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Unformatted text preview: Chapter 18 Derivatives and Risk Management Answers to End-of-Chapter Questions 18-1 Risk management may increase the value of a firm because it allows corporations to (1) increase their use of debt; (2) maintain their optimal 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; (6) reduce the higher taxes that result from fluctuating earnings; and (7) initiate compensation systems that reward managers for achieving earnings stability. 18-2 The market value of an option is typically higher than its exercise value due to the speculative nature of the investment. Options allow investors to gain a high degree of personal leverage when buying securities. The option allows the investor to limit his or her loss but amplify his or her return. The exact amount this protection is worth is the premium over the exercise value. 18-3 There are several ways to reduce a firm’s risk exposure. First, a firm can transfer its risk to an insurance company, which requires periodic premium payments established by the insurance company based on its perception of the firm’s risk exposure. Second, the firm can transfer risk- producing functions to a third party. For example, contracting with a trucking company can in effect, pass the firm’s risks from transportation to the trucking company. Third, the firm can purchase derivatives contracts to reduce input and financial risks. Fourth, the firm can take specific actions to reduce the probability of occurrence of adverse events. This includes replacing old electrical wiring or using fire resistant materials in areas with the greatest fire potential. Fifth, the firm can take actions to reduce the magnitude of the loss associated with adverse events, such as installing an automatic sprinkler system to suppress potential fires. Finally, the firm can totally avoid the activity that gives rise to the risk. 18-4 The futures market can be used to guard against interest rate and input price risk through the use of hedging. If the firm is concerned that interest rates will rise, it would use a short hedge, or sell financial futures contracts. If interest rates do rise, losses on the issue due to the higher interest rates would be offset by gains realized from repurchase of the futures at maturity--because of the increase in interest rates, the value of the futures would be less than at the time of issue. If the firm increase in interest rates, the value of the futures would be less than at the time of issue....
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- Spring '11
- Option time value