Download Derivatives and Risk Management

Chapter 23
Enterprise Risk Management
ANSWERS TO END-OF-CHAPTER QUESTIONS
23-1
a. A derivative is an indirect claim security that derives its value, in whole or in part, by
the market price (or interest rate) of some other security (or market). Derivatives
include options, interest rate futures, exchange rate futures, commodity futures, and
swaps.
b. According to COSO, enterprise risk management “is a process, effected by an entity’s
board of directors, management and other personnel, applied in strategy setting and
across the enterprise, designed to identify potential events that may affect the entity,
and manage risk to be within its risk appetite, to provide reasonable assurance
regarding the achievement of entity objectives.” .
c. Financial futures provide for the purchase or sale of a financial asset at some time in
the future, but at a price established today. Financial futures exist for Treasury bills,
Treasury notes and bonds, CDs, Eurodollar deposits, foreign currencies, and stock
indexes. While physical delivery of the underlying asset is virtually never taken,
under forward contracts goods are actually delivered.
d. A hedge is a transaction that lowers a firm’s risk of damage due to fluctuating stock
prices, interest rates, and exchange rates. A natural hedge is a transaction between
two counterparties where both parties’ risks are reduced. The two basic types of
hedges are long hedges, in which futures contracts are bought in anticipation of (or to
guard against) price increases, and short hedges, in which futures contracts are sold to
guard against price declines. A perfect hedge occurs when the gain or loss on the
hedged transaction exactly offsets the loss or gain on the unhedged position. A
symmetric hedge is one that protects against both upward and downward price
changes. Futures contracts are frequently used for symmetric hedges. An asymmetric
hedge protects against one direction price change more than the other. This type of
hedge looks like insurance, hedging against a loss but not compromising a gain.
Options are frequently used for asymmetric hedges.
e. A swap is an exchange of cash payment obligations, which usually occurs because the
parties involved prefer someone else’s payment pattern or type. A structured note is a
debt obligation derived from another debt obligation, and permits a partitioning of
risks to give investors what they want.
Answers and Solutions: 23 - 1
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website, in whole or in part.
f. Commodity futures are futures contracts which involve the sale or purchase of
various commodities, including grains, oilseeds, livestock, meats, fiber, metals, and
wood.
23-2
If the elimination of volatile cash flows through risk management techniques does not
significantly change a firm’s expected future cash flows and WACC, investors will be
indifferent to holding a company with volatile cash flows versus a company with stable
cash flows. Note that investors can reduce volatility themselves: (1) through portfolio
diversification, or (2) through their own use of derivatives.
23-3
The six reasons why risk management might increase the value of a firm is that it allows
corporations to (1) increase their use of debt; (2) maintain their capital budget over time;
(3) avoid costs associated with financial distress; (4) utilize their comparative advantages
in hedging relative to the hedging ability of individual investors; (5) reduce both the risks
and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from
fluctuating earnings.
23-4
There are several ways to reduce a firm's risk exposure. First, a firm can transfer its risk
to an insurance company, which requires periodic premium payments established by the
insurance company based on its perception of the firm's risk exposure. Second, the firm
can transfer risk-producing functions to a third party. For example, contracting with a
trucking company can in effect, pass the firm's risks from transportation to the trucking
company. Third, the firm can purchase derivatives contracts to reduce input and financial
risks. Fourth, the firm can take specific actions to reduce the probability of occurrence of
adverse events. This includes replacing old electrical wiring or using fire resistant
materials in areas with the greatest fire potential. Fifth, the firm can take actions to
reduce the magnitude of the loss associated with adverse events, such as installing an
automatic sprinkler system to suppress potential fires. Finally, the firm can totally avoid
the activity that gives rise to the risk.
23-5
The futures market can be used to guard against interest rate and input price risk through
the use of hedging. If the firm were concerned that interest rates will rise, it would use a
short hedge, or sell financial futures contracts. If interest rates do rise, losses on the issue
due to the higher interest rates would be offset by gains realized from repurchase of the
futures at maturity--because of the increase in interest rates, the value of the futures
would be less than at the time of issue. If the firm were concerned that the price of an
input will rise, it would use a long hedge, or buy commodity futures. At the future's
maturity date, the firm will be able to purchase the input at the original contract price,
even if market prices have risen in the interim.
Answers and Solutions: 23 - 2
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website, in whole or in part.
23-6
Swaps allow firms to reduce their financial risk by exchanging their debt for another
party's debt, usually because the parties prefer the other's debt contract terms. There are
several ways in which swaps reduce risk. Currency swaps, where firms exchange debt
obligations denominated in different currencies, can eliminate the exchange rate risk
created when currency must first be converted to another currency before making
scheduled debt payments. Interest rate swaps, where counterparties trade fixed-rate debt
for floating rate debt, can reduce risk for both parties based on their individual views
concerning future interest rates.
