Chapter 18

Derivatives and Risk Management

Learning Objectives

After reading this chapter, students should be able to:

Identify the circumstances in which it makes sense for companies to manage risk.
Describe the various types of derivatives and explain how they can be used to manage risk.
Value options using the Black-Scholes Option Pricing Model.
Discuss the various elements of risk management and the different processes that firms use to
manage risks.

Chapter 18: Derivatives and Risk Management

Learning Objectives 477

Lecture Suggestions

This chapter provides information on derivatives and how they are used in risk management. We begin by
identifying the reasons why risk should be managed. Then, we give a brief background on derivatives.
We present the Black-Scholes Option Pricing Model to discuss the various factors that affect a call options
value. We specifically discuss forward and futures contracts, as well as other types of derivatives such as
swaps and structured notes. In addition, we explain how derivatives are used to reduce risk through
hedging, particularly with financial and commodity futures. Finally, we discuss risk management, define
different types of risks, and then provide an approach to risk management that firms can follow.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 18, which appears at the end of this chapter solution. For other suggestions about the
lecture, please see the Lecture Suggestions in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 58 DAYS (50-minute periods)

478 Lecture Suggestions

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 firms 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 firms risk exposure. Second, the firm can transfer riskproducing functions to a third party. For example, contracting with a trucking company can in
effect, pass the firms 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 is concerned that the price of an input will rise, it would use a long hedge, or buy commodity
futures. At the futures maturity date, the firm will be able to purchase the input at the original
contract price, even if market prices have risen in the interim.

18-5

Swaps allow firms to reduce their financial risk by exchanging their debt for another partys debt,
usually because the parties prefer the others debt contract terms. There are several ways in
which swaps reduce risk. Currency swaps, where firms exchange debt obligations denominated in
different currencies, can eliminate the exchange-rate risk created when currency must first be
converted to another currency before making scheduled debt payments. Interest rate swaps,
where counterparties trade fixed-rate debt for floating-rate debt, can reduce risk for both parties
based on their individual views concerning future interest rates.

18-6

If the elimination of volatile cash flows through risk management techniques does not significantly
change a firms 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.

Chapter 18: Derivatives and Risk Management

Answers and Solutions 479

Solutions to End-of-Chapter Problems

18-1

Call options market price = $7; Stocks price = $30; Option exercise price = $25.
a. Exercise value = Current stock price Exercise price
= $30 $25
= $5.00.
b. Premium value = Options market price Exercise value
= $7 $5
= $2.00.

18-2

Options exercise price = $15; Exercise value = $22; Premium value = $5; V = ? P 0 = ?
Premium = Market price of option Exercise value
$5 = V $22
V = $27.
Exercise value = P0 Exercise price
$22 = P0 $15
P0 = $37.

18-3

a. The value of an option increases as the stock price increases, but by less than the stock price
increase.
b. An increase in the volatility of the stock price increases the value of an option. The riskier the
underlying security, the more valuable the option.
c. As the risk-free rate increases, the options value increases.
d. The shorter the time to expiration of the option, the lower the value of the option. The
options value depends on the chances for an increase in the price of the underlying stock,
and the longer the options maturity, the higher the stock price may climb.
Therefore, conditions a, b, and c will cause an options market value to increase.

18-4

P = $15; X = $15; t = 0.5; rRF = 0.10; 2 = 0.12; d1 = 0.32660; d2 = 0.08165; N(d1) = 0.62795;
N(d2) = 0.53252; V = ?
Using the Black-Scholes Option Pricing Model, you calculate the options value as:
V=
=
=
=
=

P[N(d1)] Xe- rRF t [N(d2)]

$15(0.62795) $15e(-0.10)(0.5)(0.53252)
$9.4193 $15(0.9512)(0.53252)
$9.4193 $7.5982
$1.8211 $1.82.

