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
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
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,
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
e. A swap is an exchange of cash payment obligations, which usually occurs because the
f. Commodity futures are futures contracts which involve the sale or purchase of
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
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;
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
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
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
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
23-3 Futures contract settled at 100 16/32% of $100,000 contract value, so PV = 1.005
If interest rates increase to 6.9569%, then we would solve for PV as follows: N = 40; I =
23-4 If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR +
If Brence issues fixed rate debt and then swaps, its net cash flows will be: -11% + 7.95%
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
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:
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;
Now, if interest rates increased by 200 basis points, to 8.399232%, the value of
However, the value of the short futures position began at $95,531.25(105) =
transaction costs.
Thus, the firm gained $1,951,497.45 on its futures position, but lost
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
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.