Chapter 23 - Derivatives and Risk Management

Chapter 23 - Derivatives and Risk Management - Brigham and...

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Brigham and Daves (2004) , Intermediate Financial Management Chapter 23 “Derivatives and Risk Management” Reasons to manage risks o Debt capacity – risk management can reduce the variability in cash flows and this decreases the probability of bankruptcy o Firms wit lower operating risk can use more debt and this can lead to higher stock prices due to tax shields o Maintaining the optimal capital budget over time – firms are reluctant to raise external equity due to high flotation costs and market pressure o Internal cash flows may be (sometimes) too low to support the optimal capital budget or else incur the high associated costs o Financial distress – can range from worrying stockholders to higher interest rates o Comparative advantages in hedging – management can hedge more effectively and efficiently due to lower transaction costs and asymmetric information o Borrowing costs firms can lower the interest rate on debt through swaps o Compensation systems – bonuses are higher if earnings are stable due to caps and floors Background on derivatives o Derivatives – highly leveraged o Risks can be transferred rather than eliminated Basic principles When futures markets are chosen to hedge a risk the objective is usually to take a position that neutralizes the risk as far as possible If the price of the commodity goes down, the gain on the futures position offsets the loss on the rest of the company’s business If the price of the commodity goes up, the loss on the futures position is
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Chapter 23 - Derivatives and Risk Management - Brigham and...

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