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MINI CASE
Assume that you have just been hired as a financial analyst by Tennessee Sunshine Inc., a
mid-sized Tennessee company that specializes in creating exotic sauces from imported
fruits and vegetables. The firm's CEO, Bill Stooksbury, recently returned from an industry
corporate executive conference in San Francisco, and one of the sessions he attended was
on the pressing need for smaller companies to institute corporate risk management
programs. Since no one at Tennessee Sunshine is familiar with the basics of derivatives and
corporate risk management, Stooksbury has asked you to prepare a brief report that the
firm's executives could use to gain at least a cursory understanding of the topics.
To begin, you gathered some outside materials on derivatives and corporate risk
management and used these materials to draft a list of pertinent questions that need to be
answered. In fact, one possible approach to the paper is to use a question-and-answer
format. Now that the questions have been drafted, you have to develop the answers.
a. Why might stockholders be indifferent whether or not a firm reduces the
volatility of its cash flows?
Answer: If volatility in cash flows is not caused by systematic risk, then stockholders can
eliminate the risk of volatile cash flows by diversifying their portfolios. Also, if a
b. What are six reasons risk management might increase the value of a
corporation?
Answer: There are no studies proving that risk management either does or does not add value.
However, there are six reasons why risk management might increase the value of a
c. What is COSO? How does COSO define enterprise risk management?
Answer: The Committee of Sponsoring Organizations of the Treadway Commission, is a group
of private accounting firms that put together a framework for internal control systems
Here are some key points. ERM is an ongoing process, not something a company
does once and then is finished. ERM requires involvement from the board, to
executives, to managers, to workers. It is broad, and includes strategic choices as well
d. Describe the eight components of the COSO ERM framework.
Answer: The COSO ERM framework has eight components.
1. Internal environment. This includes the company’s mission, culture, and risk
appetite.
2. Objective setting. Explicit objectives must be set at all levels in organization.
3. Risky event identification. An event is something that affects the achievement of
an objective.
.
e. Describe some of the risks events within the following major categories of risk:
Answer: 1. Strategy and reputation. A company’s strategic choices simultaneously influence
and respond to its competitors’ actions, corporate social responsibilities, the
public’s perception of its activities, and its reputation among suppliers, peers, and
customers.
2. Control and compliance. This category includes risk events related to regulatory
requirements, litigation risks, intellectual property rights, reporting accuracy, and
internal control systems
7. Financial management. This category includes risk events related to (1) foreign
exchange risk, (2) commodity price risk, (3) interest rate risk, (4) project selection
.
f. What are some actions that companies can take to minimize or reduce risk
exposures?
Answer: There are several actions that companies can take to minimize or reduce their risk
exposure. First, companies can transfer risk to an insurance company by paying
periodic premiums. Second, companies can transfer functions that produce risk to
g. What are forward contracts? How can they be used to manage foreign exchange
risk?
Answer: A forward contract is an agreement between two parties. One party agrees to sell a
If a company knows it is going to have a future cash flow denominated in a different
currency, it can use a forward contract to lock in a price. For example, suppose a
h. Describe how commodity futures markets can be used to reduce input price risk.
Answer: Futures markets involve contracts that call for the purchase or sale of a financial (or
Futures are similar to forwards, except futures require daily marking-to-market,
Thus, these markets provide the opportunity to reduce financial risk exposure.
i. It is January and Tennessee Sunshine is considering issuing $5 million in bonds
in June to raise capital for an expansion. Currently, TS can issue 20-year bonds
at 7 percent, but interest rates are on the rise and Stooksbury is concerned that
long-term interest rates might rise by as much as 1 percent before June. You
looked online and found that June T-bond futures are trading at 111’25. What
are the risks of not hedging and how might TS hedge this exposure? In your
analysis, consider what would happen if interest rates all increased by 1 percent.
Answer: If TS waits until June to issue its bonds, and if interest rates rise, then TS will have to
pay a higher interest rate on its debt. How much does that cost TS? One way to
Since they were going to be worth $5 million if they were issued immediately, then
The T-bond futures contracts are trading at 111 + 25/32 percent of par, or $111,781
T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon,
semiannual payment bond, and the 111’25 futures price translates to a $1,117.81 for
The value of each futures contract will be $99,344 at this higher interest rate. This
TS will lose $494,819 on the bonds it issues but gain $559,665 on its futures
Note that if interest rates were to decrease instead, then TS would gain on the bonds it
issues but lose on its futures contracts.
j. What is a swap? Suppose two firms have different credit ratings. Firm Hi can
borrow fixed at 11% and floating at LIBOR + 1%. Firm Lo can borrow fixed at
11.4% and floating at LIBOR + 1.5%. Describe a floating versus fixed interest
rate swap between firms Hi and Lo in which Lo also makes a “side payment” of
45 basis points to Firm L.
Answer: Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating
rate, but it will issue fixed and swap with Hi. Lo also makes “side payment” of
0.45% to Hi.
Transaction Hi Lo
CF to lender -(LIBOR+1%) -11.40%
