Risk Management and Hedging Concepts

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is the primary function of hedging in risk management?

It increases expected profit.

It reduces potential price fluctuations. (correct)

It diversifies unsystematic risk.

It eliminates all types of risk.

Which type of risk does the CAPM Model primarily account for when determining the discount rate (R)?

Operational risk.

Unsystematic risk.

Market-specific risk.

Systematic risk. (correct)

What is the perceived economic value of hedging according to companies?

It is believed to produce value despite theoretical views. (correct)

It guarantees higher returns on investments.

It eliminates all future cash flow risks.

It always increases the company's market value.

Why are investors not remunerated for bearing unsystematic risk?

It can be diversified away. Signup and view all the answers

What effect does hedging have on expected profit?

It remains unchanged regardless of hedging. Signup and view all the answers

How does hedging impact the company's value according to theory?

It has no effect on the company's value. Signup and view all the answers

What type of risk is primarily reduced by investors through portfolio diversification?

Unsystematic risk. Signup and view all the answers

What is a key reason companies choose to hedge despite theoretical shortcomings?

To create perceived value among stakeholders. Signup and view all the answers

What does hedging primarily aim to reduce?

Uncertainty in profit Signup and view all the answers

What is one potential benefit of hedging for companies?

Creates certainty in future profits Signup and view all the answers

What is meant by the term 'irrelevance proposition' in the context of corporate finance?

The source of funds is not as important as how they are utilized. Signup and view all the answers

What is implied by a standard deviation of zero in the context of hedging?

There is complete certainty regarding costs. Signup and view all the answers

In the context of profit uncertainty, what is the expected unit profit mentioned?

€5 Signup and view all the answers

What is the primary risk source for industrial companies mentioned in the document?

Foreign exchange rate changes Signup and view all the answers

What role is indicated to be present in every company regarding risk management?

Chief Risk Manager Signup and view all the answers

What ensures that the uncertainty of future unit profit disappears according to the content?

Fixing unit costs at their expected value Signup and view all the answers

Why do companies that hedge their risks tend to be valued higher in the market?

They are perceived as less risky by the market. Signup and view all the answers

What are family firms typically more averse to in terms of financial practices?

Maintaining control and avoiding external finance. Signup and view all the answers

What is a primary reason behind the informational opacity of family firms?

They maintain a lack of transparency towards investors. Signup and view all the answers

Which of the following instruments is primarily used for hedging in the derivatives market?

Options and Swaps. Signup and view all the answers

What is a derivative primarily based on?

The performance of an underlying variable. Signup and view all the answers

Which of the following types of risks do family firms exhibit due to holding an under-diversified portfolio?

Increased market risks. Signup and view all the answers

Which method is commonly used to reduce uncertainty over a company’s cash flow?

Financial hedging through derivatives. Signup and view all the answers

What key benefit do companies experience when they hedge effectively?

Lower costs of capital. Signup and view all the answers

What is the primary purpose of creating derivative instruments like futures and forwards?

To hedge against price fluctuations Signup and view all the answers

How does a futures contract primarily differ from a forward contract?

Futures contracts are standardized and traded on exchanges. Signup and view all the answers

If a coffee shop enters into a futures contract to buy coffee at $3 per pound and the market price rises to $4 at maturity, what is the financial outcome?

The coffee shop pays $3 and benefits from the contract. Signup and view all the answers

What does cash settlement in a futures contract mean?

Only the monetary difference is exchanged at maturity. Signup and view all the answers

What concept do both partial hedging and over-hedging introduce to companies?

Speculative elements Signup and view all the answers

Which of the following statements is true regarding speculation in futures markets?

Speculators may not have any intention of using the underlying asset. Signup and view all the answers

What is one possible downside for the coffee shop if the market price drops to $2 per pound while locked into a futures contract at $3 per pound?

The coffee shop is obligated to pay $3 despite lower market prices. Signup and view all the answers

What benefit does the coffee shop gain by entering a futures contract?

It locks in a purchase price, reducing uncertainty. Signup and view all the answers

What is one expected benefit of hedging for a company facing financial distress?