480 Answers and Solutions

Chapter 18: Derivatives and Risk Management

18-5

Futures contract settled at 10016/32% of $100,000 contract value, so PV = 1.005 $1,000 =

$1,005 100 bonds = $100,500. Using a financial calculator, we can solve for rd as follows:
N = 30; PV = -1005; PMT = 30; FV = 1000; solve for I/YR = rd = 2.9746% 2 = 5.9491%
5.95%.
If interest rates increase to 6.95%, then we would solve for PV as follows:
N = 30; I/YR = 6.95/2 = 3.475; PMT = 30; FV = 1000; solve for PV = $912.3635 100 =
$91,236.35. Thus, the contracts value has decreased from $100,500 to $91,236.35.

18-6

a. In this situation, the firm would be hurt if interest rates were to rise by December, so it would
use a short hedge, or sell futures contracts. Since futures contracts are for $100,000 in
Treasury bonds, the firm must sell 200 contracts to cover its planned $20,000,000 December
bond issue. Since futures maturing in December are selling for 11220.5/32 of par, the value of
Zinns futures is about $22,528,125. Should interest rates rise by December, Zinn Company
will be able to repurchase the futures contracts at a lower cost, which will help offset their loss
from financing at the higher interest rate. Thus, the firm has hedged against rising interest
rates.
b. The firm would now pay 13% on the bonds. With an 11% coupon rate, the bond issue would
bring in only $17,796,299, so the firm would lose $20,000,000 $17,796,299 = $2,203,701:
N = 20; I/YR = 6.5; PMT = 1100000; FV = 20000000; and solve for PV = $17,796,299.
However, the value of the short futures position began at $22,528,125:
11220.5/32 of $20,000,000 = 1.12640625($20,000,000) = $22,528,125, or roughly N = 30; PMT
= 600000; FV = 20000000; and PV = -22528125; and solve for I/YR/2 = 2.40378211.
I/YR = 2.40378211% 2 = 4.80756421% 4.8%.
(Note that the future contracts are on hypothetical 15-year, 6% semiannual coupon bonds
that are yielding about 4.8%.)
Now, if interest rates increased by 200 basis points, to 6.8%, the value of the futures
contract will drop to $18,510,027.
N = 30; I/YR = 6.8/2 = 3.4; PMT = 600000; FV = 20000000; and solve for PV = $18,510,027.
Since Zinn Company sold the futures contracts for $22,528,125, and will, in effect, buy them
back at $18,510,027, the firm would make a $22,528,125 $18,510,027 = $4,018,098 profit
on the transaction ignoring transaction costs.
Thus, the firm gained $4,018,098 on its futures position, but lost $2,203,701 on its
underlying bond issue. On net, it gained $4,018,098 $2,203,701 = $1,814,397.
c. In a perfect hedge, the gains on futures contracts exactly offset losses due to rising interest
rates. For a perfect hedge to exist, the underlying asset must be identical to the futures
asset. Using the Zinn Company example, a futures contract must have existed on Zinns own
debt (it existed on Treasury bonds) for the company to have an opportunity to create a
perfect hedge. In reality, it is virtually impossible to create a perfect hedge, since in most
cases the underlying asset is not identical to the futures asset.

Chapter 18: Derivatives and Risk Management

Answers and Solutions 481

18-7

a. The current exercise value of the put option is max(0, $55 $60) = $0. Since the market
value of the put option is $3.06, the premium associated with the put is $3.06. The current
exercise value of the call option is max(0, $60 $55) = $5. Since the market value of the call
option is $9.29, the premium associated with the call is $4.29.
b. Remember, that the options will be exercised only if they yield a positive payoff. In this case,
the put option will not be exercised. In addition, the initial investments for the options will be
the market values of the options. The returns under each of the scenarios are summarized
below:
Investment
Own stock
Buy call option
Buy put option

Returns
[($70 $60)/$60]
[($70 $55)/$9.29] 1
[($0)/$3.06] 1

=
16.67%.
=
61.46%.
= -100%.

c. In this case, the call option will not be exercised. The returns under each of the scenarios are
summarized below:
Investment
Own stock
Buy call option
Buy put option

Returns
[($50 $60)/$60]
[($0)/$9.29] 1
[($55 $50)/$3.06] 1

= -16.67%.
= -100%.
=
63.40%.

