Chapter 23 Derivatives and Risk Management

ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

23-1

“Managing Risks” means taking steps to mitigate the effects of adverse events. Buying fire insurance is an attempt to mitigate the adverse consequences of a fire. Risk managers attempt to identify all the risks a firm faces, and then consider what steps might be taken to mitigate them. Buying insurance is one form of mitigation for certain risks. The most prevalent risk most firms face is that customers will not want to buy enough of their products at a price that will permit the firm to earn a profit. Only good general management, not by risk management as we define it, can generally mitigate that particular risk. However, risk managers can often use hedging techniques to guard against adverse price, interest rate, and exchange rate changes. In general, stockholders dislike risk, so if a firm can stabilize its earnings by using hedging techniques and the like without unduly high costs, this will benefit its stock price. Of course, stockholders can themselves diversify. For example, an increase in the price of copper might hurt a firm that uses copper, but copper producers will benefit, so the effect on a diversified investor’s portfolio should be small. Even so, investors prefer predictability in earnings, so even if they can diversify themselves, they probably prefer to have firms diversify, provided the cost is not too high. Another reason for managing risk has to do with capital investment programs. If a firm’s earnings are unstable, it might not be able to obtain financing to meet its capital expenditure program requirements. This can be disruptive and costly, for a start-stop long-term construction program is less efficient than one that proceeds smoothly. Swaps are transactions where two parties swap payment streams. For example, one firm might have to make floating rate payments and another firm have to make fixed rate payments. The firms can use a swap under which each agrees to make the other’s payments. Similarly, firms with debt denominated in different currencies can arrange swaps. For example, a U.S. firm may have borrowed in the U.S. to finance its Italian operations, which will provide Euros, which would then have to be converted to dollars to make payments on the debt. If the dollar rises against the Euro, the Euros the firm earns may not buy enough dollars to make the required payments. So, the U.S. firm might want to swap its dollar payment obligation for Euro payments. An Italian firm (or any other Euro bloc firm) that has to make Euro payments derived from U.S. operations would be a logical counter-party to the swap. More likely, though, an international bank would serve as counter-party to both firms, and if it had both ends of the ultimate transaction, it would be hedged itself. Companies whose earnings rise with interest rate (like many banks) might prefer floating rate to fixed rate debt, while other companies would want to lock in fixed payment obligations. If two such firms Answers and Solutions: 23 - 1

23-2

the cost of setting up the hedge. As market interest rates in the economy change. a bank would probably be the counter-party. something a specified future date.2 . Again. and if it is that afraid interest rates will rise before it can bring out the new issue. and again. For example. and the results under different assumptions interest rate changes over the next 6 months. Futures contracts are deals where one party agrees to buy. it would be internally hedged. 6%. so will the value of the T-bond contract.000 of a hypothetical 20 year. it will earn a profit on its short positions and thus offset the higher interest rate it will have to pay on its refunding bonds. a T-bond futures contract is a contract to buy (or to sell) $100. See the BOC Excel model for the answer to Question 5. with a nominal value of $50 million). Interest rate futures are used to hedge against changes adverse changes in interest rates. and at a lower cost than if they borrowed directly with the desired pattern. Then. if a firm plans to issue new bonds to refund a currently outstanding highrate issue.both had the “wrong” kind of debt. Here we show that both companies get the payment pattern they prefer. they could arrange a swap. then it can hedge by shorting Treasury bond futures. Here we show the number of T-bond futures contracts that would be used in the hedge (500 contract. and the other agrees to sell. Treasury bond at some specified future date. For example. 23-3 See the Excel model for an answer to Question 3. if market rates do rise. 23-4 23-5 Answers and Solutions: 23 .

