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Chapter 13
Answers to Review Problems
Finance For Executives – 4th Edition
1. Various types of risk.
a.
Business risk results from the choice of nonfinancial assets the firm has made (the left
b.
Diversifiable risk is the risk investors can eliminate by holding well-diversified portfolios
of shares of companies, whereas undiversifiable risk is the risk investors cannot eliminate
through diversification.
c.
Systematic risk is the same as undiversifiable risk. It is the only risk that matters to
d.
An insurable risk can be covered by buying an insurance contract (for example the risk of
fire), whereas an uninsurable risk is a risk for which the firm cannot get an insurance
e.
Project risk originates at the level of the project itself, whereas corporate risks are risks
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f.
Foreign-exchange risk and currency risk are the same.
g.
h.
Credit risk is the risk that the firm’s may not be able to cash the sales it has made to some
i.
Liquidity risk is part of the firm’s financial investment risk: it is the risk that the firm’s
j.
Both these risks occur because the firm borrows: financing cost risk is the risk that a loan
may have to be renewed at a higher interest rate, whereas refinancing risk is the risk that
the loan may not be renewed irrespective of what the cost of borrowing is.
2. Systematic risk.
a.
A firm faces 4 broad types of risk: Business risk, financial risk, financial investment risk,
b.
The firm’s systematic risk (beta) of 1.20 captures both its systematic business risk and
systematic financial risk, with the latter occurring because the firm borrows. To get the
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3. Risk Policy.
Some of the major issues a firm risk policy should address are:
1. Making sure that there is a process in place to identify and control risk, and that
the process to decide whether to reject or accept a risk is well established – this
can be the responsibility of a risk management committee headed by a senior
executive
4. Measuring risk exposure.
a.
The value of the firm’s assets (its enterprise value) is
.625€
%3%11
m50€
EV =
−
=
The table
below summarizes the impact of the three sources of risk on the firm’s enterprise value.
The reduction in EV is the difference between €625m and the value in the second
column. MVR is equal to the reduction in EV multiplied by the probability of occurrence.
Source
of risk
EV
Reduction
in EV
Probability
of occurrence
MVR
b.
The first risk listed in the table is low; the second is high; and the third is moderate.
5. Inventory value and the risk of obsolescence.
HDM is exposed to two particular types of business risk. The risk of a decline in the price
of inventory is that the cost of HDM’s computers will be higher than that of competitors
6. Exposure to interest rate and currency risk.
a.
A firm that borrows abroad is exposed to two of the four broad risks firms face: the
b.
Using a swap contract, the firm can hedge its currency risk exposure. The firm borrows
abroad and then enter into an agreement with a bank to exchange (to swap), at a fixed
7. Swaption contracts.
As the name indicates, a swaption contract is a swap option that gives the firm the right,
but not the obligation, to enter into a swap on a predetermined amount of borrowing at
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8. Hedging imports with forwards, futures, and options.
MPC can either do nothing or hedge its position using one of the following hedging
techniques: (1) forward contracts, (2) futures contracts, or (3) options. Each of these cases
is examined below.
1. Hedging with forward contracts
Buy JPY 250 million at the forward rate of JPY/USD 106.42 for delivery on
2. Hedging with currency futures contracts
Buy 20 September yen futures on June 10 at USD 0.0095 per yen; sell 20
September yen futures on September 8. The price at which MPC would sell the
futures on September 8 is not known on June 10 since their expiration date is on
September 17. Furthermore, MPC would have to buy 250 million yen in the spot
market on September 8 in order to pay its supplier. As a result, the net dollar cost
of the computer equipment would not be known on June 10.
3. Hedging with options
Buy JPY 250 million OTC call options on June 10 with a strike price of USD
0.00021 per yen. The cost of the option is:
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Case 1: On September 8, the spot exchange rate is higher than the strike price of
JPY/USD 108. MPC will exercise its right to buy yen at the spot rate and pay:
Case 2: On September 8, the spot exchange rate is lower than the strike price of
JPY/USD 108. MPC would not exercise its option. The dollar cost of the
equipment, although not known on June 10, would be lower than USD 2,367,315.
What should MPC do? Unless (1) MPC has another yen exposure that is the opposite
9. Currency risk management.
The problem here is that there are two sources of uncertainty: the exposure, which is
dependent on a successful bid, and the future exchange rate. The company needs to find
the appropriate instrument for hedging a contingent risk.
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If Charles were to use an option hedge, he would buy 30-day put options that would
expire to coincide with the announcement of the bid’s success. At current option prices,
these would cost USD 23,750 per hedge in premiums (€2.5 million USD 0.0095 per
euro). One third of the time, the option would not be needed—when the bid was not
successful. In these cases, the most that could be lost would be the amount of the
premium, which, at USD 23,750, is considerably less than the potential loss from the
10. Long-term currency risk management.
An important underlying assumption for locking-in long-term exposures is that the
exposures have a high probability of occurring. The problem described is based on an
actual case. Following the dramatic fall in the mobile telephone markets beginning in the
second half of 2000, the European company revised sharply downward its purchases. The
Singapore company found itself with long-term forward contracts substantially in excess
of the revised future expected revenues. A partial unwinding of these contracts has
produced losses at the same time as their core business has suffered.
Operating and financing strategies that can help manage long-term exposures include
trying to match cash flows. The Singapore company could buy some of its components
from European suppliers and thereby match part of its revenues with expenses in euros. It
could also try to finance in euros or enter into a swap agreement to create a euro cash
outflow.