**Derivatives and Structured Products

Option pricing is a cornerstone of derivatives understanding. The Black-Scholes model, though with some limitations, is the foundation. It uses variables like current stock price, strike price, time to expiration, risk-free interest rate, and implied volatility to determine option prices.

Example: Suppose a stock is trading at $100, the strike price of a call option is $110, the time to expiration is 1 year, the risk-free rate is 5%, and the implied volatility is 25%. Plugging these values into the Black-Scholes formula (or using a financial calculator or software) will yield the option's theoretical price. Keep in mind that real-world markets often exhibit 'smiles' or 'skews' in volatility surfaces that Black-Scholes doesn't account for. These indicate that options with different strike prices and the same expiration date will have different volatility figures. More sophisticated models, such as those that incorporates stochastic volatility, have been developed to capture these issues.

Volatility is the most critical input in option pricing. It represents the degree of price fluctuation of the underlying asset. Higher volatility means greater uncertainty and, thus, higher option prices (both call and put). Implied volatility (IV) is derived from market option prices, reflecting the market's expectation of future price movement. Historical volatility (HV), calculated from past price data, provides a reference point but may not perfectly predict future volatility. Managing volatility requires hedging strategies (e.g., using options to protect against adverse price movements) and understanding how different market events can impact volatility levels.

Example: Imagine an earnings announcement for a company is approaching. Market participants anticipate significant price movement (high volatility) after the announcement. This anticipation leads to higher implied volatility and more expensive options.

Securitization is the process of pooling assets (e.g., mortgages, auto loans, corporate debt) and issuing securities backed by those assets. This allows companies to free up capital, reduce funding costs, and diversify their investor base. The structure of a securitization involves Special Purpose Vehicles (SPVs) that isolate the assets, tranching the assets into different risk and return profiles (senior, mezzanine, and junior tranches), and credit enhancements (e.g., overcollateralization, guarantees) to improve the creditworthiness of the securities.

Example: A bank has a portfolio of mortgages. It can pool these mortgages, creating a Mortgage-Backed Security (MBS). Investors purchase these securities, and the cash flow from the mortgages is used to pay the investors. The structure could have senior tranches (low risk, lower return), mezzanine tranches (moderate risk and return), and equity tranches (high risk, potentially high reward). The 2008 financial crisis highlighted the risks of over-reliance on this product and complex structures. Understand the benefits and risks of securitization when used in corporate finance to manage debt profiles or provide liquidity.

CFOs use derivatives and structured products for several strategic purposes:

• Risk Management: Hedging currency exposure, interest rate risk, and commodity price fluctuations.
• Investment Enhancement: Using options to enhance portfolio returns (e.g., covered calls, protective puts).
• Capital Structure Optimization: Issuing structured notes or using derivatives to manage debt profiles and funding costs.
• M&A and Strategic Transactions: Employing derivatives to manage risks related to future cash flows. Understanding the regulatory environment (e.g., Dodd-Frank) and accounting standards (e.g., hedge accounting) is also important.

Example: A multinational company with significant foreign currency exposure might use currency forwards or options to hedge against adverse movements in exchange rates.