Reduces expected costs of financial distress Signup and view all the answers

Which of the following is considered a direct cost of bankruptcy?

Legal and administrative costs Signup and view all the answers

What does debt overhang refer to?

Reluctance to invest in new profitable projects due to pre-existing debt Signup and view all the answers

Which indirect cost is associated with a company in financial distress?

Loss of willing suppliers Signup and view all the answers

Why might stockholders prefer a riskier project in a debt overhang situation?

The potential for a small chance of gaining value Signup and view all the answers

How does hedging affect the likelihood of future investments for a firm?

Increases the likelihood of attractive investments being undertaken Signup and view all the answers

What is one of the indirect costs experienced during bankruptcy?

Loss of customers due to service disruption Signup and view all the answers

What is one implication of a company having a debt overhang regarding its stockholders?

They support riskier projects with negative NPVs Signup and view all the answers

What is the effective cost per pound for the coffee shop when the market price is $2 per pound?

$3 per pound Signup and view all the answers

What happens to the buyer's payoff if the market price of the underlying asset, S, is less than the forward price, F?

The buyer incurs a loss. Signup and view all the answers

Which of the following statements about the seller's payoff is correct?

Seller’s payoff starts at +F when S is 0. Signup and view all the answers

What is the slope of the payoff line for the long position?

Upward Signup and view all the answers

At what point does the buyer's payoff break even?

When S = F Signup and view all the answers

Which of the following defines the market value of a forward contract at maturity?

The price of the underlying asset Signup and view all the answers

What does the payoff for the long position equal when S > F?

S - F Signup and view all the answers

What occurs if the market price of the underlying asset drops significantly for the seller?

Profit for the seller Signup and view all the answers

Study Notes

Corporate Risk Management (Hedging)

Gross Profit: Revenues minus costs
Uncertain Profit: (Output Price x Quantity Sold) - (Input Price x Quantity Bought)
Risk Source: Fluctuations in input price (e.g., foreign exchange rates, commodity prices)
Hedging: Reducing risk by fixing a variable cost at its expected value. The aim is to remove the volatility of potential outcomes
Expected Unit Profit: €5, but has volatility/risk
Standard Deviation: A measure of volatility or risk in unit profit. A higher standard deviation indicates greater volatility.
Hedging Impact: Fixing the unit cost today removes the uncertainty surrounding future unit profit, resulting in stable unit profit.
Irrelevance Proposition: Companies create value from how they invest money, not where they obtain funding. The way money is used is more important than its source.
Financial Distress Costs: Costs incurred when a company goes bankrupt. These costs include legal and administrative fees, and difficulties in running a bankrupt business.
Hedging's impact on Financial Distress: Lower the probability of bankruptcy and therefore lowers the expected financial distress costs because hedging reduces variability, not the cost.
Hedging and Taxes: Hedging can stabilize a company's earnings and potentially reduce taxes owed since a constant stream of earnings will more consistently comply with tax regulations.
Hedging and Market Risk: Hedging reduces unsystematic risk but does not change systematic risks (marketwide).
Hedging and Family Businesses: Family firms are often more risk-averse because they usually hold a more undiversified portfolio. They also tend to be more interested in firm survival and future generations.
Hedging Techniques: Futures contracts. Options contracts. Swaps are the main types of derivatives used in financial markets.
- Futures/Forwards: An agreement to buy or sell an asset in the future at a price agreed today.
- Options: A contract allowing the holder to buy or sell an asset but not obligating them to do so.
- Swaps: Exchanges of cash flows between two parties over a period of time.
Commodity Swaps: Agreements to exchange a fixed price for a commodity, often used to hedge against fluctuations in commodity prices.
Operational Hedging: Adjusting company operations to minimise currency risk. This can involve setting up a production facility in a country that uses the same currency as the company's revenue stream.
Imperfect Markets: Real-world markets are not perfect, allowing financial instruments to be effectively used.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Test your knowledge on the primary functions of hedging in risk management, the CAPM model and its relation to discount rates, and the economic value of hedging for companies. Additionally, explore why unsystematic risk does not offer returns for investors and the impact of hedging on expected profits.