JWI 531 Financial Management II, week7 summary, 5/23/13
This week was all about managing risk - by hedging against negative events - through derivatives and options. The lectures were fantastic this week as they explained in simple
terms what the world of options looks like and gave us the insights
needed to make our way quickly forward with risk take downs. Now I have a
firmer grip on the options fundamentals.
Options fundamentals
Options are a form of financial derivatives -whose value is derived
from one or more underlying assets, that serve three key purposes in
running a business:
(a) mitigating risk -
by purchasing the right to take a buy/sell action at a certain price
and certain date in the future, a business can offset its risks. They
give the business tools necessary to create advanced risk management
systems (JWI 531 W7L1), hedging uncertainty and protect profits.
(b) generating rewards-
by accurately reading the trends in an apparently volatile market,
anticipating potential upsides or downsides, call or put bets can be
made to generate outsized gains (JWI 531 W7L2).
(c) added flexibility
- because options allow participation in price movements in the market
without committing large amount of funds needed to buy stocks outright,
they allow a firm greater flexibility (cboe.com). A firm can control
many shares without sinking a lot of capital at risk.
Under what conditions do options investments become more appealing or less appealing?
Options offer an excellent risk
mitigation opportunity that limit the down side for a firm. Options are
also an excellent investment option - at the risk of losing only the the
premium paid, a firm stands to benefit from the growth or fall of a
stock by making call or put options. Investors who base their decisions
on sound market research will better understand which stocks are likely
to rise and which are likely to fall. When accurate market forecasts can
be made, options trading can lead to significant income and therefore
becomes quite appealing.
On the other hand, speculative
activity where options investment actions of a firm are based not on
market fundamentals but on hunches and unproven theories can lead a firm
into mortal danger (JWI 531, W7L1). Under such situations, instead of
mitigating risk - through cheap insurance against negative events,
options actually magnify the risk - through expensive bets, and can lead
a firm to epic destruction.
In summary, it is important to have a
clear understanding of market fundamentals, and well defined objectives
including risk mitigation, income generation and flexibility needed.
Risks associated with strategies need to be well understood through
constant learning from multiple sources of insights and data. Options
trading can then become a rewarding challenge.
References
http://www.cboe.com/learncenter/pdf/understanding.pdf
Dr DP
JWI 531 W7L1
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I. Risk Management Tools: Derivatives
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Risk is inherent in every move you make.
Avoiding risk restricts opportunity for gains.
Sophisticated orgs embrace risk, harness it in productive and profitable ways.
Corporate systems and processes that capitalize on risk is what risk management is all about.
II. Manage risk to reach success
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Step1 - Look at and understand all the risks the firm faces
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Decide which ones give you competitive advantage and which ones to hedge/offset/backup against
Hedge against scarcity of supply: move from single source => multiple suppliers
watch monetary shifts across the globe
Step2 - Look at which risks can be hedged against and which ones should be hedged
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Strategically Decide risks to mitigate
risks to leave alone
Example of effective risk mitigation
Google - hedges against failure to innovate, loss of creative talent
time, money, talent spent on projects that add nothing to bottomline
20% of time on pet projects
Financial risk management
- figure out what the firm is good at, focus efforts there, leverage those advantages fully
- reduce risks that are not central to the core mission
Rise of financial derivatives
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Derivative: A security whose price is based on and derived from one or more assets
It is a contract between two or more parties who promise to fulfull specific elements of the contract at a certain date.
eg. futures on commodity prices, stock market indices
Value of a derivative is proportional to changes in the value of principal asset
Pay for the right to buy at a certain price over the next few years.
Tracks value of stocks, bonds, commodities, currencies, interest rates, market indexes
Futures contract - lock in a price for upcoming crop (prevent losses if the price falls or if glut in supply develops)
Derivative contracts exist for anything today
They offer the purchaser boundless flexibility
They offer business people the tools necessary to create advanced risk management systems
Gives great powers to gamble,speculate material gain vs mitigating material risk
Derivatives began as a way to reduce risk but evolved into a means to take on as much risk as possible using as little capital as possible.