Financial futures exist for Treasury bills. While physical delivery of the underlying asset is virtually never taken. and swaps. but at a price established today. fiber. Financial futures provide for the purchase or sale of a financial asset at some time in the future. in whole or in part.3 .ANSWERS TO END-OF-CHAPTER QUESTIONS 23-1 a. and permits a partitioning of risks to give investors what they want. Treasury notes and bonds. Corporate risk management relates to the management of unpredictable events that have adverse consequences for the firm. under forward contracts goods are actually delivered. A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position. f. in which futures contracts are bought in anticipation of (or to guard against) price increases. g. Derivatives include options. commodity futures. This effort involves reducing the consequences of risk to the point where there would be no significant adverse impact on the firm’s financial position. Eurodollar deposits. and exchange rates. metals. Answers and Solutions: 23 . exchange rate futures. CDs. and wood. b. A structured note is a debt obligation derived from another debt obligation. interest rates. and short hedges. A derivative is an indirect claim security which derives its value. A hedge is a transaction which lowers a firm’s risk of damage due to fluctuating stock prices. which usually occurs because the parties involved prefer someone else’s payment pattern or type. c. A natural hedge is a transaction between two counterparties where both parties’ risks are reduced. interest rate futures. foreign currencies. The two basic types of hedges are long hedges. livestock. Commodity futures are futures contracts which involve the sale or purchase of various commodities. including grains. in which futures contracts are sold to guard against price declines. e. by the market price (or interest rate) of some other security (or market). A swap is an exchange of cash payment obligations. meats. oilseeds. and stock indexes.

If interest rates do rise. Fourth. investors will be indifferent to holding a company with volatile cash flows versus a company with stable cash flows. If the firm were concerned that the price of an input will rise. For example. (2) maintain their capital budget over time. Six reasons why risk management might increase the value of a firm is that it allows corporations to (1) increase their use of debt. There are several ways to reduce a firm's risk exposure. or (2) through their own use of derivatives. Fifth. the firm can take specific actions to reduce the probability of occurrence of adverse events. or sell financial futures contracts. contracting with a trucking company can in effect. The futures market can be used to guard against interest rate and input price risk through the use of hedging. it would use a long hedge. pass the firm's risks from transportation to the trucking company.4 . the firm can take actions to reduce the magnitude of the loss associated with adverse events. or buy commodity futures. which requires periodic premium payments established by the insurance company based on its perception of the firm's risk exposure. the firm can totally avoid the activity that gives rise to the risk. the firm will be able to purchase the input at the original contract price.23-2 If the elimination of volatile cash flows through risk management techniques does not significantly change a firm’s expected future cash flows and WACC. 23-3 23-4 23-5 Answers and Solutions: 23 . At the future's maturity date. the value of the futures would be less than at the time of issue. (3) avoid costs associated with financial distress. even if market prices have risen in the interim. losses on the issue due to the higher interest rates would be offset by gains realized from repurchase of the futures at maturity--because of the increase in interest rates. First. Third. Finally. Note that investors can reduce volatility themselves: (1) through portfolio diver-sification. such as installing an automatic sprinkler system to suppress potential fires. (5) reduce both the risks and costs of borrowing by using swaps. it would use a short hedge. (4) utilize their comparative advantages in hedging relative to the hedging ability of individual investors. Second. the firm can transfer risk-producing functions to a third party. If the firm were concerned that interest rates will rise. This includes replacing old electrical wiring or using fire resistant materials in areas with the greatest fire potential. a firm can transfer its risk to an insurance company. and (6) reduce the higher taxes that result from fluctuating earnings. the firm can purchase derivatives contracts to reduce input and financial risks.

where counterparties trade fixed-rate debt for floating rate debt. Currency swaps. There are several ways in which swaps reduce risk. can eliminate the exchange rate risk created when currency must first be converted to another currency before making scheduled debt payments.23-6 Swaps allow firms to reduce their financial risk by exchanging their debt for another party's debt. where firms exchange debt obligations denominated in different currencies. usually because the parties prefer the other's debt contract terms.5 . can reduce risk for both parties based on their individual views concerning future interest rates. Interest rate swaps. Answers and Solutions: 23 .

