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CHAPTER 23
RISK MANAGEMENT: AN
INTRODUCTION TO FINANCIAL
ENGINEERING
Answers to Concepts Review and Critical Thinking Questions
1. 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. 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. 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
4. 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
5. 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. 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.
CHAPTER 23 B-357
7. 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
8. 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
9. 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
10. 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. 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
12. The risk is that the dollar will strengthen relative to the yen, since the fixed yen payments in the future
will be worth fewer dollars. Since this implies a decline in the $/¥ exchange rate, the firm should sell
yen futures.
13. 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
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 film.
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.
B-358 SOLUTIONS
14. Sysco must have felt that the combination of fixed plus swap would result in an overall better rate. In
other words, variable rate available via a swap may have been more attractive than the rate available
from issuing a floating-rate bond.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.
Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. The initial price is $3,122 per metric ton and each contract is for 10 metric tons, so the initial contract
value is:
2. The price quote is $16.607 per ounce and each contract is for 5,000 ounces, so the initial contract value
is:
