10.5.4 Option Strategies For Corporations

Option Strategies for Corporations

Unlike individual and institutional investors, corporations do not normally speculate with derivatives because they do not want to risk their shareholders’ money betting on the price of an underlying asset. However, they are very interested in managing risk and often use options to achieve this goal. The risks corporations most frequently manage are related to interest rates, exchange rates, or commodity prices. For example, corporations regularly take on debt to help finance their operations. Sometimes, the interest rate on the debt is a floating rate that rises and falls with market interest rates. Just like an investor who buys a call option to establish a maximum purchase price for a stock, corporations can buy a call option to cap a maximum interest rate on their floating-rate debt.

Example of Corporate Call Option Purchase

Scenario: A Canadian company knows it will purchase US$1 million worth of goods from a U.S. supplier in three months’ time. Based on the current exchange rate of C$1.32 per U.S. dollar, the company’s cost will be C$1.32 million.

The company can either:

1. Buy US$1 million now and pay C$1.32 million.
2. Wait three months and pay the rate at that time, risking that the value of the U.S. dollar could strengthen relative to the Canadian dollar, thereby increasing costs.

To mitigate this risk, the corporation buys a three-month U.S. dollar call option with a strike price of C$1.35, purchased either at the Montréal Exchange or in the OTC (Over-The-Counter) market.

• If, at the end of three months, the exchange rate is C$1.40: The corporation will exercise the call and purchase U.S. dollars at the capped rate of C$1.35 million.
• If, at the end of three months, the exchange rate is C$1.30: The corporation will let the option expire and buy the U.S. dollars at the lower exchange rate.

The purchase of the call option ensures that the exchange rate is capped at C$1.35, plus the cost of the option premium.

Example of Corporate Put Option Purchase

Scenario: A Canadian oil company anticipates selling 1 million barrels of crude oil in six months. The current price of crude oil is US$40 per barrel, but the company is uncertain about the future price.

To lock in a minimum sale price, the oil company buys a put option on 1 million barrels of crude with a strike price of US$38 per barrel. This will protect the company from any price drops below US$38 per barrel.

• If, in six months, the price of crude oil drops below US$38: The company will exercise its put option, selling the oil to the option writer at the strike price.
• If the price is above US$38 after six months: The company lets the option expire and sells the oil at the prevailing market price.

Key Option Terms

Understanding the terminologies associated with options is crucial for navigating this complex financial instrument. Below are key terms frequently used in options trading:

• Call Option: Gives the holder the right but not the obligation to buy an asset at a specified strike price within a set period.
• Put Option: Grants the holder the right but not the obligation to sell an asset at a specific strike price within a set time period.
• Strike Price: The predetermined price at which the holder of the option can buy or sell the underlying asset.
• Premium: The price paid by the buyer to the seller (writer) of the option for acquiring the right to exercise the option.
• Exercise: The act of utilizing the right to buy (for a call option) or sell (for a put option) the underlying asset.
• OTC Market: Over-The-Counter market where derivatives not traded on a centralized exchange are customized and traded directly between parties.

Trading Options

When trading options, understanding the mechanics is essential:

• Option Contract: Each option contract typically represents 100 shares of the underlying asset.
• Expiration Date: The date on which the option rights expire.
• In-the-Money (ITM): Situation where exercising the option would result in a profitable transaction based on current asset prices.
• Out-of-the-Money (OTM): When exercising the option would not be profitable and has no intrinsic value.
• At-the-Money (ATM): When the current price of the asset is equal to the strike price of the option.

Frequently Asked Questions

Q: Why don’t corporations speculate with derivatives?

A: Corporations avoid speculating with derivatives to prevent risking shareholders’ money on unpredictable price movements of underlying assets. Their primary focus is on hedging and managing financial risks.

Q: How do corporations use call options in managing interest rate risks?

A: Corporations buy call options on interest rates to cap the maximum interest they must pay on floating-rate debts, thus protecting against rising interest rates.

Q: What is the difference between call and put options in corporate strategies?

A: A call option allows a corporation to buy an asset at a predetermined price, useful for capping costs, such as exchange rates or loan interests. A put option allows a company to sell an asset at a fixed price, used to lock in minimum sale prices, mitigating risks of falling costs such as commodity prices.

Key Takeaways

• Corporations primarily use options for risk management rather than speculation.
• Call options can establish maximum purchase prices for corp assets like foreign currencies or manage interest rate risks.
• Put options lock in minimum prices for corporate goods such as commodities.
• Understanding key options terminologies is essential for efficiently operating in the derivatives market.

This completes our overview of the option strategies specifically tailored for corporations to manage and mitigate financial risks effectively.