Chapter 18, Problem 11IC

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
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. Call option 2. Put option 3. Exercise price 4. Striking, or strike, price 5. Option price 6. Expiration date 7. Exercise value 8. Covered option 9. Naked option 10. In-the-money call 11. Out-of-the-money call 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. 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. 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. What assumptions underlie this model? 2. Write the three equations that constitute the model.

a.

Summary Introduction

To discuss: The reason why stockholders are indifferent to whether a firm decreases the volatility of its cash flows.

Introduction:

Stock is a type of security in a company that denotes ownership. The company can raise the capital by issuing stocks.

Explanation

The reason why stockholders are indifferent to whether a firm decreases the cash flows ‘s volatility is as follows:

The stockholder can reduce the risk of volatile cash flows by way of diversifying their portfolio at the time when the volatility in cash flows are not caused by systematic risk...

b.

Summary Introduction

To discuss: The reasons for risk management may raise the corporation value.

Introduction:

Risk management is a technique used in business to evaluate the financial risks associated by it. It helps to identify certain procedures to avoid or minimize their impact in the business.

c.

Summary Introduction

To discuss:  The meaning of option and importance characteristic of an option.

Introduction:

A type of financial security whose value is derived from the value of a particular underlying asset is termed as Derivative. This form of financial security consists of two or more parties who enter into an agreement to purchase or sell an asset at a specific price on a particular period. They are four types of derivative securities that are as follows:

• Forward contract
• Future contract
• Swap
• Option

d.1.

Summary Introduction

To discuss:  The meaning of call option.

d.2.

Summary Introduction

To discuss:  The meaning of put option.

d.3.

Summary Introduction

To discuss:  The meaning of exercise price.

d.4.

Summary Introduction

To discuss:  The meaning of strike price.

d.5.

Summary Introduction

To discuss:  The meaning of option price.

d.6.

Summary Introduction

To discuss:  The meaning of expiration date.

d.7.

Summary Introduction

To discuss:  The meaning of exercise value.

d.8.

Summary Introduction

To discuss:  The meaning of covered option.

d.9.

Summary Introduction

To discuss:  The meaning of naked option.

d.10.

Summary Introduction

To discuss:  The meaning of in-the-money call.

d.11.

Summary Introduction

To discuss:  The meaning of out-the-money call.

d.12.

Summary Introduction

To discuss:  The meaning of LEAPS.

e.1.

Summary Introduction

To determine:  The strike price, stock price, exercise value, premium of option over the exercise value, and option price.

e.2.

Summary Introduction

To discuss:  The premium of option over exercise value when there is a raise in stock price and its reasons.

f.1.

Summary Introduction

To discuss:  The assumption of Black-Scholes option pricing model.

f.2.

Summary Introduction

To discuss:  The three equations that constitute Black-Scholes option pricing model.

f.3.

Summary Introduction

To determine:  The value of call option as per the Black-Scholes option pricing model.

g.

Summary Introduction

To determine: The value of call option of the firm using binominal model.

h.1.

Summary Introduction

To discuss: The effect of current stock price has on the value of a call option.

Introduction:

Option is a contract to purchase a financial asset from one party and sell it to another party on an agreed price for a future date. There are two types of options, which are as follows:

• An option that buys an asset called call option
• An option that sells an asset called put option

h.2.

Summary Introduction

To discuss: The effect of exercise price has on the value of a call option.

Introduction:

Exercise price is a price wherein a call or put options can be exercised in a derivative. It is also termed as Strike price.

h.3.

Summary Introduction

To discuss: The effect of length of the option period has on the value of a call option.

h.4.

Summary Introduction

To discuss: The effect of risk-free rate has on the value of a call option.

h.5.

Summary Introduction

To discuss: The effect of variability of the stock price has on the value of a call option.

i.

Summary Introduction

To discuss: The difference between futures and forward contracts.

Introduction:

A type of financial security whose value is derived from the value of a particular underlying asset is termed as Derivative. This form of financial security consists of two or more parties who enter into an agreement to purchase or sell an asset at a specific price on a particular period. They are four types of derivative securities that are as follows:

• Forward contract
• Future contract
• Swap
• Option

j.

Summary Introduction

To discuss: The working of swaps.

k.

Summary Introduction

To discuss: The ways how futures and swaps are used by the firm to hedge risk.

l.

Summary Introduction

To discuss: The meaning of corporate risk management and reason for its importance to all the firms.

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