Introduction to Corporate Finance

23: Introduction to Financial Risk Management

Equation 23.4 prices a forward rate

agreement (FRA), which is a forward where

the underlying asset is an interest rate.

■ A forward contract is an over-the-counter

instrument that involves two parties

agreeing on a price at which the purchaser

will buy a specified amount of an asset

from the seller at a fixed date some time

in the future. A futures contract is similar

to a forward contract but is traded on an

organised exchange.

■ Unlike forward contracts, which are

customised instruments, futures are

standardised. Several issues to consider

when using futures to hedge include basis

risk, cross-hedging, tailing the hedge and

delivery options.

■ Options offer a corporation the opportunity to

hedge its downside risk without giving up its

upside potential. However, this comes at a cost

in the form of the premium paid for the option.

Swap contracts are longer-term hedging

instruments that allow corporations to change

the characteristics of their periodic cash flows.

■ In some cases, a corporation may not be

able to hedge its risk exposure using off-

the-shelf forwards, futures, options or swaps.

In these cases, the corporation may turn to

financial engineering in an effort to create

a specialised financial instrument that will

hedge the exposure.

IMPORTANT EQUATIONS

23.1 F = S 0 (1 + rf )n

23.2 F = (S 0 – I + W)(1 + rf )n

23.3^ =()

+

+









FS

r

r

1

1

for

dam

23.4^

()()

()

=

×− ×

+× 

CF

np rr D

rD

/ 360

1/ 360

FRA

sfwd

s

KEY TERMS

arbitrage, 795

basis, 804

basis risk, 804

closing futures price, 801

cross-hedging, 805

currency forward contract, 796

currency swap, 810

economic exposure, 789

financial engineering, 787

financial risk management, 787

fixed-for-floating currency

swap, 811

fixed-for-floating interest rate

swap, 808

forward price, 794

forward rate, 796

forward rate agreement (FRA),

799

fungibility, 803

futures contract, 800

initial margin, 803

interest differential, 808

interest rate cap, 807

interest rate collar, 807

interest rate floor,807

interest rate risk, 788

interest rate swap, 808

maintenance margin, 803

margin account, 803

marking-to-market, 802

opening futures price, 800

open interest, 801

settlement date, 794

settlement price, 801

settle price, 801

spot price, 794

swap contract, 807

tailing the hedge, 805

transactions exposure, 789

LO23.3

LO23.4