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Questions and Answers for Derivatives and Risk Management

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					37debb83-1104-4083-9548-eedb346d5f20.xls                                                                                                                   Ch 23 Mini Case




                      Ch 23 Mini Case                                                                                                          3/30/2003

                                                  Chapter 23. Mini Case for Derivatives and Risk Management

                      Assume that you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that
                      specializes in creating exotic sauces from imported fruits and vegetables. The firm's CEO, Bill Stooksbury, recently
                      returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the
                      pressing need for smaller companies to institute corporate risk management programs. Since no one at Tennessee Sunshine
                      is familiar with the basics of derivatives and corporate risk management, Stooksbury has asked you to prepare a brief
                      report that the firm's executives could use to gain at least a cursory understanding of the topics.


                      To begin, you gathered some outside materials on derivatives and corporate risk management and used these 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 have to develop the answers.

                      a. Why might stockholders be indifferent whether or not a firm reduces the volatility of its 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.

                      b. What are six reasons risk management might increase the value of a corporation?

                      Risk management allows firms to:
                      1) Have greater debt capacity, which has a larger tax shield of interest payments.
                      2) Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow
                      due to volatility.
                      3) Avoid costs of financial distress.
                      4) Utilize comparative advantage in hedging relative to hedging ability of investors.
                      5) Reduce borrowing costs by using interest rate swaps
                      6) Minimize negative tax effects due to convexity in tax code.

                      c. What is corporate risk management? Why is it important to all firms?

                      Corporate risk management is the management of unpredictable events that would have adverse consequences for the firm.

                      d. Risks that firms face can be categorized in many ways. Define the following types of risk: (1) speculative risks; (2) pure
                      risks; (3) demand risks; (4) input risks; (5) financial risks; (6) property risks; (7) personnel risks; (8) environmental risks;
                      (9) liability risks; and (10) insurable risks.

                      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 firm’s products or services.
                      Input risks: Those associated with a firm’s input costs.
                      Financial risks: Those that result from financial transactions.
                      Property risks: Those associated with loss of a firm’s 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.

                      e. 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.

                      f. 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.
                      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.

                      g. What is financial risk exposure? Describe the following concepts and techniques that can be used to reduce financial
                      risks: (1) derivatives; (2) futures markets; (3) hedging; and (4) swaps.

                      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.



Michael C. Ehrhardt                                                                Page 1                                                                       7/27/2011
37debb83-1104-4083-9548-eedb346d5f20.xls                                                                                                             Ch 23 Mini Case

                      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.
                      Hedging: Generally conducted where a price change could negatively affect a firm’s 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.
                      Swaps: Involve the exchange of cash payment obligations between two parties, usually because each party prefers the terms
                      of the other’s debt contract. Swaps can reduce each party’s financial risk.

                      h. Describe how commodity futures markets can 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 today’s price, even
                      if the market price on the item has risen substantially in the interim.




Michael C. Ehrhardt                                                             Page 2                                                                    7/27/2011

				
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