d. Recall, that the stock price is expected to be either $50 or $70, with equal probability. If
Audrey buys 0.6 shares of stock and sells one call option, her expected payoffs are:
Ending Price
$50
$70

0.60 = Ending Stock Value

0.60 =
$30
0.60 =
$42

Ending Option Value

$ 0
$15

Audreys investment strategy would yield a payoff of $30 $0 = $30, if the ending stock price
is $50. Her strategy has a payoff of $42 $15 = $27, if the ending stock price is $70. The
strategies do not have identical payoffs; therefore, this is not a riskless hedged portfolio.
e. Recall, that the stock price is expected to be either $50 or $70, with equal probability. If
Audrey buys 0.75 shares of stock and sells one call option, her expected payoffs are:
Ending Price
$50
$70

0.75 = Ending Stock Value

0.75 =
$37.50
0.75 =
$52.50

Ending Option Value

$ 0
$15

Audreys investment strategy would yield a payoff of $37.50 $0 = $37.50, if the ending stock
price is $50. Her strategy has a payoff of $52.50 $15 = $37.50, if the ending stock price is
$70. Since her payoff is guaranteed to be $37.50, regardless of the ending stock price, this is
a riskless hedged portfolio.
18-8

a. Data: P0 = $60; X = $50; Price range = $45-$70; rRF = 7%.

Range

Ending Price
$45
$70
$25

482 Answers and Solutions

Strike Price =
$50
=
$50
=

Option Value
$ 0.00
$20.00
$20.00

Chapter 18: Derivatives and Risk Management

b.
Range
c. Ending Price
$45
$70

Ending Price
$45
$70
$25

0.80 = Ending Stock Value

0.80 =
$36.00
0.80 =
$56.00
$20.00

0.80 = Ending Stock Value

0.80 =
$36.00
0.80 =
$56.00

Ending Option Value

$ 0.00
$20.00
$20.00

+ Ending Option Value =

+
$ 0.00
=
+
-$20.00
=

Portfolio Value
$36.00
$36.00

d. Cost of stock = 0.8($60) = $48.00

e. PV = $36/1.07 = $33.64
f.

Price of option = Cost of stock PV of portfolio

= $48.00 $33.64 = $14.36

Chapter 18: Derivatives and Risk Management

Answers and Solutions 483

Comprehensive/Spreadsheet Problem
Note to Instructors:

The solution to the reworked part of this problem is provided at the back of the text; however,
the solutions to Parts a and b are not. Instructors can access the Excel file on the textbooks
web site or the Instructors Resource CD.
18-9

a. Assume you have been given the following information on Purcell Industries:

P
t
2

$15
0.5
0.12

X
rRF

$15
10%

First, we will use formulas from the text to solve for d 1 and d2.

(d1)

0.32660

(d2)

0.08165

Using the formula for option value and the normal distribution function, we can find the call option
value.

b.

Exercise
Price
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00
$15.00

Current
stock
price
$1.00
$3.00
$6.00
$9.00
$12.00
$15.00
$18.00
$21.00
$24.00
$27.00
$30.00

$1.82

Option Value
Intrinsic B-S formula
Value
Value
Option
$0
$1.82 Premium
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.03
$0.03
$0.00
$0.45
$0.45
$0.00
$1.82
$1.82
$3.00
$4.09
$1.09
$6.00
$6.83
$0.83
$9.00
$9.76
$0.76
$12.00
$12.74
$0.74
$15.00
$15.73
$0.73

484 Comprehensive/Spreadsheet Problem

Chapter 18: Derivatives and Risk Management

Intrinsic-vs-Market Value of Options

Option Value
$15

$10

Intrinsic Value
Market Value

$5

$0
$0

c.

XCALL =
if P=
$1
$3
$6
$9
$12
$15
$18
$21
$24
$27

$10

$20
$30
Stock Price

$15
Call
-$1.82
-$1.82
-$1.82
-$1.82
-$1.82
-$1.82
$1.18
$4.18
$7.18
$10.18

Chapter 18: Derivatives and Risk Management

Comprehensive/Spreadsheet Problem 485

d.

