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Unformatted text preview: 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. 23-2 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....
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- Spring '09
- Interest Rates, Firm, futures contracts