Banking Chapter 30 Risk Management Outline The Following Outline Correlated The Powerpoint

Unlock access to all the studying documents.

View Full Document

Chapter 30

Risk Management

I. Chapter Outline

The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides

are referenced in bold. Alternative Examples to selected textbook examples are also available in the

PowerPoint Lecture Slides and are also referenced in bold.

30.1 Insurance (Slides 8–10)

• The Role of Insurance: An Example (Slides 11–14)

• Insurance Pricing in a Perfect Market (Slides 15–19)

• Example 30.1 Insurance Pricing and the CAPM (Slides 20–21)

• PowerPoint Alternative Example 30.1 (Slides 22–24)

• The Value of Insurance (Slides 25–37)

– Bankruptcy and Financial Distress Costs (Slide 26)

– Issuance Costs (Slide 27)

• Example 30.2 Avoiding Distress and Issuance Costs (Slides 28–29)

• PowerPoint Alternative Example 30.2 (Slides 30–33)

– Tax Rate Fluctuations (Slide 34)

– Debt Capacity (Slide 35)

– Managerial Incentives (Slide 36)

– Risk Assessment (Slide 37)

• The Costs of Insurance (Slides 38–42)

30.2 Commodity Price Risk (Slide 47)

• Hedging with Vertical Integration and Storage (Slides 48–50)

• Hedging with Long-Term Contracts (Slides 51–60)

• Figure 30.1 Commodity Hedging Smoothes Earnings (Slide 53)

30.3 Exchange Rate Risk (Slides 72–73)

• Exchange Rate Fluctuations (Slides 72-73)

• Figure 30.3 Dollars per Euro ($/€), 1999-2015 (Slide 74)

• Example 30.5 The Effect of Exchange Rate Risk (Slides 75–76)

• PowerPoint Alternative Example 30.5 (Slides 77–78)

• Hedging with Forward Contracts (Slides 79–81)

• Example 30.6 Using a Forward Contract to Lock in an Exchange Rate (Slides 82–83)

• Figure 30.4 The Use of Currency Forwards to Eliminate Exchange Rate Risk (Slide 84)

• Cash-and-Carry and the Pricing of Currency Forwards (Slides 85–87, 89–94)

– The Law of One Price and the Forward Exchange Rate (Slide 86)

• Figure 30.5 Currency Timeline Showing Forward Contract and Cash-and-Carry Strategy

(Slide 88)

• Global Financial Crisis: Arbitrage in Currency Markets?

of $1.20/€ and an Initial Premium of $0.05/€ (Slide 102)

• Figure 30.6 Comparison of Hedging the Exchange Rate Using a Forward Contract, an

30.4 Interest Rate Risk (Slide 116)

• Interest Rate Risk Measurement: Duration (Slides 116, 120)

• Example 30.11 The Duration of a Coupon Bond (Slides 117–119)

• Table 30.3 Computing the Duration of a Coupon Bond (Slide 119)

• Example 30.12 Estimating Interest Rate Sensitivity Using Duration (Slides 121–122)

• Duration-Based Hedging (Slides 123–138)

• Table 30.4 Market-Value Balance Sheet for Acorn Savings and Loan (Slide 127)

– Savings and Loans: An Example (Slides 124–136)

• Table 30.5 Market-Value Balance Sheet for Acorn Savings and Loan After Immunization

(Slide 136)

128 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition

• Table 30.7 Trade-Offs of Long-term Versus Short-Term Borrowing for ACC (Slide 153)

• Example 30.13 Using Interest Rate Swaps (Slides 154–155)

– Using a Swap to Change Duration (Slide 156)

• Example 30.14 Using a Swap to Immunize a Portfolio (Slides 157–158)

II. Learning Objectives

30-2 Compute the value of an actuarially fair insurance premium.

30-4 Discuss five market imperfections that are sources of value for insurance.

30-6 Describe three risk management strategies firms use to hedge their exposure to commodity

price movements.

30-8 Discuss the use of the cash-and-carry strategy in currency hedging.

30-10 Use the Black-Scholes formula to compute the value of a currency option.

30-12 Define and compute duration of a single asset and of a portfolio.

30-14 Explain the use of equity duration to manage interest rate risk.

30-15 Describe the use of swaps in managing interest rate risk; explain how the use of swaps

separates the risk of interest changes from the risk of changes in the firm’s credit quality.

III. Chapter Overview

All firms are subject to various forms of risk. This risk should be managed to minimize its effect on

firm value. Insurance and financial markets allow some risk associated with changes in commodity

30.1 Insurance

There are four common types of insurance used by companies to reduce risk. They are property

insurance, business liability insurance, business interruption insurance, and key personnel insurance.

This section explains the role of insurance in reducing risk by examining pricing and potential costs

and benefits.

issuance costs, tax rate fluctuations, debt capacity, managerial incentives, and risk assessment.

Example 30.2 shows how financial distress and issuance costs can cause insurance to be

beneficial. To illustrate the effect of tax rate fluctuations, the authors use the example of an almond

grower subject to graduated income tax rates. If the grower’s crop fails, he will be in a lower tax

bracket. The NPV from purchasing insurance will be positive because of his lower tax rate.

30.2 Commodity Price Risk

This section shows ways firms can hedge their exposure to commodity price movements.

The most common strategies to hedge risk are vertical integration and storage. However, while

vertical integration can reduce risk, it does not always increase value, because investors can do their

30.3 Exchange Rate Risk

The section begins with a brief discussion of exchange rate determination and a definition of

exchange rate risk. Example 30.5 shows the effect of exchange rate risk on a hypothetical company.

The chapter then defines currency forwards and forward exchange rates and explains their use in

130 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition

There are several advantages to forward contracts over the cash-and-carry strategy. In particular, the

forward contract is simpler, may cost less in transaction fees, and some firms may not be able to

borrow in the foreign currency without paying a very high rate. The cash-and-carry method is most

often used by banks to offset their currency risk.

30.4 Interest Rate Risk

This section begins with an illustration of a duration calculation (using equation 30.6), for a 10-year

coupon bond. Example 30.11 shows the duration calculation. The example is extended to show, in

Table 30.6 shows the cash flows for a fixed-for-floating interest rate swap. Example 30.13 shows how

interest rate swaps are used to take advantage of declining interest rates without changing the firm’s

credit rating. Example 30.14 shows how the Savings and Loan can use a swap to hedge interest rate

exposure, rather than to sell mortgages.

IV. Spreadsheet Solutions in Excel

The following Problems for Chapter 30 have spreadsheet versions of the problems available: 6, 8, 9,

12, and 13.