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FM12 Ch 23 Solutions Manual - Chapter 23 Derivatives and...

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Chapter 23 Derivatives and Risk Management ANSWERS TO END-OF-CHAPTER QUESTIONS 23-1 a. A derivative is an indirect claim security that derives its value, in whole or in part, by the market price (or interest rate) of some other security (or market). Derivatives include options, interest rate futures, exchange rate futures, commodity futures, and swaps. b. Corporate risk management relates to the management of unpredictable events that have adverse consequences for the firm. 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. c. Financial futures provide for the purchase or sale of a financial asset at some time in the future, but at a price established today. Financial futures exist for Treasury bills, Treasury notes and bonds, CDs, Eurodollar deposits, foreign currencies, and stock indexes. While physical delivery of the underlying asset is virtually never taken, under forward contracts goods are actually delivered. e. A hedge is a transaction that lowers a firm’s risk of damage due to fluctuating stock prices, interest rates, and exchange rates. A natural hedge is a transaction between two counterparties where both parties’ risks are reduced. The two basic types of hedges are long hedges, in which futures contracts are bought in anticipation of (or to guard against) price increases, and short hedges, in which futures contracts are sold to guard against price declines. A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position. f. A swap is an exchange of cash payment obligations, which usually occurs because the parties involved prefer someone else’s payment pattern or type. A structured note is a debt obligation derived from another debt obligation, and permits a partitioning of risks to give investors what they want. g. Commodity futures are futures contracts which involve the sale or purchase of various commodities, including grains, oilseeds, livestock, meats, fiber, metals, and wood. Answers and Solutions : 23 - 1
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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, investors will be indifferent to holding a company with volatile cash flows versus a company with stable cash flows. Note that investors can reduce volatility themselves: (1) through portfolio diversification, or (2) through their own use of derivatives. 23-3 The six reasons why risk management might increase the value of a firm is that it allows corporations to (1) increase their use of debt; (2) maintain their capital budget over time; (3) avoid costs associated with financial distress; (4) utilize their comparative advantages in hedging relative to the hedging ability of individual investors; (5) reduce both the risks and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from fluctuating earnings.
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