486 Comprehensive/Spreadsheet Problem

Chapter 18: Derivatives and Risk Management

Integrated Case

18-10

Tropical Sweets Inc.

Derivatives and Corporate Risk Management

Assume that you have just been hired as a financial analyst by Tropical
Sweets Inc., a mid-sized California company that specializes in creating
exotic candies from tropical fruits such as mangoes, papayas, and dates. The
firms CEO, George Yamaguchi, recently returned from an industry corporate
executive conference in San Francisco. One of the sessions he attended was
on the pressing need for smaller companies to institute corporate risk
management programs. As no one at Tropical Sweets is familiar with the
basics of derivatives and corporate risk management, Yamaguchi has asked
you to prepare a brief report that the firms executives can use to gain at
least a cursory understanding of the topics.
To begin, you gather some outside materials on derivatives and
corporate risk management and use those materials to draft a list of
pertinent questions that need to be answered. In fact, one possible
approach to the paper is to use a question-and-answer format. Now that the
questions have been drafted, you must develop the answers.
A.

Why might stockholders be indifferent to whether a firm reduces

the volatility of its cash flows?

Answer:

[Show S18-1 and S18-2 here.] 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. Also, if a
company decided to hedge away the risk associated with the
volatility of its cash flows, the company would have to pass on the

Chapter 18: Derivatives and Risk Management

Integrated Case 487

costs of hedging to the investors. Sophisticated investors can

hedge risks themselves and thus they are indifferent as to who
actually does the hedging.
B.

What are seven reasons risk management might increase the

value of a corporation?

Answer:

[Show S18-3 here.] There are no studies proving that risk

management either does or does not add value. However, there
are seven reasons why risk management might increase the value
of a firm. Risk management 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
programs to reward managers for achieving stable earnings.

C.

What is an option? What is the single most important

characteristic of an option?

Answer:

[Show S18-4 here.] An option is a contract that gives its holder

the right to buy (or sell) an asset at some predetermined price
within a specified period of time. An options most important
characteristic is that it does not obligate its owner to take any
action; it merely gives the owner the right to buy or sell an asset.

488 Integrated Case

Chapter 18: Derivatives and Risk Management

D.

Options have a unique set of terminology. Define the following

terms: (1) call option; (2) put option; (3) exercise price; (4)
striking, or strike, price; (5) option price; (6) expiration date; (7)
exercise value; (8) covered option; (9) naked option; (10) in-themoney call; (11) out-of-the-money call; and (12) LEAPS.

Answer:

[Show S18-5 through S18-7 here.]

A call option is an option to buy a specified number of shares of a
security within some future period.
A put option is an option to sell a specified number of shares of a
security within some future period.
Exercise price is another name for strike price, the price stated in
the option contract at which the security can be bought (or sold).
The strike price is the price stated in the option contract at which
the security can be bought (or sold).
The option price is the market price of the option contract.
The expiration date is the date the option matures.
The exercise value is the value of a call option if it were exercised
today, and it is equal to the current stock price minus the strike
price.
A covered option is a call option written against stock held in an
investors portfolio.
A naked option is an option sold without the stock to back it up.
An in-the-money call is a call option whose exercise price is less
than the current price of the underlying stock.

Chapter 18: Derivatives and Risk Management

Integrated Case 489

An out-of-the-money call is a call option whose exercise price

exceeds the current price of the underlying stock.
LEAPS stands for long-term equity anticipation securities. They
are similar to conventional options except they are long-term
options with maturities of up to 2 years.
E.

Consider Tropical Sweets call option with a $25 strike price. The
following table contains historical values for this option at
different stock prices:
Stock Price
$25
30
35
40
45
50

Call Option Price

$ 3.00
7.50
12.00
16.50
21.00
25.50

(1) Create a table that shows the (a) stock price, (b) strike price, (c)
exercise value, (d) option price, and (e) premium of option price
over exercise value.
Answer:

[Show S18-8 and S18-9 here.]

Price of
Stock
(a)
$25.00
30.00
35.00
40.00
45.00
50.00

E.

