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SOC 202
Louis Pike

CHAPTER 24 RISK MANAGEMENT: AN INTRODUCTION TO FINANCIAL ENGINEERING Learning Objectives LO1 The sources of financial risk. LO2 How to identify specific financial risks faced by firms. LO3 The basics of hedging with forward contracts and futures. LO4 The basics of hedging with swaps and options. Answers to Concepts Review and Critical Thinking Questions 1. (LO2) Since the firm is selling futures, it wants to be able to deliver the lumber; therefore, it is a supplier. Since a decline in lumber prices would reduce the income of a lumber supplier, it has hedged its price risk by selling lumber futures. Losses in the spot market due to a fall in lumber prices are offset by gains on the short position in lumber futures. 2. (LO2) Buying call options gives the firm the right to purchase pork bellies; therefore, it must be a consumer of pork bellies. While a rise in pork belly prices is bad for the consumer, this risk is offset by the gain on the call options; if pork belly prices actually decline, the consumer enjoys lower costs, while the call option expires worthless. 3. (LO3) Forward contracts are usually designed by the parties involved for their specific needs and are rarely sold in the secondary market; forwards are somewhat customized financial contracts. All gains and losses on the forward position are settled at the maturity date. Futures contracts are standardized to facilitate their liquidity and allow them to be effectively traded on organized futures exchanges. Gains and losses on futures are marked-to-market daily. The default risk is greatly reduced with futures, since the exchange acts as an intermediary between the two parties, guaranteeing performance; default risk is also reduced because the daily settlement procedure keeps large loss positions from accumulating. You might prefer to use forwards instead of futures if your hedging needs were different from the standard contract size and maturity dates offered by the futures contract. 4. (LO2) The firm is hurt by declining oil prices, so it should sell oil futures contracts. The firm may not be able to create a perfect hedge because the quantity of oil it needs to hedge doesn’t match the standard contract size on crude oil futures, or perhaps the exact settlement date the company requires isn’t available on these futures (exposing the firm to basis risk), or maybe the firm produces a different grade of crude oil than that specified for delivery in the futures contract. 5. (LO2) The firm is directly exposed to fluctuations in the price of natural gas, since it is a natural gas user. In addition, the firm is indirectly exposed to fluctuations in the price of oil. If oil becomes less expensive relative to natural gas, its competitors will enjoy a cost advantage relative to the firm. 6. (LO3, 4) Buying the call options is a form of insurance policy for the firm. If cotton prices rise, the firm is protected by the call, while if prices actually decline, they can just allow the call to expire worthless. However, options hedges are costly because of the initial premium that must be paid. The futures contract can be entered into at no initial cost, with the disadvantage that the firm is locking in one price for cotton; it can’t profit from cotton price declines. 7. (LO4) The put option on the bond gives the owner the right to sell the bond at the option’s strike price. If bond prices decline, the owner of the put option profits. However, since bond prices and interest rates move in opposite directions, if the put owner profits from a decline in bond prices, he would also profit from a rise in interest rates. Hence, a call option on interest rates is conceptually the same thing as a put option on bond prices. 24-1 8. (LO2, 3, 4) The company would like to lock in the current low rates, or at least be protected from a rise in rates, allowing for the possibility of benefit if rates actually fall. The former hedge could be implemented by selling bond futures; the latter could be implemented by buying put options on bond prices or buying call options on interest rates. 9. (LO4) A swap contract is an agreement between parties to exchange assets over several time intervals in the future. The swap contract is usually an exchange of cash flows, but not necessarily so. Since a forward contract is also an agreement between parties to exchange assets in the future, but at a single point in time, a swap can be viewed as a series of forward contracts with different settlement dates. The firm participating in the swap agreement is exposed to the default risk of the dealer, in that the dealer may not make the cash flow payments called for in the contract. The dealer faces the same risk from the contracting party, but can more easily hedge its default risk by entering into an offsetting swap agreement with another party. 10. (LO4) The firm will borrow at a fixed rate of interest, receive fixed rate payments from the dealer as part of the swap agreement, and make floating rate payments back to the dealer; the net position of the firm is that it has effectively borrowed at floating rates. 11. (LO2) Transactions exposure is the short-term exposure due to uncertain prices in the near future. Economic exposure is the long-term exposure due to changes in overall economic conditions. There are a variety of instruments available to hedge transaction exposure, but very few long-term hedging instruments exist. It is much more difficult to hedge against economic exposure, since fundamental changes in the business generally must be made to offset long-run changes in the economic environment. 12. (LO3) The risk is that the Canadian dollar will strengthen relative to the US dollar, since the fixed US dollar payments in the future would then be worth less Canadian dollars. Since this implies a decline in the $CDN/ $US exchange rate, the firm should sell US dollar futures. 13. (LO3) a. Buy oil and natural gas futures contracts, since these are probably your primary resource costs. If it is a coal-fired plant, a cross-hedge might be implemented by selling natural gas futures, since coal and natural gas prices are somewhat negatively related in the market; coal and natural gas are somewhat substitutable. b. Buy sugar and cocoa futures, since these are probably your primary commodity inputs. c. Sell corn futures, since a record harvest implies low corn prices. d. Buy silver and platinum futures, since these are primary commodity inputs required in the manufacture of photographic equipment. e. Sell natural gas futures, since excess supply in the market implies low prices. f. Assuming the bank doesn’t resell its mortgage portfolio in the secondary market, buy bond futures. g. Sell stock index futures, using an index most closely associated with the stocks in your fund, such as the S&P 100 or the Major Market Index for large blue-chip stocks. h. Buy Swiss franc futures, since the risk is that the dollar will weaken relative to the franc over the next six month, which implies a rise in the $/SFr exchange rate. i. Sell Euro futures, since the risk is that the dollar will strengthen relative to the Euro over the next three months, which implies a decline in the $/€ exchange rate. 14. (LO4) Telus wanted variable-rate bonds in Canadian dollars to minimize its interest payments, but Telus only had fixed rate instruments available to back the sale of the bonds in the US bond market. Telus needed to package the payments to fit the market. The swap agreement allowed them to offer bond purchasers what they wanted, and gave Telus what it wanted. If Telus had not entered into the swap agreements, it would have had higher interest payments and risked currency fluctuations between the Canadian and US dollars. 15. (LO1) The misuse of financial engineering leading to the credit crisis of 2007 – 2009 is generally attributed to both a lack of regulatory oversight to limit risk taking and a lack of transparency arising from inadequate reporting requirements. New regulations for financial institutions are being put forward to control excessive risk taking and to require public reporting of such activities. 24-2 Solutions to Questions and Problems Basic For the 1st printing of the textbook, please note the following amendment to the question printed in the textbook: 1. ‘September 2009 canola fut
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