so it would use a short hedge.9569% ≈ 5.553.40/2 = 4.898.553. the firm would be hurt if interest rates were to rise by June.400%) = 6. Since futures maturing in June are selling for 95 17/32 of par.5.000 = 0.200% per six months. With an 11 percent coupon rate.$8. Answers and Solutions: 23 .898.000 contract value.000.4842 × 100 = $89. PMT = 300000. PV = -1005. The nominal annual yield is 2(6. the value of the short futures position began at $9.9569%. b.500. However.9553125($10. PMT = 300000. or roughly N = 40. PMT = 30. PMT = 0.) Now.748. FV = 10000000.125.42. FV = 10000000. and solve for PV = $8.11/2 × 10. Since futures contracts are for $100.000.42. so the firm would lose $10. PMT = 30.000) = $9. PV = -9553125.40 percent.005 × 100 bonds = $100. Thus. Zinn Company will be able to repurchase the futures contracts at a lower cost. so PV = 1. 6 percent semiannual coupon bonds which are yielding 6. which will help offset their loss from financing at the higher interest rate. I = 6. (Note that the future contracts are on hypothetical 20-year. we can solve for rd as follows: N = 40.20.149.851: N = 20. In this situation.748. the value of the futures contract will drop to $7.693.96%.553. Thus.000. if interest rates increased by 200 basis points.9784% × 2 = 5. and solve for PV = $7. solve for PV = $897.005 × $1. then we would solve for PV as follows: N = 40.898. I = 13/2 = 6. the firm must sell 100 contracts to cover the planned $10.9569/2 = 3.125.149.40%.000 = 550000. I = 6. FV = 1000. Should interest rates rise by June. solve for I = 3.693.948.000.000 June bond issue. FV = 10000000.149 = $1.000 .000 in Treasury bonds.948: N = 40.101. The firm would now pay 13 percent on the bonds.40 percent.47845. solve for I = r d = 2. Using a financial calculator. FV = 1000.125: 95 17/32 of $10. If interest rates increase to 6. to 8. the value of Zinn's futures is about $9.000 = $1.500 to $89.SOLUTIONS TO END-OF-CHAPTER PROBLEMS 23-1 Futures contract settled at 100 16/32% of $100. the bond issue would bring in only $8.000. the contact’s value has decreased from $100. 23-2 a. or sell futures contracts. the firm has hedged against rising interest rates.6 .

693. since in most cases the underlying asset is not identical to the futures asset. Answers and Solutions: 23 . a futures contract must have existed on Zinn's own debt (it existed on Treasury bonds) for the company to have an opportunity to create a perfect hedge. In reality.$1.95%. it is virtually impossible to create a perfect hedge. the gains on futures contracts exactly offset losses due to rising interest rates. 23-3 If Carter issues floating rate debt and then swaps. it gained $1.859.$7.326. the firm would make a $9. in effect.95% + LIBOR = -9. buy them back at $7. For a perfect hedge to exist.948.177 on its futures position.Since Zinn Company sold the futures contracts for $9.851 on its underlying bond issue. its net cash flows will be: -(LIBOR + 2%) – 7.859. In a perfect hedge. the underlying asset must be identical to the futures asset.125 .125. If Brence issues fixed rate debt and then swaps. the firm gained $1.05%). and will. This is less than the rate at which it could directly issue floating rate debt (LIBOR + 3%). Thus.693.95% .851 = $757.LIBOR = -(LIBOR + 3. so the swap is good for Carter.859.553. On net.553.101. c.7 .177 profit on the transaction ignoring transaction costs.948 = $1. its net cash flows will be: -11% + 7. This is less than the 10% rate at which it could directly issue fixed rate debt. so the swap is good for Brence. Using the Zinn Company example.101.177 . but lost $1.

com.SOLUTION TO SPREADSHEET PROBLEM 23-4 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution to Ch 23-4 Build a Model. Solution to Spreadsheet Problem: 23 .xls) and on the instructor’s side of the web site.8 . http://brigham.swcollege.