Strike
Price
(b)
$25.00
25.00
25.00
25.00
25.00
25.00

Exercise Value
of Option
(a) (b) = (c)
$ 0.00
5.00
10.00
15.00
20.00
25.00

Market Price
of Option
(d)
$ 3.00
7.50
12.00
16.50
21.00
25.50

Premium
(d) (c) = (e)
$3.00
2.50
2.00
1.50
1.00
0.50

(2) What happens to the premium of option price over exercise value
as the stock price rises? Why?

490 Integrated Case

Chapter 18: Derivatives and Risk Management

Answer:

[Show S18-10 and S18-11 here.] As the table shows, the

premium of the option price over the exercise value declines as
the stock price increases. This is due to the declining degree of
leverage provided by options as the underlying stock price
increases, and to the greater loss potential of options at higher
option prices.

F.

In 1973, Fischer Black and Myron Scholes developed the BlackScholes Option Pricing Model (OPM).
(1) What assumptions underlie the OPM?

Answer:

[Show S18-12 here.] The assumptions that underlie the OPM are
as follows:

The stock underlying the call option provides no dividends

during the life of the option.

No transactions costs are involved with the sale or purchase

of either the stock or the option.

The short-term, risk-free interest rate is known and is

constant during the life of the option.

Security buyers may borrow any fraction of the purchase price

at the short-term, risk-free rate.

Short-term selling is permitted without penalty, and sellers

receive immediately the full cash proceeds at todays price for
securities sold short.

The call option can be exercised only on its expiration date.

Security trading takes place in continuous time, and stock

prices move randomly in continuous time.

Chapter 18: Derivatives and Risk Management

Integrated Case 491

492 Integrated Case

Chapter 18: Derivatives and Risk Management

F.

(2) Write the three equations that constitute the model.

Answer:

[Show S18-13 here.] The OPM consists of the following three

equations:
V = P[N(d1 )] Xe rRFt [N(d2 )] .
d1 =

ln(P/X) [rRF ( 2/2)]t

t

d2 = d1 t .
Here,
V = Current value of a call option with time t until expiration.
P = Current price of the underlying stock.
N(di) = Probability that a deviation less than di will occur in a
standard normal distribution. Thus, N(d1) and N(d2)
represent areas under a standard normal distribution
function.
X = Exercise, or strike, price of the option.
e 2.7183.
rRF = Risk-free interest rate.
t = Time until the option expires (the option period).
ln(P/X) = Natural logarithm of P/X.
2 = Variance of the rate of return on the stock.

Chapter 18: Derivatives and Risk Management

Integrated Case 493

F.

(3) What is the value of the following call option according to the
OPM?
Stock price = $27.00.
Exercise price = $25.00.
Time to expiration = 6 months.
Risk-free rate = 6.0%.
Stock return variance = 0.11.

Answer:

[Show S18-14 and S18-15 here.] The input variables are:

P = $27.00; X = $25.00; rRF = 6.0%; t = 6 months = 0.5 years;
and
2 = 0.11.
Now, we proceed to use the OPM:
V = $27[N(d1)] $25e-(0.06)(0.5) [N(d2)].
ln($27/$25) [(0.06 0.11/2)](0.5)
(0.3317)(0.7071)
0.0770 0.0575
=
0.5736.
0.2345

d1 =

d2 = d1 (0.3317)(0.7071) = d1 0.2345
= 0.5736 0.2345 = 0.3391.
N(d1) = N(0.5736) = 0.5000 + 0.2168 = 0.7168.
N(d2) = N(0.3391) = 0.5000 + 0.1327 = 0.6327.
Therefore,
V = $27(0.7168) $25e-0.03(0.6327)
= $19.3536 $25(0.97045)(0.6327)
= $19.3536 $15.3500 = $4.0036 $4.00.
Thus, under the OPM, the value of the call option is about $4.00.
494 Integrated Case

Chapter 18: Derivatives and Risk Management

G.

Disregard the information in Part F. Determine the value of a

firms call option by creating a riskless hedge given the following
information. A firms current stock price is $15 per share. Options
exist that permit the holder to buy one share of the firms stock at
an exercise price of $15. These options expire in 6 months, at
which time the firms stock will be selling at one of two prices, $10
or $20. The risk-free rate is 6%. What is the value of the firms
call option?

