CHAPTER 5
Risk-Handling Techniques:
Diversification and Hedging
I. SUGGESTED CLASSROOM TIME: 90–105 MINUTES
II. CHAPTER OVERVIEW
This chapter covers the principal techniques available to offset speculative risks:
diversification and hedging. Speculative risks, because of the potential for gain, can
present many opportunities for firms. However, those opportunities come with a down
side. It is critical to manage these risks carefully to maximize the opportunities they
present.
III. LECTURE OUTLINE
A. Introduction: This is a continuation of Chapter 4, now discussing speculative risks.
B. Risk-Bearing Financial Institutions
1. Pension plans
C. Covariance and Correlation
1. Covariance, how random variables move in relation to each other
30 Chapter 5/Risk-Handling Techniques: Diversification and Hedging
D. Risk Diversification
1. Risk diversification with negatively correlated groups, optimal condition
2. Risk diversification with positively correlated groups, no opportunity
E. Additional Benefits from Risk-Bearing Financial Institutions
1. Professional management
4. Investment in infrastructure
F. Hedging of Speculative Financial Risk
1. Commonly hedged financial risks
2. Derivative securities and other financial transactions
a. Futures contracts
3. Hedging and correlation; derivatives are effective because of their negative
correlation with the firm’s underlying risk
G. ERM and Portfolios
1. Perfect positive correlation among risk exposures is unlikely.
2. Natural diversification occurs across correlated risks.
IV. ANSWERS TO REVIEW QUESTIONS
1. Risk-bearing financial institutions diversify risk by combining a large
number of exposure units in a risk group. Describe the types of
exposure units found in the risk groups of an insurer, a mutual fund,
Chapter 5/Risk-Handling Techniques: Diversification and Hedging 31
and a pension. The exposure units for an insurer are the various property and
2. Describe the difference between the covariance and the correlation.
3. Calculate the covariance and correlation for the returns for Stock A and
Stock B. Covariance equals 0.0, and correlation equals 0.0.
4. Based on Equation 5-3, describe the impact of including Stock A and
5. Calculate the covariance and correlation for the returns for Stock C and
Stock D. Covariance equals 92 and correlation equals 0.997176.
6. Based on Equation 5-3, describe the impact of including Stock C and
7. Calculate the covariance and correlation for the returns for Stock E and
Stock F. Covariance equals –21 and correlation equals –0.97073.
8. Based on Equation 5-3, describe the impact of including Stock E and
9. Explain why insurance risk pooling is most efficient when the losses
from the policyholders in the risk pool are distributed independently.
When losses are random and the exposure units are independent of each other, then
10. Discuss why perils like earthquake damage or unemployment are not
insured easily by private insurers. This follows on the answer to question 9.
Earthquake and unemployment are exposures where there is a great likelihood that
11. Looking beyond risk diversification, discuss some of the additional
benefits that risk-bearing financial institutions offer their customers.
32 Chapter 5/Risk-Handling Techniques: Diversification and Hedging
12. What is the difference between output price risk and input price risk?
Output price risk has to do with a firm’s ability to maintain the planned price for the
13. What are the types of loss that are dealt with through the use of hedging
in financial risk management? Describe the tools that are available to
14. From the viewpoint of the option holder, what is the difference between
a call option and a put option? A call option is a right to buy something at a
15. Based on Equation 5-3, explain why hedging is a useful risk-handling
technique. Hedging involves taking a position in an asset, perhaps a commodity,
16. Under what conditions will the bundling of risk exposures yield no
reduction of risk? This occurs when the exposure units are positively correlated.
V. ANSWERS TO OBJECTIVE QUESTIONS
1. Currency risk is defined as which of the following?
2. A contract to buy or sell a commodity that is traded on securities markets in advance
is called which of the following?
Chapter 5/Risk-Handling Techniques: Diversification and Hedging 33
3. Which of the following statements about ERM is correct?
I. ERM encompasses the management of hazard risk and financial risk.
II. ERM does not encompass the management of financial losses from derivatives.
4. If you hold a call option, you have
5. A(n) ____ is not a risk-bearing financial institution.
6. Opportunities for risk reduction are greatest when the correlations among exposure
units in a portfolio are which of the following?
7. Which of the following does not affect the risk in a portfolio consisting of two
stocks?
8. For insurance risk pools in which exposure units exhibit a 0.1 correlation, which of
the following is true?
I. As the size of the risk pool increases, the standard deviation of the mean loss
decreases.
II. As the size of the risk pool becomes extremely large, the standard deviation of
the mean loss equals zero.
34 Chapter 5/Risk-Handling Techniques: Diversification and Hedging
9. In 2010, which of the following was the largest risk-bearing financial institution
(based on assets)?
10. Which of the following statements regarding correlated risks is correct?
I. Stock prices tend to be positively correlated to marketwide economic events.
II. Natural disasters like hurricanes are positively correlated to prices in the stock
markets.
VI. IDEAS FOR INSTRUCTORS AND TEACHING METHODS
1. Consult The Wall Street Journal for information on the prices of futures contracts.
Who buys futures contracts in metals and agricultural commodities? Discuss why a
2. Discuss the kind of risk management that will be practiced by an insurance
company. Ask the class what kinds of risks are faced by insurers. (Note: The classic
3. Ask the class if any of them have ever hedged, perhaps a wager on their favorite
sports team. If they have, then discuss what that says about human beings and risk
aversion.