1. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.1 LEARNING OBJECTIVES Explain the nature of options and the distinction between different kinds of options, and demonstrate their application in a wide variety of areas Show the value of the forwards, futures, FRAs, swaps, caps and floors markets by demonstrating transactions which manage and transfer risk

2. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.2 DERIVATIVES A derivative instrument is an asset whose performance is based on (derived from) the behaviour of the value of an underlying asset “Underlyings” –Commodities –Shares –Bonds –Share indices –Currencies –Interest rates Derivatives are contracts that give the holder the right, and sometimes the obligation, to buy or sell a quantity of the underlying, … …. or benefit in another way from a rise or fall in the value of the underlying.

3. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.3 It is the legal right that becomes an asset, with its own value. It is the right that is purchased or sold. Derivative instruments include the following: –Futures –Options –Swaps –Forward rate agreements –Forwards Derivatives can be used to: –Speculate –Hedge –Arbitrage

4. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.4 OPTIONS An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price, at or before a specified date. For example, property development options Share options A call option gives the purchaser a right, but not the obligation, to buy a fixed number of shares at a specified price at some time in the future On LIFFE, one option contract relates to a quantity of 1,000 shares The seller of the option, who receives the premium, is referred to as the writer American-style options can be exercised by the buyer at any time up to the expiry date European-style options can only be exercised on a predetermined future date

5. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.5 CALL OPTION HOLDER (CALL OPTION BUYER) Cadbury Schweppes Intrinsic value – the payoff that would be received if the underlying is at its current level when the option expires Time value – the amount by which option premium exceeds the intrinsic value In-the-money-option – an option with intrinsic value Out-of-the-money-option – an option with no intrinsic value At-the-money-option – market price equal to option exercise price

6. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.6

7. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.7

8. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.8 CALL OPTION WRITERS

9. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.9 PUT OPTIONS A put option gives the holder the right, but not the obligation, to sell a specific quantity of shares on or before a specified date at a fixed exercise price. Cadbury Schweppes Purchase, for a premium of 19.5p per share (£195 in total), the right to sell 1,000 shares on or before late January 2002 at 460p.

10. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.10 USING SHARE OPTIONS TO REDUCE RISK: HEDGING Options can give protection against unfavourable movements in the underlying while permitting the possibility of benefiting from favourable movements Example: You hold 1,000 shares in Cadbury Schweppes on 13 Aug. 2001, worth £4,820 (482p per share) Possible takeover bid Or dramatic price fall Sell shares? - loss of possible upside Alternative: Buy put option - a 460 April put purchased, premium £280

11. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.11 If share price falls to 380p in late April: Loss on underlying shares £1,020 Intrinsic value of put option £800 ((460-380) x 1000) Below 460p for every 1p lost in share price 1p is gained on the put option. Maximum loss is £500 (£220 intrinsic value + £280 option premium) Hedging reduces the dispersion of possible outcomes. There is a floor below which losses cannot increase, while on the upside the benefit is reduced due to premium.

12. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.12

13. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.13 INDEX OPTIONS Options on whole share indices can be purchased Index options are cash settled The index is regarded as a price and each one-point movement on the index represents £10 HEDGING AGAINST A DECLINE IN THE MARKET A fund manager controlling a £30m portfolio of shares. Concerned the market might fall. Number of options needed to hedge: With the index at 5431 on 13 August 2001 and each point of that index settled at £10, one contract has a value of 5431  £10 = £54,310 To cover a £30m portfolio: £30m £54,310 = 552 contracts

14. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.14 Buy 552 December 5425 puts for 229 points per contract. Premium: 229 points  £10  552 = £1,264,080 (4.2% premium) The index falls 15% to 4616, and the loss on the portfolio is: £30m  0.15 = £4,500,000 Gain on options : (5425 – 4616)  552  £10 = £4,465,680 Less option premium paid£1,264,080 £3,201,600

15. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.15 CORPORATE USES OF OPTIONS 1 Share options schemes 2 Warrants 3 Convertible bonds 4 Rights issues 5 Share underwriting 6 Commodities

16. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.16 OPERATIONAL AND STRATEGIC DECISIONS WITH OPTIONS (REAL OPTIONS) The expansion option The option to abandon Option on timing True NPV True NPV takes into account the value of options. True NPV = Crude NPV + + + + NPV of expansion option NPV of the option to abandon NPV of timing option NPV of other option possibilities

17. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.17 FORWARDS AND FUTURES CONTRACTS Forwards A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now. Example: potato crisp manufacturer Futures Agreements between two parties to undertake a transaction at an agreed price on a specified future date Exchange-based instruments traded on a regulated exchange The clearing house becomes the formal counterparty to every transaction Standardised legal agreements traded in highly liquid markets

18. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.18 FORWARDS AND FUTURES CONTRACTS

19. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.19 MARKING TO MARKET AND MARGINS Daily marking to market Member’s margin account Initial margin Maintenance margin Variation margin Day £MondayTuesdayWednesdayThursdayFriday Value of future (based on daily closing price)50,00049,00044,00050,00055,000 Buyers’ position Initial margin5,000 Variation margin (+ credited)0–1,000–5,000+6,000+5,000 (– debited) Accumulated profit (loss)0–1,000–6,0000+5,000 Sellers’ position Initial margin5,000 Variation margin (+ credited)0+1,000+5,000–6,000–5,000 (– debited) Accumulated profit (loss)0+1,000+6,0000–5,000 Exhibit 21.16 Example of initial margin and marking to market

20. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.20 Leverage

21. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.21 Settlement: Physical delivery Cash

22. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.22 SHORT-TERM INTEREST RATE FUTURES Notional fixed-term deposits, usually for three-month periods starting at a specific time in the future. The buyer of one contract is buying the right to deposit money at a particular rate of interest for three months at least notionally.

23. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.23 The unit of trading for a three-month sterling time deposit is £500,000. Cash delivery is the means of settlement. Delivery defines the date and time of the expiry of the contact – September, December, March and June. Price is defined as: P = 100 – i where: P = price index; i = the future interest rate in percentage terms. Tick A tick is the minimum price movement on a future. On a three-month sterling interest rate contract a tick is a movement of 0.01 per cent on a trading unit of £500,000. £12.50 is the value of a tick movement in a three-month sterling interest rate futures contract. SHORT-TERM INTEREST RATE FUTURES

24. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.24 FORWARD RATE AGREEMENTS (FRAs) Agreements about the future level of interest rates. The rate of interest at some point in the future is compared with the level agreed when the FRA was established and compensation is paid by one party to the other based on the difference. Certainty over the effective interest cost of borrowing is generated in the future if an FRA is bought. The sale of an FRA by a company protects against a fall in interest rates.

25. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.25 FRA Example: A company needs to borrow £6m in six months’ time for a period of one year It arranges this with bank X The current rate of interest is 7% Concern: interest rates will be higher when the loan is drawn down Purchase FRA at 7% from bank Y to take effect 6 months from now and relate to 12 month loan Six months later: Spot interest rates for 1 year borrowing = 8.5% Payment to bank X: £6m  0.085 = £510,000 (£90,000 more than if rate is 7%) Bank Y pays (0.085-0.07)  £6m = £90,000 If rates fall below 7% company compensates Bank Y. A “sale” of an FRA: protects against a fall in rates.

26. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.26 Exhibit 21.22 A comparison of options, futures and forward rate agreements OptionsFuturesFRAs Advantages Downside risk is limited butSpecific rates are locked in.No margins or premiums the buyer is able to participateNo right to let the contract in favourable movements.lapse, as with options. Available on or off exchanges.No premium is payable. (HoweverTailor-made, not standardised as Exchange regulation and clearingmargin payments are required.)to size, duration and terms. house reduce counterparty default risk for those options traded on exchanges. Usually highly liquid markets.Very liquid markets. Able toCan create certainty. Locks in reverse transactions quicklyspecific effective interest rate. and cheaply. May be useful if no strong viewExchange regulation and clearing is held on direction of underlying.house reduce counterparty default risk. Disadvantages Premium payable reduces returns.If the underlying transaction doesBenefits from favourable not materialise, potential loss ismovements in rates are forgone. unlimited. Margin required on writtenMany exchange restrictionsGreater risk of counterparty options.on size, duration, trading times.default – not exchange traded. Margin calls require daily workMore difficult to liquidate. for ‘back office’. payable.

27. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.27 CAPS An interest cap is a contract that gives the purchaser the right to effectively set maximum level for interest rates payable. Compensation is paid to the purchaser of a cap if interest rates rise above an agreed level. Example: Oakham borrows £20m for 5 years from Bank A at variable interest rate Libor + 1.5% (interest reset every 3 months – currently 7%) Concern: interest rates rise Buys an interest rate cap set at Libor of 8.5% Cost, say 2.3% payable now for 5 year cover (£20m x 0.023=£460,000) 3 rd Year: Libor = 9.5% Oakham pays to Bank A 9.5+1.5% Receives 1% from cap seller If rates fall Oakham benefits Floors and collars If the interest rate falls below an agreed level, the seller (the floor writer) makes compensatory payments to the floor buyer.

28. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.28 SWAPS A swap is an exchange of cash payment obligations. Cat plc and Dog plc Cat plc and Dog plc both want to borrow £150m for eight years Cat would like to borrow on a fixed-rate basis because this would better match its asset position Dog prefers to borrow at floating rates because of optimism about future interest- rate falls Cat could obtain fixed-rate borrowing at 10 per cent and floating rate at Libor +2 per cent Dog is able to borrow at 8 per cent fixed and Libor +1 per cent floating: FixedFloating Cat can borrow at10%Libor +2% Dog can borrow at 8%Libor +1%

29. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.29 SWAPS CAT AND DOG Exhibit 21.23 An interest rate swap Cat: PaysLibor +2% ReceivesLibor +2% PaysFixed 9.5% Net paymentFixed 9.5% Dog: PaysFixed 8% ReceivesFixed 9.5% Pays Libor +2% Net paymentLibor +0.5% Fixed 8% CatDog Bank BBank A Libor +2% Fixed 9.5%

30. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.30 DERIVATIVES USERS Hedgers To hedge is to enter into transactions which protect a business or assets against changes in some underlying Speculators Speculators take a position in financial instruments and other assets with a view to obtaining a profit on changes in value. Arbitrageurs The act of arbitrage is to exploit price differences on the same instrument or similar assets

31. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.31 OVER-THE-COUNTER (OTC) AND EXCHANGE-TRADED DERIVATIVES Exhibit 21.25 OTC and exchange-traded derivatives AdvantagesOTC derivative Contracts can be tailor-made, which allows perfect hedging and permits hedges of more unusual underlyings. Disadvantages There is a risk (credit risk) that the counterparty will fail to honour the transaction. Often difficult to reverse a hedge once the agreement has been made. Higher transaction costs. AdvantagesExchange-traded derivative Credit risk is reduced because the clearing house is counterparty. High regulation encourages transparency and openness on the price of recent trades. Liquidity is usually much higher than for OTC – large orders can be cleared quickly due to high daily volume of trade. Positions can be reversed by closing quickly – an equal and opposite transaction is completed in minutes. Disadvantages Standardisation may be restrictive, e.g. standardised terms for quality of underlying, quantity, delivery dates. The limited trading hours and margin requirements may be inconvenient. Low level of market regulation with resultant loss of transparency and price dissemination.

32. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.32 OPTION PRICING Notation to be used: C= value of call option S= current market price of share X= future exercise price R f = risk-free interest rate (per annum) T= time to expiry (in years)  = standard deviation of the share price E= mathematical fixed constants: 2.718.... Options have a minimum value of zero C  0 The market value of an option will be greater than the intrinsic value at any time prior to expiry Market value = intrinsic value + time value Intrinsic value (S – X) rises as share price increases or exercise price falls X (1 + r f ) t The higher the risk-free rate of return the higher will be intrinsic value The maximum value of an option is the price of the share C < S A major influence boosting the time value is the volatility of the underlying share price Intrinsic value = S –

33. 21 DERIVATIVES Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 21.33 BLACK AND SCHOLES’ OPTION PRICING MODEL C = SN(d 1 ) – X e r t where: N (.) = cumulative normal distribution function of d 1 and d 2 ; ln(S/X) + (r f +  2 /2)t  t ln = natural log d 2 = d 1 –  t N (d 2 ) d 1 = f