Solutions to Chapter 24
Risk Management
1.
a. True. Hedging is a zero‐sum game.
b. False. Reducing risk always increases company value.
2. Insurance is a part of risk management that is similar in many ways to hedging. Both
activities are designed to eliminate the firm’s exposure to a particular source of risk.
Hedging and insurance have several advantages. They can reduce the probability of
Hedging and insurance make most sense when the source of uncertainty has a significant
impact on the firm’s performance. It is not worth the time or effort to protect against events
3. spot price: a. Price for immediate delivery
futures price: e. The price fixed today for delivery in the future
forward contract: b. A tailor‐made futures contract
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4.
a. False. Buyers of futures contracts generally wait until the contract matures and then take
b. False. The great advantage of a futures contract is that the buyer is not obliged to deliver
c. False. Because the buyer of the future can sell his contract before maturity rather than
d. False. In contrast to a futures contract, a forward contract requires payment up front.
5. One advantage of holding futures is greater liquidity (ease of purchasing and selling
positions) than is typical in the spot market. Another is the fact that you do not need to
buy the commodity. You simply put up the margin on the contract until the maturity date
6. The object of hedging is to eliminate risk. If you eliminate uncertainty, you eliminate the
happy surprises as well as the unhappy ones. If the farmer wishes to lock in the value of
7.
a. She should sell futures. If interest rates rise and bond prices fall, her gain on the futures
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b. He should sell futures. If interest rates rise and bond prices fall, the firm’s profits on the
8. The car manufacturers could have bought dollars forward for a specified number of euros
(or, equivalently, sold euro contracts). This would serve to hedge total profits because,
On the other hand, it is less clear that such hedging would improve the competitive position of
the manufacturers. Once the contracts are in place, each firm should still evaluate the car sale
as an incremental transaction that is independent of any proceeds from the forward position.
9. Suppose you lend $100 today for 1 year at 4% and borrow $100 today for 2 years at 5%.
10.
a. If the spot price falls to $1,500 per ounce in three months’ time, Phoenix Motors has a
b. Phoenix Motors has locked in the cost of purchasing 10,000 ounces of platinum at
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c. If the spot price increases to $1,800, then Phoenix has a gain in the futures market that
d. The cost in the spot market is: 10,000 $1,800 = $18,000,000. The total cost is still
11. a.i. At $1,520 an ounce, the firm’s revenue will be $1,520,000.
b. At a futures price of $1,620 an ounce, the firm’s revenue will be $1,620,000
c. The revenues will depend on the eventual price of gold in one month, but the option will
12. One way to protect the position is to sell 10 million yen forward. This locks in the dollar
value of the yen you will receive if you get the contract. However, if you do not receive
the contract, you will have inadvertently ended up speculating against the yen. Suppose
the forward price for delivery in 3 months is ¥105/$ and you agree to sell forward 10
million yen, or $95,238. Consider the possible outcomes if the spot rate 3 months from
now will be either ¥100/$ or ¥110/$:
¥100/$ ¥110/$
If you win contract:
Dollar value of contract $100,000 $90,909
If you lose contract:
If you win the contract, the forward contract locks in the dollar value of the contract at the
forward exchange rate. However, if you lose the contract, then your short position in yen will
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Another approach is to buy put options on yen. If you buy options to sell 10 million yen at an
exercise price of ¥105/$, then, if you win the contract, you are guaranteed an exchange rate no
13.
a. An airline – Long oil futures
b. A Kansas wheat farmer – Short wheat futures
14. Various answers are possible.
15. You sold the market short, which is a bet that it will decline, when in fact it increased
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16. The contract size is 5,000 bushels, so the farmer who sells a wheat futures contract
realizes the following cash flows on each contract:
Futures
Price
Change in
Futures Price
Cash Flow per Contract
(5,000
decrease in futures price)
Day 1
$5.83
0.00
0
Day 2 $5.89 +0.06 300
17.
a. The company is showing a profit on the interest rate swap since they originally owned a
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McGraw-Hill Education.