Mini Case: 23 .MINI CASE ASSUME THAT YOU HAVE JUST BEEN HIRED AS A FINANCIAL ANALYST BY TENNESSEE SUNSHINE INC. BEEN DRAFTED. AND ONE OF THE SESSIONS HE ATTENDED WAS ON THE PRESSING NEED FOR SMALLER COMPANIES TO INSTITUTE CORPORATE RISK MANAGEMENT PROGRAMS. SOPHISTICATED INVESTORS CAN HEDGE RISKS THEMSELVES AND THUS THEY ARE INDIFFERENT AS TO WHO ACTUALLY DOES THE HEDGING. BILL STOOKSBURY.9 . A MID-SIZED TENNESSEE COMPANY THAT SPECIALIZES IN CREATING EXOTIC SAUCES FROM IMPORTED FRUITS AND VEGETABLES. WHY MIGHT STOCKHOLDERS BE INDIFFERENT WHETHER OR NOT A FIRM REDUCES THE VOLATILITY OF ITS CASH FLOWS? ANSWER: IF VOLATILITY IN CASH FLOWS IS NOT CAUSED BY SYSTEMATIC RISK. THE FIRM'S CEO. THEN STOCKHOLDERS CAN ELIMINATE THE RISK OF VOLATILE CASH FLOWS BY DIVERSIFYING THEIR PORTFOLIOS. IN FACT. YOU HAVE TO DEVELOP THE ANSWERS. TO BEGIN. THE COMPANY WOULD HAVE TO PASS ON THE COSTS OF HEDGING TO THE INVESTORS. STOOKSBURY HAS ASKED YOU TO PREPARE A BRIEF REPORT THAT THE FIRM'S EXECUTIVES COULD USE TO GAIN AT LEAST A CURSORY UNDERSTANDING OF THE TOPICS. YOU GATHERED SOME OUTSIDE MATERIALS ON DERIVATIVES AND CORPORATE RISK MANAGEMENT AND USED THESE MATERIALS TO DRAFT A LIST OF PERTINENT QUESTIONS THAT NEED TO BE ANSWERED. IF A COMPANY DECIDED TO HEDGE AWAY THE RISK ASSOCIATED WITH THE VOLATILITY OF ITS CASH FLOWS. RECENTLY RETURNED FROM AN INDUSTRY CORPORATE EXECUTIVE CONFERENCE IN SAN FRANCISCO. ALSO. A. SINCE NO ONE AT TENNESSEE SUNSHINE IS FAMILIAR WITH THE BASICS OF DERIVATIVES AND CORPORATE RISK MANAGEMENT. ONE POSSIBLE APPROACH TO THE NOW THAT THE QUESTIONS HAVE PAPER IS TO USE A QUESTION-AND-ANSWER FORMAT..

(8) ENVIRONMENTAL RISKS. HOWEVER. ANSWER: WHAT IS CORPORATE RISK MANAGEMENT? WHY IS IT IMPORTANT TO ALL FIRMS? CORPORATE RISK MANAGEMENT IS THE MANAGEMENT OF UNPREDICTABLE EVENTS THAT HAVE ADVERSE CONSEQUENCES FOR THE FIRM. AND (10) INSURABLE RISKS. Mini Case: 23 . RISK TO THE POINT WHERE THERE SHOULD BE THIS FUNCTION IS VERY NO SIGNIFICANT ADVERSE IMPORTANT TO A FIRM SINCE IT INVOLVES REDUCING THE CONSEQUENCES OF EFFECTS ON THE FIRM’S FINANCIAL POSITION. (9) LIABILITY RISKS. SUCH AS A PRODUCT LIABILITY OR MALPRACTICE LAWSUIT (FROM THE DEFENDANT'S STANDPOINT). (3) DEMAND RISKS. ANSWER: 1. (4) INPUT RISKS. DEFINE THE FOLLOWING TYPES OF RISK: (1) SPECULATIVE RISKS. RISK MANAGEMENT ALLOWS CORPORATIONS TO (1) INCREASE THEIR USE OF DEBT. RISKS THAT FIRMS FACE CAN BE CATEGORIZED IN MANY WAYS. 3. THERE ARE SIX REASONS WHY RISK MANAGEMENT MIGHT INCREASE THE VALUE OF A FIRM.B. (2) PURE RISKS. D. SUCH AS BUYING AN OWNERSHIP SHARE IN A COMPANY. C. (5) REDUCE BOTH THE RISKS AND COSTS OF BORROWING BY USING SWAPS. (4) UTILIZE THEIR COMPARATIVE ADVANTAGES IN HEDGING RELATIVE TO THE HEDGING ABILITY OF INDIVIDUAL INVESTORS. (7) PERSONNEL RISKS. SPECULATIVE RISKS ARE THOSE THAT OFFER THE CHANCE OF A GAIN AS WELL AS A LOSS. WHAT ARE SIX REASONS RISK MANAGEMENT MIGHT INCREASE THE VALUE OF A CORPORATION? ANSWER: THERE ARE NO STUDIES PROVING THAT RISK MANAGEMENT EITHER DOES OR DOES NOT ADD VALUE. PURE RISKS ARE THOSE THAT ONLY OFFER THE PROSPECT OF LOSSES. SUCH AS NEW PRODUCTS DEVELOPED BY COMPETITORS.10 . (3) AVOID COSTS ASSOCIATED WITH FINANCIAL DISTRESS. (2) MAINTAIN THEIR CAPITAL BUDGET OVER TIME. DEMAND RISKS ARE THOSE ASSOCIATED WITH THE DEMAND FOR A FIRM'S PRODUCTS OR SERVICES. (6) PROPERTY RISKS. 2. AND (6) REDUCE THE HIGHER TAXES THAT RESULT FROM FLUCTUATING EARNINGS. (5) FINANCIAL RISKS.