Answers and Solutions: 23 - 3
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website, in whole or in part.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
23-1
If Zhao issues fixed rate debt and then swaps, its net cash flows will be: −7% + 6.8% −
LIBOR = −(LIBOR + 0.2%).
23-2
The price of the hypothetical bond is $1,000(89 + 8/32)/100 = $892.50. Using a financial
calculator, we can solve for rd as follows:
N = 40; PV = -892.50; PMT = 30; FV = 1000; solve for I/YR = 3.504. The annual value
of rd is 3.504% 2  7.01%.
23-3
Futures contract settled at 100 16/32% of $100,000 contract value, so PV = 1.005 
$1,000 = $1,005  100 bonds = $100,500. Using a financial calculator, we can solve for
rd as follows:
N = 40; PV = -1005; PMT = 30; FV = 1000; solve for I = rd = 2.9784%  2 = 5.9569% 
5.96%.
If interest rates increase to 6.9569%, then we would solve for PV as follows: N = 40; I =
6.9569/2 = 3.47845; PMT = 30; FV = 1000; solve for PV = $897.4842  100 =
$89,748.42. Thus, the contract’s value has decreased from $100,500 to $89,748.42.
23-4
If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR +
2%) – 7.95% + LIBOR = -9.95%. This is less than the 10% rate at which it could
directly issue fixed rate debt, so the swap is good for Carter.
If Brence issues fixed rate debt and then swaps, its net cash flows will be: -11% + 7.95%
- LIBOR = -(LIBOR + 3.05%). This is less than the rate at which it could directly issue
floating rate debt (LIBOR + 3.1%), so the swap is good for Brence.
23-5
a. In this situation, the firm would be hurt if interest rates were to rise by June, so it
would use a short hedge, or sell futures contracts. Since futures maturing in June are
selling for 95 17/32 of par, and futures contracts are for $100,000 in Treasury bonds,
the value of 1 contract is $95,531.25. This means the firm must sell 10,000,000/
$95,531.25 = 104.678 ≈ 105 contracts to cover the planned $10,000,000 June bond
issue. Should interest rates rise by June, Zinn Company will be able to repurchase the
futures contracts at a lower cost, which will help offset their loss from financing at the
higher interest rate. Thus, the firm has hedged against rising interest rates.
Answers and Solutions: 23 - 4
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website, in whole or in part.
b. The firm would now pay 13 percent on the bonds. With an 11 percent coupon rate,
the bond issue would bring in only $8,585,447.31:
N = 40; I = 13/2 = 6.5; PMT = −0.11/2  10,000,000 = −550000; FV = −10000000;
and solve for PV = $8,585,447.31.
The firm would lose $10,000,000 − $8,585,447.31= $1,414,552.69 on the bond issue.
However, the firm will make money on its futures contracts. The implied yield at the
time the futures contracts were entered is found by inputting N = 40; PMT = 3000;
FV = 100000; PV = -95531.25; solving for I/YR = 3.199616% per six months. The
nominal annual yield is 2(3.199616%) = 6.399232%. (Note that the futures contracts
are on hypothetical 20-year, 6 percent semiannual coupon bonds which are yielding
6.399232%.)
Now, if interest rates increased by 200 basis points, to 8.399232%, the value of
each futures contract will drop to $76,945.56, found by inputting N = 40; I =
8.399232/2 = 4.199616; PMT = −3000; FV = −100000; and solving for PV =
$76,945.56.
The value of all of the futures contracts will drop to $76,945.56(105) =
$8,079,283.80.
However, the value of the short futures position began at $95,531.25(105) =
$10,030,781.25. Since Zinn Company sold the futures contracts for $10,030,781.25,
and will, in effect, buy them back at $8,079,283.80, the firm would make a
$10,030,781.25 - $8,079,283.80 = $1,951,497.45 profit on the transaction ignoring
transaction costs.
Thus, the firm gained $1,951,497.45 on its futures position, but lost
$1,414,552.69 on its underlying bond issue. On net, it gained $1,951,497.45 $1,414,552.69 = $536,944.76.
c. In a perfect hedge, the gains on futures contracts exactly offset losses due to rising
interest rates. For a perfect hedge to exist, the underlying asset must be identical to
the futures asset. Using the Zinn Company example, a futures contract must have
existed on Zinn's own debt (it existed on Treasury bonds) for the company to have an
opportunity to create a perfect hedge. In reality, it is virtually impossible to create a
perfect hedge, since in most cases the underlying asset is not identical to the futures
asset.
Answers and Solutions: 23 - 5
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website, in whole or in part.
