management 9e © Carlos Correia  8

Financial Management 9e © Carlos Correia  9

Financial Management 9e © Carlos Correia  10

Financial Management 9e © Carlos Correia  12

Payoff = Max(S1- E,0) 2.00

8.50 2.00 1.50

Financial Management 9e © Carlos Correia  15

 Option is out of the money if S<E

 Time Value relates to the probability that S>E (for a call

Financial Management 9e © Carlos Correia  16

Financial Management 9e © Carlos Correia  17

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Financial Management 9e © Carlos Correia  20

Increase in volatility? In second case prices are

 R70 > R52

Expected Expected value

 More volatility results in a higher option value.

Financial Management 9e © Carlos Correia  23

Financial Management 9e © Carlos Correia  24

Upper bound = price of share

Lower bound = Share

X C + E/(1+r) (S1 - E) + E = S1 0+E=E

Financial Management 9e © Carlos Correia  26

Financial Management 9e © Carlos Correia  27

 Value of portfolio = 0.50(R50) – R18.52 = R6.48 = value of call

Financial Management 9e © Carlos Correia  28

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Financial Management 9e © Carlos Correia

Financial Management 9e © Carlos Correia

Financial Management 9e © Carlos Correia  36

15 Value of Call Option 1.841 C = SN(d1) - Ee-rtN(d2)

17 Value of Put Option 1.212 P=C-S+Ee-rt

15 Value of Call Option 0.156 C = SN(d1) - Ee-rtN(d2)

17 Value of Put Option 0.143 P=C-S+Ee-rt

Financial Management 9e © Carlos Correia  39

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 We can solve for p:

Financial Management 9e © Carlos Correia  42

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 Rho: This refers to the change in option price for a one

Financial Management 9e © Carlos Correia  49

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 If the dividend is assumed to occur at the end of the period then we

Financial Management 9e © Carlos Correia  51

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