OR EMPLOYEE LIABILITY. INCLUDING THE THREAT OF FIRE. INSURABLE RISKS ARE THOSE WHICH TYPICALLY CAN BE COVERED BY INSURANCE. WHAT ARE SOME ACTIONS THAT COMPANIES CAN TAKE TO MINIMIZE OR REDUCE RISK EXPOSURES? Mini Case: 23 . FINANCIAL RISKS. PROPERTY RIOTS. LIABILITY RISKS ARE CONNECTED WITH PRODUCT. SUCH AS INTEREST RATE AND CURRENCY EXCHANGE RATE PRODUCTIVE ASSETS. AND DECIDE HOW EACH RELEVANT RISK SHOULD BE HANDLED. SERVICE. ACTIONS PRODUCTS. FLOODS. ENVIRONMENTAL RISKS INCLUDE THOSE RISKS ASSOCIATED WITH RISKS ARE ASSOCIATED WITH DESTRUCTION OF A FIRM'S RISKS ARE THOSE THAT RESULT FROM FINANCIAL TRANSACTIONS. 9. 6.11 . MEASURE THE POTENTIAL IMPACT OF THE RISKS IDENTIFIED. BY SUCH AS COSTS OR INCURRED DAMAGES AS A RESULT OF IMPROPER DEFECTIVE EMPLOYEES RESULTING FROM E. INPUT RISKS ARE THOSE ASSOCIATED WITH A FIRM'S INPUT COSTS. 5.4. SUCH AS THEFT AND FRAUD. 7. ANSWER: WHAT ARE THE THREE STEPS OF CORPORATE RISK MANAGEMENT? THE THREE STEPS ARE: IDENTIFY THE RISKS FACED BY THE FIRM. 8. F. 10. PERSONNEL RISKS ARE RISKS THAT RESULT FROM HUMAN ACTIONS. AND POLLUTING THE ENVIRONMENT. INCLUDING MATERIALS AND LABOR.