Answer:

[Show S18-16 through S18-19 here.]

Chapter 18: Derivatives and Risk Management

Integrated Case 495

H.

What effect does each of the following call option parameters

have on the value of a call option? (1) Current stock price; (2)
Exercise price; (3) Options term to maturity; (4) Risk-free rate;
(5) Variability of the stock price.

Answer:

[Show S18-20 and S18-21 here.]

1.

The value of a call option increases (decreases) as the current

stock price increases (decreases).

2.

As the exercise price of the option increases (decreases), the

value of the option decreases (increases).

3.

As the expiration date of the option is lengthened, the value

of the option increases. This is because the value of the
option depends on the chance of a stock price increase, and
the longer the option period, the higher the stock price can
climb.

4.

As the risk-free rate increases, the value of the option tends

to increase as well. Since increases in the risk-free rate tend
to decrease the present value of the options exercise price,
they also tend to increase the current value of the option.

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Chapter 18: Derivatives and Risk Management

5.

The greater the variance in the underlying stock price, the

greater the possibility that the stocks price will exceed the
exercise price of the option; thus, the more valuable the
option will be.

I.

What are the differences between forward and futures contracts?

Answer:

[Show S18-22 here.] Forward contracts are agreements where

one party agrees to buy a commodity at a specific price on a
specific future date and the other party agrees to make the sale.
Goods are actually delivered under forward contracts.
A future contract is similar to a forward contract, but with
three key differences: (1) Futures contracts are marked to
market on a daily basis, meaning that gains and losses are noted
and money must be put up to cover losses. This greatly reduces
the risk of default that exists with forward contracts. (2) With
futures, physical delivery of the underlying asset is virtually never
takenthe two parties simply settle up with cash for the
difference between the contracted price and the actual price on
the expiration date. (3) Futures contracts are generally
standardized instruments that are traded on exchanges, whereas
forward contracts are generally tailor-made, are negotiated
between two parties, and are not traded after they have been
signed.

J.

Explain briefly how swaps work.

Answer:

[Show S18-23 here.] A swap is the exchange of cash payment

obligations between two parties, usually because each party
prefers the terms of the others debt contract because the terms

Chapter 18: Derivatives and Risk Management

Integrated Case 497

more closely match the firms cash flows: Fixed for floating and
floating for fixed. Swaps can reduce each partys financial risk.
K.

Explain briefly how a firm can use futures and swaps to hedge
risk.

Answer:

[Show S18-24 and S18-25 here.] Hedging is usually used when a

price change could negatively affect a firms profits. A long hedge
involves the purchase of a futures contract to guard against a
price increase. A short hedge involves the sale of a futures
contract to protect against a price decline. The purchase of a
commodity futures contract will allow a firm to make a future
purchase of the input at todays price, even if the market price on
the item has risen substantially in the interim.
Swaps are used to better match each firms cash flows. Most
swaps today involve either interest payments or currencies.
Suppose Company F has a $100 million, 20-year, fixed-rate issue
and Company S has a 20-year, $100 million floating-rate bond
outstanding. If S has stable cash flows and wants to lock in its
cost of debt, it would prefer a fixed-rate obligation. If F has cash
flows that fluctuate with the economy, rising when the economy is
strong and falling when it is weak, it would prefer a floating-rate
obligation. The reason is that interest rates also move up and
down with the economy, so F has concluded that it would be
better off with variable-rate debt. Thus, by swapping debt
instruments the firms better match their cash flows and thus
reduce their risk.

L.

What is corporate risk management? Why is it important to all

firms?

498 Integrated Case

Chapter 18: Derivatives and Risk Management

Answer:

[Show S18-26 through S18-29 here.] Corporate risk management

relates to the management of unpredictable events that have
adverse consequences for the firm. This function is very
important to a firm since it involves reducing the consequences of
risk to the point where there should be no significant adverse
effects on the firms financial position.

Chapter 18: Derivatives and Risk Management

Integrated Case 499