978-1305637108 Chapter 23 Solution Manual Part 1

Answers and Solutions: 23 – 2

Chapter 23

Enterprise Risk Management

23-1 a. A derivative is an indirect claim security that derives its value, in whole or in part, by

the market price (or interest rate) of some other security (or market). Derivatives

include options, interest rate futures, exchange rate futures, commodity futures, and

swaps.

the future, but at a price established today. Financial futures exist for Treasury bills,

Treasury notes and bonds, CDs, Eurodollar deposits, foreign currencies, and stock

indexes. While physical delivery of the underlying asset is virtually never taken,

under forward contracts goods are actually delivered.

hedged transaction exactly offsets the loss or gain on the unhedged position. A

symmetric hedge is one that protects against both upward and downward price

changes. Futures contracts are frequently used for symmetric hedges. An asymmetric

hedge protects against one direction price change more than the other. This type of

risks to give investors what they want.

Answers and Solutions: 23 – 3

website, in whole or in part.

f. Commodity futures are futures contracts which involve the sale or purchase of

various commodities, including grains, oilseeds, livestock, meats, fiber, metals, and

wood.

23-2 If the elimination of volatile cash flows through risk management techniques does not

diversification, or (2) through their own use of derivatives.

23-3 The six reasons why risk management might increase the value of a firm is that it allows

and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from

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

risks. Fourth, the firm can take specific actions to reduce the probability of occurrence of

adverse events. This includes replacing old electrical wiring or using fire resistant

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

input will rise, it would use a long hedge, or buy commodity futures. At the future’s

maturity date, the firm will be able to purchase the input at the original contract price,

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

several ways in which swaps reduce risk. Currency swaps, where firms exchange debt

Answers and Solutions: 23 – 5

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

23-1 If Zhao issues fixed rate debt and then swaps, its net cash flows will be: −7% + 6.8% −

23-2 The price of the hypothetical bond is $1,000(89 + 8/32)/100 = $892.50. Using a financial

23-3 Futures contract settled at 100 16/32% of $100,000 contract value, so PV = 1.005 

5.96%.

23-4 If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR +

– LIBOR = -(LIBOR + 3.05%). This is less than the rate at which it could directly issue

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

selling for 95 17/32 of par, and futures contracts are for $100,000 in Treasury bonds,

the value of 1 contract is $95,531.25. This means the firm must sell 10,000,000/

Answers and Solutions: 23 – 6

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;

FV = 100000; PV = -95531.25; solving for I/YR = 3.199616% per six months. The

nominal annual yield is 2(3.199616%) = 6.399232%. (Note that the futures contracts

The value of all of the futures contracts will drop to $76,945.56(105) =

$8,079,283.80.

$1,414,552.69 on its underlying bond issue. On net, it gained $1,951,497.45 –

$1,414,552.69 = $536,944.76.

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

Answers and Solutions: 23 – 7