12 . 1. COMPANIES CAN TRANSFER RISK TO SECOND. INPUT AND FINANCIAL RISK. THESE MARKETS PROVIDE THE OPPORTUNITY TO REDUCE FINANCIAL RISK EXPOSURE. G. FIRST.ANSWER: THERE ARE SEVERAL ACTIONS THAT COMPANIES CAN TAKE TO MINIMIZE OR REDUCE THEIR RISK EXPOSURE. (2) FUTURES MARKETS. AND (4) SWAPS. IS CONCERNED ABOUT PRICE DECLINES IN COMMODITIES OR FINANCIAL SECURITIES. OR TO GUARD A SHORT HEDGE. CAN TRANSFER FUNCTIONS WHICH PRODUCE RISK TO THIRD PARTIES. COMPANIES AN INSURANCE COMPANY BY PAYING PERIODIC PREMIUMS. 3. Mini Case: 23 . PRICE INCREASES. EXPOSURE. A DERIVATIVE IS A SECURITY WHOSE VALUE STEMS. THUS. OR SALE OF FUTURES. BUT AT A PRICE WHICH IS FIXED TODAY. FINALLY. SUCH AS INSTALLING AUTOMATIC SPRINKLER SYSTEMS. MADE WHEN THE FIRM IS A LONG HEDGE INVOLVES THE PURCHASE OF FUTURE CONTRACTS IN ANTICIPATION OF. ACTIONS CAN BE TAKEN TO REDUCE THE MAGNITUDE OF THE LOSS ASSOCIATED WITH ADVERSE EVENTS. AGAINST. PURCHASE DERIVATIVES CONTRACTS TO REDUCE FOURTH. WHAT IS FINANCIAL RISK EXPOSURE? DESCRIBE THE FOLLOWING CONCEPTS (1) AND TECHNIQUES THAT CAN BE USED TO REDUCE FINANCIAL RISKS: DERIVATIVES. FUTURES MARKETS INVOLVE CONTRACTS WHICH CALL FOR THE PURCHASE OR SALE OF A FINANCIAL (OR REAL) ASSET AT SOME FUTURE DATE. ANSWER: FINANCIAL RISK EXPOSURE REFERS TO THE RISK INHERENT IN THE FINANCIAL MARKETS DUE TO PRICE FLUCTUATIONS. SUCH AS ELIMINATING RISKS ASSOCIATED WITH TRANSPORTATION BY CONTRACTING WITH A TRUCKING COMPANY. (3) HEDGING. SUCH AS REPLACING OLD WIRING TO REDUCE THE POSSIBILITY OF FIRE. COMPANIES CAN TAKE ACTIONS TO FIFTH. REDUCE THE PROBABILITY OF OCCURRENCE OF AN ADVERSE EVENT. 2. COMPANIES CAN SIMPLY AVOID THE ACTIVITIES THAT GIVE RISE TO RISK. HEDGING IS GENERALLY CONDUCTED WHERE A PRICE CHANGE COULD OPTIONS AND FUTURES CONTRACTS ARE TWO TYPES OF DERIVATIVES THAT ARE USED TO MANAGE SECURITY PRICE NEGATIVELY AFFECT A FIRM'S PROFITS. OR IS DERIVED. THIRD. FROM THE VALUES OF OTHER ASSETS.

SWAP THEIR DEBT FOR EXAMPLE. Mini Case: 23 . PURCHASE OF A COMMODITY FUTURES CONTRACT WILL ALLOW A FIRM TO MAKE A FUTURE PURCHASE OF THE INPUT MATERIAL AT TODAY'S PRICE. H. FIRM WITH A POUND-DENOMINATED DEBT COULD DOLLAR-DENOMINATED DEBT. EVEN IF THE MARKET PRICE ON THE GOOD HAS RISEN SUBSTANTIALLY IN THE INTERIM. SWAPS CAN REDUCE EACH FIRM'S FINANCIAL RISK.4. CURRENCY EXCHANGE RATE RISK CAN BE WITH A BRITISH FIRM THAT HAS AN EQUIVALENT ELIMINATED IF A U.S.13 . SWAPS INVOLVE THE EXCHANGE OF CASH PAYMENT OBLIGATIONS ON DEBT BETWEEN TWO PARTIES. ANSWER: ESSENTIALLY. USUALLY BECAUSE EACH PARTY PREFERS THE TERMS OF THE OTHER'S DEBT CONTRACT. DESCRIBE HOW COMMODITY FUTURES MARKETS CAN BE USED TO REDUCE INPUT PRICE RISK.

Sign up to vote on this title
UsefulNot useful