SOLUTION TO SPREADSHEET PROBLEM
23-6
The detailed solution for the spreadsheet problem, Ch23 P06 Build a Model Solution.xls,
is available on the textbook’s Web site.
Answers and Solutions: 23 - 6
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
MINI CASE
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?
Answer: 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. Also, if a
company decided to hedge away the risk associated with the volatility of its cash
flows, the company would have to pass on the costs of hedging to the investors.
Sophisticated investors can hedge risks themselves and thus they are indifferent as to
who actually does the hedging.
b.
What are six reasons risk management might increase the value of a
corporation?
Answer: There are no studies proving that risk management either does or does not add value.
However, there are six reasons why risk management might increase the value of a
firm. Risk management allows corporations to (1) increase their use of debt; (2)
maintain their capital budget over time; (3) avoid costs associated with financial
distress; (4) utilize their comparative advantages in hedging relative to the hedging
ability of individual investors; (5) reduce both the risks and costs of borrowing by
using swaps; and (6) reduce the higher taxes that result from fluctuating earnings.
Mini Case: 23 - 7
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website, in whole or in part.
c.
What is COSO? How does COSO define enterprise risk management?
Answer: The Committee of Sponsoring Organizations of the Treadway Commission, is a
group of private accounting firms that put together a framework for internal control
systems to prevent accounting fraud. They extended this framework to include
enterprise risk management (ERM) and define ERM as “a process, effected by an
entity’s board of directors, management and other personnel, applied in strategy
setting and across the enterprise, designed to identify potential events that may affect
the entity, and manage risk to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives.” (We added italics for
emphasis.) .
Here are some key points. ERM is an ongoing process, not something a company
does once and then is finished. ERM requires involvement from the board, to
executives, to managers, to workers. It is broad, and includes strategic choices as well
as operating tactics. It is applied at all levels in the organization, from the corporate
level all the way to the individual operating units. Its steps include risk identification
risk, risk assessment, and risk responses. The company must explicitly articulate its
tolerance for risk, which is called its risk appetite. There must be a reliable and timely
reporting and monitoring system.
Mini Case: 23 - 8
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website, in whole or in part.
d.
Describe the eight components of the COSO ERM framework.
Answer: The COSO ERM framework has eight components.
1. Internal environment. This includes the company’s mission, culture, and risk
appetite.
2. Objective setting. Explicit objectives must be set at all levels in organization.
3. Risky event identification. An event is something that affects the achievement of
an objective.
4. Risky event assessment. How likely is the event and how bad could it be?
5. Risky event responses. These include prevention and should correspond with the
previously identified risk appetite. Responses should consider the portfolio of
risky events and not just each event in isolation.
6. Control activities. These are ways to ensure that people apply the previously
identified responses. Control activities include handbooks, guidelines, policies,
etc.
7. Information & Communication. A successful ERM system requires reliable and
timely information regarding risk events and responses.
8. Monitoring.
.
Mini Case: 23 - 9
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website, in whole or in part.
e.
Describe some of the risks events within the following major categories of risk:
Answer: 1. Strategy and reputation. A company’s strategic choices simultaneously influence
and respond to its competitors’ actions, corporate social responsibilities, the
public’s perception of its activities, and its reputation among suppliers, peers, and
customers.
2. Control and compliance. This category includes risk events related to regulatory
requirements, litigation risks, intellectual property rights, reporting accuracy, and
internal control systems
3. Hazards. These include fires, floods, riots, acts of terrorism, and other natural or
man-made disasters.
4. Human resources. These addresses risk events related to employees, including
recruiting, succession planning, employee health, and employee safety.
5. Operations. Risk events include supply chain disruptions, equipment failures,
product recalls, and changes in customer demand.
6. Technology. These include risk events related to innovations, technological
failures, and IT reliability and security
7. Financial management. This category includes risk events related to (1) foreign
exchange risk, (2) commodity price risk, (3) interest rate risk, (4) project selection
risk (including major capital expenditures, mergers, and acquisitions), (5)
liquidity risk (the risk of not having access to financing when needed), (6)
customer credit risk, and (7) portfolio risk (the risk that a portfolio of financial
assets will decrease in value).
.
f.
What are some actions that companies can take to minimize or reduce risk
exposures?
Answer: There are several actions that companies can take to minimize or reduce their risk
exposure. First, companies can transfer risk to an insurance company by paying
periodic premiums. Second, companies can transfer functions that produce risk to
third parties, such as eliminating risks associated with transportation by contracting
with a trucking company. Third, purchase derivatives contracts to reduce input and
financial risk. Fourth, companies can take actions to reduce the probability of
occurrence of an adverse event, such as replacing old wiring to reduce the possibility
of fire. Fifth, actions can be taken to reduce the magnitude of the loss associated with
adverse events, such as installing automatic sprinkler systems. Finally, companies
can simply avoid the activities that give rise to risk.
