Answers and Solutions: 23 – 2
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
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.
b. According to COSO, enterprise risk management “is a process, effected by an entity’s
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 hedges are
long hedges, in which futures contracts are bought in anticipation of (or to guard
against) price increases, and short hedges, in which futures contracts are sold to guard
Answers and Solutions: 23 – 3
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
indifferent to holding a company with volatile cash flows versus a company with stable
cash flows. Note that investors can reduce volatility themselves: (1) through portfolio
diversification, or (2) through their own use of derivatives.
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
trucking company can in effect, pass the firm’s risks from transportation to the trucking
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
due to the higher interest rates would be offset by gains realized from repurchase of the
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 obligations
denominated in different currencies, can eliminate the exchange rate risk created when
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% −
LIBOR = −(LIBOR + 0.2%).
23-3 Futures contract settled at 100 16.0/32% of $100,000 contract value, so PV = 1.005
$1,000 = $1,005 100 bonds = $100,500. Using a financial calculator, we can solve for
rd as follows:
N = 40; PV = -1005; PMT = 30; FV = 1000; solve for I = rd = 2.9784% 2 = 5.9569%
23-4 If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR +
2%) – 7.95% + LIBOR = -9.95%. This is less than the 10% rate at which it could directly
issue fixed rate debt, so the swap is good for Carter.
If Brence issues fixed rate debt and then swaps, its net cash flows will be: –11% + 7.95% –
LIBOR = -(LIBOR + 3.05%). This is less than the rate at which it could directly issue
floating rate debt (LIBOR + 3.05%), so the swap is good for Brence.
23-5 a. The percent price of the underlying bond is: (95/100) + (17/32)/(1,000)) = 0.9553125.
Therefore, the price on the underlying bond is $1,000(0.9553125) = $955.3125
The inputs to calculate the implied yield are: N = 40, PV = -955.3125, PMT = 30,
Answers and Solutions: 23 – 6
10,000,000/ $95,531.25 = 104.678 ≈ 105 contracts to cover the planned $10,000,000
June bond issue.
b. The firm would now pay 13 percent on the bonds. With an 11 percent coupon rate, the
bond issue proceeds are found by inputting N = 40; I = 13/2 = 6.5, PMT = −0.11/2
10,000,000 = −550000; FV = −10000000 and solving for PV = $8,585,447.31.
market yield before the change was 3.1996. If market interest rates increased by 200
basis points, that would add 2% to the annual market rate and 1% to the semiannual
market rate. The implied semiannual yield on the underlying bond would be 1% +
3.1996 = 4.1996. At this new rate, the value of each underlying bond in the futures
contract will drop to $769.45817, found by inputting N = 40; I = 4.1996 ; PMT = −30;
FV = −1000; and solving for PV = $76,45817.
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 the
futures asset. Using the Zinn Company example, a futures contract must have existed
Answers and Solutions: 23 – 7
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.
Mini Case: 23 – 8
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
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.
Mini Case: 23 – 9
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
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.
.
Mini Case: 23 – 10
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.
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
Mini Case: 23 – 11
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
specified item at a specified price on a specified date, and the other party agrees to
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
real) asset at some future date, but at a price which is fixed today.
Futures are similar to forwards, except futures require daily marking-to-market, futures
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 111’250. 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
Mini Case: 23 – 12
contracts to hedge the bond position.
T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon,
semiannual payment bond, and the 111’250 futures price translates to a $1,117.81 for
each $1000 face value bond. The implied yield can be caluclated with a financial
calculator to be (N = 40; Pmt = 30; FV = 1000; PV = -1117.81; calculate I/Y = 2.5284%
semi-annually, which is an annual rate of about 5.057%. If interest rates increase by 1
percent, then the new yield on this underlying bond will be 6.057%. The six month
rate is 6.057%/2 = 3.0285%. The corresponding price at this yield is found by inputting
N = 40, I/YR = 3.0285, PMT = -30, FV = -1000 and solving for PV = 993.44.
Mini Case: 23 – 13
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.