Embedded Options Risk and Uncertainty: A Financial Management Association Survey

Embedded options are financial instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. They are often used in corporate finance to provide flexibility and manage risk. However, embedded options can also introduce risks and uncertainties into financial management.

The Financial Management Association (FMA) recently conducted a survey of its members to assess the risks and uncertainties associated with embedded options. The survey found that a majority of respondents believe that embedded options can introduce significant risks into financial management.

There are a variety of different types of embedded options. Some of the most common include:

Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty (Financial Management Association Survey and Synthesis)

by Andrew Davidson

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Language	:	English
File size	:	21901 KB
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• Call options: Give the holder the right to buy an underlying asset at a specified price on or before a specified date.
• Put options: Give the holder the right to sell an underlying asset at a specified price on or before a specified date.
• Convertible bonds: Give the holder the right to convert the bond into a specified number of shares of common stock.
• Preferred stock: Gives the holder the right to receive dividends before common stockholders and to convert the stock into common stock at a specified price.

Embedded options can introduce a number of risks into financial management, including:

• Price risk: The price of the underlying asset can fluctuate, which can affect the value of the embedded option.
• Interest rate risk: Interest rates can affect the value of embedded options, particularly those that are convertible into debt securities.
• Credit risk: The creditworthiness of the issuer of the embedded option can affect the value of the option.
• Liquidity risk: Embedded options may not be as liquid as other financial instruments, which can make it difficult to sell them when needed.

In addition to the risks associated with embedded options, there are also a number of uncertainties that can make it difficult to manage them effectively. These uncertainties include:

• The timing of the exercise of the option: The holder of an embedded option has the right to exercise the option at any time during its life. This can make it difficult to predict the impact of the option on the financial statements.
• The value of the underlying asset: The value of the underlying asset can fluctuate significantly, which can affect the value of the embedded option.
• The creditworthiness of the issuer: The creditworthiness of the issuer of the embedded option can affect the value of the option.
• The regulatory environment: The regulatory environment can affect the treatment of embedded options in the financial statements.

There are a number of steps that financial managers can take to manage the risks and uncertainties associated with embedded options. These steps include:

• Identifying and quantifying the risks: The first step is to identify and quantify the risks associated with embedded options. This can be done using a variety of techniques, including financial modeling and sensitivity analysis.
• Developing a risk management plan: Once the risks have been identified and quantified, a risk management plan can be developed. This plan should outline the steps that will be taken to mitigate the risks.
• Monitoring the risks: The risks associated with embedded options should be monitored on an ongoing basis. This will help to ensure that the risks are being managed effectively.
• Reporting the risks: The risks associated with embedded options should be reported to senior management and the board of directors. This will help to ensure that the risks are being appropriately addressed.

Embedded options can be a useful tool for managing risk and providing flexibility in financial management. However, it is important to be aware of the risks and uncertainties associated with embedded options. By taking the steps outlined above, financial managers can mitigate the risks and uncertainties and use embedded options to their advantage.

Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty (Financial Management Association Survey and Synthesis)

by Andrew Davidson

4.8 out of 5

Language	:	English
File size	:	21901 KB
Screen Reader	:	Supported
Print length	:	464 pages
Lending	:	Enabled

FREE