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CHAPTER 23
Derivatives and Risk Management
Risk management and stock value
maximization.
Derivative securities.
Fundamentals of risk management.
Using derivatives to reduce interest
rate risk.

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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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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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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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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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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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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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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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Definitions of Different Types of Risk


Speculative risks: Those that offer the
chance of a gain as well as a loss.

Pure risks: Those that offer only the


prospect of a loss.

Demand risks: Those associated with the


demand for a firms products or services.

Input risks: Those associated with a


firms input costs.

(More...)

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Financial risks: Those that result from


financial transactions.

Property risks: Those associated with loss of


a firms productive assets.

Personnel risk: Risks that result from human


actions.

Environmental risk: Risk associated with


polluting the environment.

Liability risks: Connected with product,


service, or employee liability.

Insurable risks: Those which typically can be


covered by insurance.

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What are the three steps of


corporate risk management?
Step 1. Identify the risks faced by the
firm.
Step 2. Measure the potential impact of
the identified risks.
Step 3. Decide how each relevant risk
should be dealt with.

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What are some actions that


companies can take to minimize
or reduce risk exposures?
Transfer risk to an insurance company
by paying periodic premiums.
Transfer functions which produce risk
to third parties.
Purchase derivatives contracts to
reduce input and financial risks.
(More...)

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Take actions to reduce the


probability of occurrence of
adverse events.
Take actions to reduce the
magnitude of the loss associated
with adverse events.
Avoid the activities that give rise
to risk.

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What is a financial risk exposure?

Financial risk exposure refers to the


risk inherent in the financial markets
due to price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the value
of the bonds falls.

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Financial Risk Management Concepts


Derivative: Security whose value stems or
is derived from the value of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.

Futures: Contracts which call for the

purchase or sale of a financial (or real) asset


at some future date, but at a price determined
today. Futures (and other derivatives) can be
used either as highly leveraged speculations
or to hedge and thus reduce risk.
(More...)

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Hedging: Generally conducted where

a price change could negatively affect a


firms profits.

Long hedge: Involves the

purchase of a futures contract to


guard against a price increase.

Short hedge: Involves the sale of a


futures contract to protect against a
price decline in commodities or
financial securities.

(More...)

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Swaps: Involve the exchange of cash


payment obligations between two
parties, usually because each party
prefers the terms of the others debt
contract. Swaps can reduce each
partys financial risk.

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How can commodity futures markets


be used to reduce input price risk?
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.

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Chapter 23 Extension:
Insurance and Bond Portfolio
Risk Management
Risk identification and
measurement
Property loss, liability loss, and
financial loss exposures
Bond portfolio risk management

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How are risk exposures identified


and measured?
Large corporations have risk management personnel which have the
responsibility to identify and measure
risks facing the firm.
Checklists are used to identify risks.
Small firms can obtain risk manage-ment
services from insurance companies or
risk management consulting firms.

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Describe (1) property loss and


(2) liability loss exposures.
Property loss exposures: Result from
various perils which threaten a firms real
and personal properties.
Physical perils: Natural events
Social perils: Related to human
actions
Economic perils: Stem from external
economic events

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Liability loss exposures: Result from


penalties imposed when responsibilities are not met.
Bailee exposure: Risks associated
with having temporary possession of
anothers property while some service
is being performed. (Cleaners ruin
your new suit.)
Ownership exposure: Risks inherent
in the ownership of property.
(Customer is injured from fall in store.)

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Business operation exposure:


Risks arising from business
practices or operations. (Airline
sued following crash.)
Professional liability exposure:
Stems from the risks inherent in
professions requiring advanced
training and licensing. (Doctor
sued when patient dies, or
accounting firm sued for not
detecting overstated profits.)

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What actions can companies take


to reduce property and
liability exposures?
Both property and liability exposures
can be accommodated by either selfinsurance or passing the risk on to an
insurance company.
The more risk passed on to an insurer,
the higher the cost of the policy.
Insurers like high deductibles, both to
lower their losses and to reduce moral
hazard.

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How can diversification reduce


business risk?

By appropriately spreading business


risk over several activities or
operations, the firm can significantly
reduce the impact of a single random
event on corporate performance.
Examples: Geographic and product
diversification.

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What is a financial risk exposure?

Financial risk exposure refers to the risk


inherent in the financial markets due to
price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the value
of the bonds falls.

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Financial risk management concepts:


Duration: Average time to bondholders'

receipt of cash flows, including interest


and principal repayment. Duration is used
to help assess interest rate and
reinvestment rate risks.

Immunization: Process of selecting

durations for bonds in a portfolio such that


gains or losses from reinvestment exactly
match gains or losses from price changes.

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