Chapter 21
Risk Management
CHAPTER 21
RISK MANAGEMENT
ANSWERS TO QUESTIONS:
1. Managers should seek to manage risks that are large enough that they have the potential to
cause financial distress or failure of the firm. Because the costs associated with financial
2. The acquisition of additional information can reduce the probability distribution of potential
3. The principle of diversification is a valuable risk management tool. By diversifying the
4. Typically firms buy insurance against negative consequence events that have the potential to
5. Patents, copyrights and legal challenges provide a very effective way to limit competitive
6. Both forward and futures contracts are agreements to buy or sell something in the future at a
price agreed to at the time the contract is purchased or sold. Forward contracts require payment
only on the delivery date, whereas futures contracts are “marked to the market” (e.g. the winner
pays the loser each day) on a daily basis. Futures contracts can be thought of as a series of one
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7. Whereas forward and futures contracts are essentially free to purchase, options require the
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SOLUTIONS TO PROBLEMS:
1. California Plastics could buy crude oil futures contracts (a long hedge) in
the amounts needed and at the times needed at prices established today.
2. a. It should use the 6 month futures price of $26.90, because this is the
b. TCI should buy 6 month futures contracts for the delivery of the quantity
of silver needed to service the account. Of course this hedge may not be
c. TCI could buy call options that give it the right to buy silver (or silver
3. Jenkins could immediately purchase forward or futures contracts to buy
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4. a. Without hedging, Disher can hope to receive $202,500 (250,000 lbs. x
b. Expected total revenue will be the crop size (250,000 lbs.) times the
c. Hedging the crop in the futures market guarantees his prices for
d. There is always the risk of a crop failure so that he would not have the
5. a. The expected future cost of natural gas is $3.75, the price in the
c. If Olde Virginia hedges by purchasing call options on natural gas with
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d. The strategy chosen depends on the size of this transaction and the
company’s need or desire to hedge. If this order is for such a large quantity
that it cannot take the risk of unfavorable price movements, then hedging
.
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