Question

pls answer the following questions:

1. Explain why firms might want to undertake risk management

2. Why, when there is counterparty credit risk, are futures contracts often to be preferred to forward contracts?

3. Name the factors that affect the value of a call option and explain the direction of the effects.

Answer 1

(1) A firm might want to undertake risk management to:

Maintain consistent and efficient operations - If a company undertakes risk management, it would be able to manage its risks so that the business operations run smoothly and efficiently. This means that any bottlenecks in business operations can be identified well in prior and the firm will take sufficient steps to mitigate and reduce the adverse effect of such events

Reduce the volatility in earnings and the firm value - Any risk arising from any activity, be it operational or financial, can significantly affect a firm's financials. Such volatility affects the firm's credit rating leading to a higher cost of capital. This, in turn, affects the firm's bottom-line.

Prevent compliance issue, lawsuits and penalties - A certain level of risk management is generally mandatory by the regulatory bodies and the legislation might impose hefty fines and penalties in case of non-compliance with these risk management measures

Improve the firm's brand value - A firm with sound risk management practices is perceived to be a less risky firm and enjoys a good reputation in the market. Again, this leads to lower credit costs. Also, a higher brand value firm is better able to market its products and services.

(2)

Counterparty credit risk is the risk associated with the counterparty in case the counterparty defaults before the financial settlement of a transaction. Future contracts are traded publicly and are standardized as against a forward contract which is private between the parties and is custom-made. Since these contracts are private, there is high counter-party risk. In a futures contract, the clearinghouse of the stock exchange acts as a counter-party for both the parties. Due to the stock exchange clearing house being the counterparty is future contract, the counterparty credit risk almost zero. Hence, when there is counterparty credit risk, futures contracts often to be preferred to forward contracts,

(3)

Factors affecting the value of a call option:

Stock price and strike price - Call option will be more valuable or pricey when the stock price increases and less valuable as strike price increases and vice-versa.

Time to maturity - A call option is more valuable as the time to expiration increases. This is because the probability of the option coming in-the-money is higher as the time to maturity increases,

Volatility - Volatility increases the value of a call option as a highly volatile stock will end up either very high or very low at maturity. Since the down-side is capped to the amount of premium in a call option, the down-side is limited. However, the upside is unlimited and hence volatility increases the value of a call option.

Risk-free interest rate - As the interest rates increases, the probability of a call option ending up in the money becomes higher. Due to this, a higher risk-free interest rate increases the value of a call option.

Amount of future dividends - Dividends have the effect of reducing the stock price. Due to this the probability of a call option ending up in the money becomes lower and hence the value of a call option is negatively related to the amount of future dividends.