Mini Case: 23 - 10
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website, in whole or in part.
g.
What are forward contracts? How can they be used to manage foreign exchange
risk?
Answer: A forward contract is an agreement between two parties. One party agrees to sell a
specified item at a specified price on a specified date, and the other party agrees to
purchase the item under the same terms
If a company knows it is going to have a future cash flow denominated in a different
currency, it can use a forward contract to lock in a price. For example, suppose a
U.S. retailer is going to import ¥1 million of electronic games from Japan and the
current exchange rate is 70 yen per dollar. The company might be able to take a
position in a forward contract to buy one million yen at 70 yen per dollar. This
locks in the dollar cost of the purchase.
Banks often act as the counterparty in forward contracts.
h.
Describe how commodity futures markets can be used to reduce input price risk.
Answer: Futures markets involve contracts that call for the purchase or sale of a financial (or
real) asset at some future date, but at a price which is fixed today.
Futures are similar to forwards, except futures require daily marking-to-market,
futures cover many more types of assets (agriculture, livestock, metals, indexes,
currencies, interest rates, energy), and futures are standardized contracts that trade on
exchanges, such as CBO.
Thus, these markets provide the opportunity to reduce financial risk exposure.
Essentially, the purchase of a commodity futures contract will allow a firm to make a
future purchase of the input material at today's price, even if the market price on the
good has risen substantially in the interim.
i.
It is January and Tennessee Sunshine is considering issuing $5 million in bonds
in June to raise capital for an expansion. Currently, TS can issue 20-year bonds
at 7 percent, but interest rates are on the rise and Stooksbury is concerned that
long-term interest rates might rise by as much as 1 percent before June. You
looked online and found that June T-bond futures are trading at 111’25. 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 percent.
Mini Case: 23 - 11
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website, in whole or in part.
Answer: If TS waits until June to issue its bonds, and if interest rates rise, then TS will have to
pay a higher interest rate on its debt. How much does that cost TS? One way to
calculate the cost is to see how much the 20-year 7 percent semi-annual bonds that it
intended to issue would be worth at the new discount rate of 8%. Input N = 40, I/YR
= 8/2, PMT = -5,000,000(7%/2) = 175,000, FV = -5,000,000 and solve for PV =
$4,505,181.
Since they were going to be worth $5 million if they were issued immediately, then
this represents a loss of $5,000,000 - $4,505,181 = $494,819. TS can hedge this risk
by selling T-bond futures contracts.
The T-bond futures contracts are trading at 111 + 25/32 percent of par, or $111,781
for a $100,000 contract value. This means TS will need to sell 5,000,000/111,781 =
44.7. Because you must trade in whole contracts, TS will use 45 T-bond futures
contracts to hedge the bond position.
T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon,
semiannual payment bond, and the 111’25 futures price translates to a $1,117.81 for
each $1000 face value bond. The implied yield can be caluclated with a financial
calculator to be (N = 40; Pmt = 30; FV = 1000; PV = -1117.81; calculate I/Y =
2.5284% semi-annually, which is an annual rate of about 5.057%. If interest rates
increase by 1 percent, then the new yield on this underlying bond will be 6.057%.
The six month rate is 6.057%/2 = 3.0285%. The corresponding price at this yield is
found by inputting N = 40, I/YR = 3.0285, PMT = -30, FV = -1000 and solving for
PV = 993.44.
The value of each futures contract will be $99,344 at this higher interest rate. This
represents a decrease of $111,781 – $99,344 = $12,437 for each contract. Since TS
has sold futures contracts, this represents a profit to TS. The total profit from the
futures contracts is 45($12,437) = $559,665.
TS will lose $494,819 on the bonds it issues but gain $559,665 on its futures
contracts. The net hedging gain is $559,665 - $494,819 = $64,846. Thus TS will end
up just a little bit better off if interest rates increase by 1%.
Note that if interest rates were to decrease instead, then TS would gain on the bonds it
issues but lose on its futures contracts.
Mini Case: 23 - 12
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website, in whole or in part.
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 “side payment” of
45 basis points to Firm L.
Answer: 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.
Transaction
CF to lender
CF Hi to Lo
CF Lo to Hi
CF Lo to Hi
Net CF
Hi
-(LIBOR+1%)
-11.40%
+(LIBOR+1%)
0.45%
-10.95%
Lo
-11.40%
11.40%
-(LIBOR+1%)
-0.45%
-(LIBOR+1.45%)
Mini Case: 23 - 13
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website, in whole or in part.
Mini Case: 23 - 14
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.