Textbook Problem

DERIVATIVES AND CORPORATE RISK MANAGEMENT Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a midsized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm’s CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco. One of the sessions he attended was on the pressing need for smaller companies to institute corporate risk management programs. As no one at Tropical Sweets is familiar with the basics of derivatives and corporate risk management, Yamaguchi has asked you to prepare a brief report that the firm’s executives can use to gain at least a cursory understanding of the topics.

To begin, you gather some outside materials on derivatives and corporate risk management and use those materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you must develop the answers.

a. Why might stockholders be indifferent to whether a firm reduces the volatility of its cash flows?

b. What are seven reasons risk management might increase the value of a corporation?

c. What is an option? What is the single most important characteristic of an option?

d. Options have a unique set of terminology. Define the following terms:

1. 1. Call option
2. 2. Put option
3. 3. Exercise price
4. 4. Striking, or strike, price
5. 5. Option price
6. 6. Expiration date
7. 7. Exercise value
8. 8. Covered option
9. 9. Naked option
10. 10. In-the-money call
11. 11. Out-of-the-money call
12. 12. LEAPS

Consider Tropical Sweets’s call option with a $25 strike price. The following table contains historical values for this option at different stock prices:

Stock Price	Call Option Price
$25	$3.00
30	7.50
35	12.00
40	16.50
45	21.00
50	25.50

1. 1. Create a table that shows the (a) stock price, (b) strike price, (c) exercise value, (d) option price, and (e) premium of option price over exercise value.
2. 2. What happens to the premium of option price over exercise value as the stock price rises? Why?

In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model.

1. 1. What assumptions underlie this model?
2. 2. Write the three equations that constitute the model.