Derivatives are financial weapons of mass destruction - Warren Buffett
They can compound gains but also losses
Mortal dangers are associated with derivatives.
Mortal dangers
Standard commodity based derivative
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value of the contract = opportunity to buy on a certain date at a certain price
market value fluctuates constantly
eg. $5000 payment today gives the ability to control $500,000 worth of notional value in oil
Property of a Derivative: Leverage
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Allows investors to control massive resources without expending much upfront capital
Speculation
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buying or selling securities based on hunches and unproven theories to expose yourself to greater gains & risks.
people bet on rise in price of gold and silver
futures contract allows control of precious metals while only having to put up a small fraction of that value in cash
Call option for a few bucks can multiply your money 10X if the bet is right that a tech stock will post great earnings next week
Example of epic collapse - AIG
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The firm sold derivatives based insurance policies against the likelihood some mortgage owners would fail to pay their bills.
Sold extremely cheap insurance policies for investors who what to protect themselves against small likelihood of something going wrong.
AIG was on the hook if something did go wrong.
AIG did not think US home values would drop drastically.
Huge leverage - the firm was responsible for much more financially
Risk & Reward
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Risk is part of business.
Smart companies mitigate events they might face.
Derivatives offer one way - a vital financial tool that is cheap and effective at risk mitigation.
Down side of derivatives - Speculation can lead to situations that quickly spiral out of control.
JWI 531 W7L2
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Risk Management Tools: Options
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Options are another form of derivative.
They derive their value from an underlying asset.
Several types exist - Stocks, bonds, commodities, stock options.
Excellent tools for generating income, protecting profits, hedging uncertainty, earning outsize gains
Excellent tool for risk management.
Stock option is the right to buy or sell 100 shares of a given stock at a predetermined price at a specified time.
ie it is a right to take Action at a specific price and a specific date
buyers are guaranteed a disproportionate amount of an asset based on the capital they put in.
investor can control 100 shares of stock without putting up the actual cost of 100 shares.
GOOG options: strike prices, bids, asks, expiration dates
Call Up, Put Down: Bet against an asset's price
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Two types of options: Puts and Calls.
When you expect a company stock to go up, you buy a call, which appreciates in value as stock rises.
When you expect a company stock will fall, you buy a put, which appreciates in value as stock declines.
Buying Call Options: Contract based on situational event (price of stock going above a certain price)
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If the situation you anticipate happens you make money
You are buying the Right to take an action at a price at a date
Central idea: Take advantage of a rising asset without committing large amounts of capital to that risk position.Businesses use this to protect themselves from losing a lot of money and also from rising costs when compared to buying a financial instrument such as a share - multiplies exposure to an asset that is going up in price.
One stock option contract represents 100 shares of stock. Works as controlled leverage, enhancing potential returns while limiting potential losses to only what the user decides to invest buyers invest a much smaller amount than an equivalent stock purchase. An investor can control and benefit from many shares of stock without putting a lot of capital at risk
If you make the wrong call, the contract expires unused and investment goes to zero. Investors have lost everything as there is no claim on an asset such as a stock.
Buying Puts
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When you believe an underlying asset will decline in value, you can buy Puts
Excellent tool for betting against highly priced or troubled stocks, assets or sectors.
Your risk is limited to the amount you invest.
Taking a long position means to invest in the asset itself.
A short position means you are borrowing the asset to bet against it.
When in a long position you will want to protect the firm from declining stock.
Buy Puts to also protect a company's position in a large portfolio.When the stock or position declines puts will increase the value.
Speculative Activity vs Mitigating Risk
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Risk managers buy puts on stocks or other assets that they expect to decline in coming months.
People also use puts to hedge long positions they take directly or indirectly.
Risk managers purchase cheap insurance against negative events this way.
Options are a valuable tool for risk management
they can mitigate risk, generate rewards and bring added flexibility to an organization.
An investor who desires to utilize options should have well-defined investment objectives
suited to his particular financial situation and a plan for achieving these objectives. The successful use of options require a willingness to learn what they are, how they work, and what risks are associated with particular options strategies.
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