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Copyright 2002 Harcourt, Inc. All rights reserved.

Risk management and stock valuemaximization.

Derivative securities.

Fundamentals of risk management.

Using derivatives to reduceinterest rate risk.

CHAPTER 24Derivatives and Risk Management

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If volatility in cash flows is not caused

by systematic risk, then stockholderscan eliminate the risk of volatile cashflows by diversifying their portfolios.

Stockholders might be able to reduceimpact of volatile cash flows by usingrisk management techniques in theirown portfolios.

Do stockholders care about volatile

cash flows?

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Risk management allows firms to:

Avoid costs offinancial distress.

Weakened relationships withsuppliers.

Loss of potential customers.

Distractions to managers.

Utilize comparative advantage inhedging relative to hedging ability ofinvestors.

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Reduce borrowing costs by usinginterest rate swaps.

Example: Two firms with differentcredit ratings, Hi and Lo:

Hi can borrow fixed at 11% and

floating at LIBOR + 1%.Lo can borrow fixed at 11.4% andfloating at LIBOR + 1.5%.

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Hi wants fixed rate, but it will issuefloating and swap with Lo. Lo wantsfloating rate, but it will issue fixed andswap with Hi. Lo also makes sidepayment 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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Minimize negative tax effects due toconvexity 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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Speculative risks: Those that offer thechance of a gain as well as a loss.

Pure risks: Those that offer only theprospect of a loss.

Demand risks: Those associated withthe demand for a firms products orservices.

Input risks: Those associated with afirms input costs.

Definitions of Different Types of Risk

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Financial risks: Those that result fromfinancial transactions.

Property risks: Those associated with lossof 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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Transfer risk to an insurance companyby paying periodic premiums.

Transfer functions which produce riskto third parties.

Purchase derivatives contracts toreduce input and financial risks.

What are some actions that

companies can take to minimizeor reduce risk exposures?

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Take actions to reduce theprobability of occurrence ofadverse events.

Take actions to reduce themagnitude of the loss associatedwith adverse events.

Avoid the activities that give riseto risk.

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Derivative: Security whose value stems oris derived from the value of other assets.Swaps, options, and futures are used tomanage financial risk exposures.

Futures: Contracts which call for thepurchase or sale of a financial (or real) asset

at some future date, but at a price determinedtoday. Futures (and other derivatives) can beused either as highly leveraged speculationsor to hedge and thus reduce risk.

Financial Risk Management Concepts

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Swaps: Involve the exchange of cashpayment obligations between twoparties, usually because each partyprefers the terms of the others debt

contract. Swaps can reduce eachpartys financial risk.

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The purchase of a commodityfutures contract will allow a firm tomake a future purchase of theinput at todays price, even if the

market price on the item has risensubstantially in the interim.

How can commodity futures markets

be used to reduce input price risk?

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Risk identification andmeasurement

Property loss, liability loss, and

financial loss exposures

Bond portfolio risk management

Chapter 24 Extension:

Insurance and Bond PortfolioRisk Management

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Large corporations have riskmanage-ment personnel which have

the responsibility to identify andmeasure risks facing the firm.

Checklists are used to identify risks.

Small firms can obtain risk manage-ment services from insurancecompanies or risk management

consulting firms.

How are risk exposures identified

and measured?

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Property loss exposures: Result fromvarious perils which threaten a firms

real and personal properties.Physical perils: Natural events

Social perils: Related to humanactions

Economic perils: Stem fromexternal economic events

Describe (1) property loss and

(2) liability loss exposures.

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Liability loss exposures: Result frompenalties imposed when responsi-

bilities are not met.

Bailee exposure: Risks associatedwith having temporary possession of

anothers property while someservice is being performed.(Cleaners ruin your new suit.)

Ownership exposure: Risksinherent in the ownership ofproperty. (Customer is injured fromfall in store.)

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Business operation exposure:

Risks arising from businesspractices or operations. (Airlinesued following crash.)

Professional liability exposure:Stems from the risks inherent inprofessions requiring advancedtraining and licensing. (Doctor

sued when patient dies, oraccounting firm sued for notdetecting overstated profits.)

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Both property and liability exposures

can be accommodated by either self-insurance or passing the risk on to aninsurance company.The more risk passed on to an insurer,

the higher the cost of the policy.Insurers like high deductibles, both tolower their losses and to reduce moralhazard.

What actions can companies take

to reduce property andliability exposures?

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By appropriately spreading businessrisk over several activities oroperations, the firm can significantlyreduce the impact of a single random

event on corporate performance.Examples: Geographic and product

diversification.

How can diversification reduce

business risk?

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Financial risk exposure refers to the

risk inherent in the financial marketsdue to price fluctuations.

Example: A firm holds a portfolio of

bonds, interest rates rise, and thevalue of the bonds falls.

What is a financial risk exposure?

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Duration: Average time to bondholders'receipt of cash flows, including interestand principal repayment. Duration is usedto help assess interest rate andreinvestment rate risks.

Immunization: Process of selecting

durations for bonds in a portfolio suchthat gains or losses from reinvestmentexactly match gains or losses from pricechanges.

Financial risk management concepts:

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