24 Derivatives and Risk Management

24 Derivatives and Risk Management - 24 - 1 CHAPTER 24...

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24 - 1 Risk management and stock value maximization. Derivative securities. Fundamentals of risk management. Using derivatives to reduce interest rate risk. CHAPTER 24 Derivatives and Risk Management
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24 - 2 If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios. Do stockholders care about volatile cash flows?
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24 - 3 How can risk management increase the value of a corporation? Risk management allows firms to: Have greater debt capacity, which has a larger tax shield of interest payments. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. (More. ..)
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24 - 4 Risk management allows firms to: Avoid costs of financial distress. Weakened relationships with suppliers. Loss of potential customers. Distractions to managers. Utilize comparative advantage in hedging relative to hedging ability of investors. (More. ..)
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24 - 5 Risk management allows firms to: Reduce borrowing costs by using interest rate swaps. Example: Two firms with different credit ratings, Hi and Lo: Hi can borrow fixed at 11% and floating at LIBOR + 1%. Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5%. (More. ..)
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24 - 6 Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of 0.45% to Hi. CF to lender -(LIBOR+1%) -11.40% CF Hi to Lo -11.40% +11.40% CF Lo to Hi +(LIBOR+1%) -(LIBOR+1%) CF Lo to Hi +0.45% -0.45% Net CF -10.95% -(LIBOR+1.45%) (More. ..)
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24 - 7 Risk management allows firms to: Minimize negative tax effects due to convexity in tax code. Example: EBT of $50K in Years 1 and 2, total EBT of $100K , Tax = $7.5K each year, total tax of $15 . EBT of $0K in Year 1 and $100K in Year 2, Tax = $0K in Year 1 and $22.5K in Year 2.
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An option is a contract which gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time. What is an option?
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This note was uploaded on 04/24/2010 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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24 Derivatives and Risk Management - 24 - 1 CHAPTER 24...

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