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IFM10 Ch24 Lecture - Chapter24 1 TopicsinChapter...

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  1 Chapter 24 Derivatives and Risk Management
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  2 Topics in Chapter Risk management and stock value  maximization.  Derivative securities. Fundamentals of risk management. Using derivatives to reduce interest rate  risk.
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  3 Do stockholders care about  volatile cash flows? 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.
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  4 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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  5 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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  6 Risk management allows  firms to  (Continued): 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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  7 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.     Hi            Lo 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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  8 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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  9 What is corporate risk  management? Corporate risk management is the  management of unpredictable events  that would have adverse consequences  for the firm.
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  10 Different Types of Risk Speculative risks:  Those that offer the  chance of a gain as well as a loss.
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