FIN 401 Chapter Notes - Chapter 24: Precautionary Statement, Cash Flow, Normal-Form Game

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22 Apr 2013

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Hedging is where we try to make a firm less vulnerable to changes in the price or rate. Derivative securities are an asset that represents a right to another financial asset. To be able to control financial risk, we must determine the types of changes in the price that will have a large impact on the value of a firm. Risk profile is a graph that shows how the value of a firm is affected by changes in the price or rate. Partnering with a firm would help reduce through contracts: set a fixed price ahead of time, cannot be affected. It is not possible to create a flat risk profile, but we can reduce risk. The goal is to reduce the risk to more manageable levels which will flatten the risk profile. Two categories: short run- causes temporary changes are the first. Long run is where there are more permanent changes.

Related Questions

1. Futures Contracts Describe the general charac- teristics of a futures contract. How does a clearinghouse facilitate the trading of financial futures contracts?

2. Futures Pricing How does the price of a financial futures contract change as the market price of the security it represents changes? Why?

3. Hedging with Futures Explain why some futures contracts may be more suitable than others for hedging exposure to interest rate risk.

4. Treasury Bond Futures Will speculators buy or sell Treasury bond futures contracts if they expect interest rates to increase? Explain

7. Hedging with Futures Assume a financial institution has more rate-sensitive assets than rate-sensitive liabilities. Would it be more likely to be adversely affected by an increase or a decrease in interest rates? Should it purchase or sell interest rate futures contracts in order to hedge its exposure?

8. Hedging with Futures Assume a financial institution has more rate-sensitive liabilities than rate- sensitive assets. Would it be more likely to be adversely affected by an increase or a decrease in interest rates.

Should it purchase or sell interest rate futures contracts in order to hedge its exposure?

9. Hedging Decision Why do some financial insti- tutions remain exposed to interest rate risk, even when they believe that the use of interest rate futures could reduce their exposure?

10. Long versus Short Hedge Explain the difference between a long hedge and a short hedge used by financial institutions. When is a long hedge more appropriate than a short hedge?

11. Impact of Futures Hedge Explain how the probability distribution of a financial institutionâs returns is affected when it uses interest rate futures to hedge. What does this imply about its risk?

12. Cross-Hedging Describe the act of cross-hedging. What determines the effectiveness of a cross-hedge?

ivorywombat545

FINANCIAL MANAGEMENT- 14th Edition Chapter #23 - Mini Case

Assume 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 firmâs 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 companies to institute enterprise risk management programs. Because no one at Tennessee Sunshine is familiar with the basics of enterprise risk management, Stooksbury has asked you to prepare a brief report that the firmâs executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and 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 to whether or not a firm reduces the volatility of its cash flows?

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

c. What is COSO? How does COSO define enterprise risk management?

d. Describe the eight components of the COSO ERM framework.

e. Describe some of the risks events within the following major categories of risk:

o (1) strategy and reputation,

o (2) control and compliance,

o (3) hazards,

o (4) human resources,

o (5) operations,

o (6) technology, and

o (7) financial management.

f. What are some actions that companies can take to minimize or reduce risk exposures?

g. What are forward contracts? How can they be used to manage foreign exchange risk?

h. Describe how commodity futures markets can be used to reduce input price risk.

i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-bond futures are trading at 111â25 . What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1% .

j. What is a swap? Suppose two firms have different credit ratings. Firm Hi can borrow fixed at 11% and floating at LIBOR + 1% . Firm Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5% . Describe a floating versus fixed interest rate swap between firms Hi and Lo in which Lo also makes a âside paymentâ of 45 basis points to Firm L.

6. Institutional portfolios can take advantage of what is called "portfolio margining" under the rules of the CBOE and other options exchanges. What IS portfolio margining? Choose only one answer.

A. You only pay attention to the bottom margin of the portfolio.

B. Great leverage is possible, as the intercorrelations and natural offsets (or what we call in English a "wash") are taken into consideration.

C. No margin is required, because these are not individual investors.

7. What does the symbol ^VVIX mean?

A. Apple's volatility.

B. An exchange-traded (ETF) volatility fund.

C. The implied volatility of the VIX options themselves.

8. An example of purchasing a "real" option is a company's opening of a Shanghai office, in order to have the capacity to pursue business in China.

True

False

9. A hedge fund is "short" a portfolio of VIX call options. It's "theta" is $16,788 per day. This means, barring some big market or political or terrorist event, the fund's net asset value will increase by about $16,788 per day.

True

False

10. Imagine an equity-oriented state pension fund (such as the State of Maryland Pension funds). Suppose their equity portfolio is NOT identical to the S&P 500 index. Further, suppose that due to a state budget shortfall, the year's additions to the pension fund are likely to be less than actuarially sound. Thus, the fund is becoming very risk-averse. And it needs to implement this feeling by hedging. CHOOSE THE BEST ANSWER, even though there might be more than one true answer. This is actually a question about hedge ratios. A. If the equity portfolio's beta is close to 0, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

B. If the equity portfolio's beta is close to .4, then they would have a tough time using S&P 500 contracts, so they would instead use foreign exchange contracts.

C. If the equity portfolio's beta is close to 1, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

11. Go to CMEGROUP.COM We are going to hedge ULSD https://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel for a railroad, that uses ultra-light diesel fuel. Choose June 2017 as the underlying future. Let's pretend we are buying ten futures contracts. What would ten contracts cost you, using the last trade as our price? Show your math, i.e., #gallons times price per futures contract. Is this contract in contango, or normal backwardation?

12. Long options positions(long does not mean long-dated) have positive gamma, and short positions have negative gamma.

True

False

13. In valuing credit default swaps, one must estimate default probabilities. A start would be to obtain historical data for default rates from rating agencies such as Standard & Poor's. But a more complete risk profile, or risk prediction, limiting ourselves to the US market (US-based companies) would be to [pick only one choice, the best one, in your opinion]:

A. Also consider the risk of another earthquake in Japan.

B. Also consider the systematic risk associated with an economic downturn in the US, accompanied by a downturn in US stocks.

C. Also consider the possibility that Facebook options are trading at an implied volatility that is not as high as it should be, considering the lofty level of its P/E ratio.

14. A total return swap can be a form of financing vehicle to allow an investor to buy a specific bond, because: (there are two correct answers, you must pick two)

A. The payer (a financial institution) could agree to pay the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

B. The payer (a financial institution) could agree to receive the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

C. The payer retains ownership of the bond for the life of the contract.

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FIN 401 Chapter Notes - Chapter 24: Precautionary Statement, Cash Flow, Normal-Form Game

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