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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
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
f.
g.
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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
may not be able to sell some of its financial assets at their fair value because of adverse
j.
Both these risks occur because the firm borrows: financing cost risk is the risk that a loan
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
75.0
60.1
20.1
)1%60(1
20.1
Equity
Debt
)rateTax1(1
U
We can infer from the above that systematic financial risk account for the difference, that
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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
2. Making sure that decision-makers make value-creating investment decisions that
take into account all the risks the firm is exposed to – this can be achieved by
3. Making sure that corporate risks are taken into account (the risks that are not
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.
Source
of risk EV Reduction
in EV
Probability
of occurrence MVR
EV
MVR
Cost of capital
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
that purchase components at a later date. To protect against this risk, the firm should buy
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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
financial risk that comes with borrowing and the currency risk that results from servicing
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
exchange rate, the future stream of foreign payments into payments denominated in the
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
some predetermined future date and specified strike price. For example, such a contract
8. Hedging imports with forwards, futures, and options.
MPC can either do nothing or hedge its position using one of the following hedging
1. Hedging with forward contracts
Buy JPY 250 million at the forward rate of JPY/USD 106.42 for delivery on
September 8 (90 days later). On September 8, the cost of the computer equipment
will be:
42.106JPY/USD
000,000,250JPY
= USD 2,349,182
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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
For illustration purposes, let us assume that on September 8 the spot rate is
The cost of buying JPY 250 million at the spot rate on September 8 is:
The net cost of the computer equipment is:
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:
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:
108JPY/USD
000,000,250JPY
= USD 2,314,815
The net cost of the computer equipment would be:
Case 2: On September 8, the spot exchange rate is lower than the strike price of
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What should MPC do? Unless (1) MPC has another yen exposure that is the opposite
of the one created by the purchase of the computer equipment, or (2) the size of the
exposure (JPY250 million) is not significant when compared to MPC cash revenues,
9. Currency risk management.
The problem here is that there are two sources of uncertainty: the exposure, which is
In the past, the firm is successful, on average, in 67 percent of the bids that they submit.
This means that if they use forward contracts—either 30-day or 90-day maturities—to
hedge these exposures, one-third of the time they would end up with an open forward
contract that could produce either a gain or loss depending on the spot rate at which they
would close it out. In essence, they would have a €2,500,000 open position one-third of
the time. The hedge would be to sell forward the amount of the exposure. If the bid were
not successful, they would have to buy euros on the spot market to close out the forward
contract. To illustrate the risk, if the euro were to appreciate by 5 percent, they would
A more satisfactory hedge could be a compound option (an option to buy an option) but
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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
A second underlying assumption when locking-in a long-term position is to estimate
whether the currency is correctly valued. The Singapore company would not want to
Determining if a currency is properly valued is notoriously difficult to do since there are a
multitude of economic and political factors that affect the value of a currency, often with
unpredictable time lags before their impact is felt. A currency can stay seriously
misvalued in terms of purchasing power parity for a number of years—the Japanese yen
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
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