Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

23. Risk Management: An
    Introduction to Financial
    Engineering

© The McGraw−Hill^803

Companies, 2002

CHAPTER

23

Risk Management:

An Introduction to

Financial Engineering

In September 1998, EquiCredit,provider of home equity loans, sold $746

million in bonds backed by home equity loans, meaning that the income from a

portfolio of home loans would be used to make the payments on the bonds.

However, EquiCredit had a problem with this sale. Investors purchasing the

securities wanted a floating-rate investment, while the bulk of the home equity

loans backing the bonds carried fixed rates. To reduce its risk and complete the

transaction, EquiCredit acted to convert its variable-rate securities into fixed-rate

by entering into what is known as an interest rate swap. In such a deal, one firm

essentially exchanges, or “swaps,” interest payments with another. As we will see

in this chapter, such agreements are just one of the tools used by firms to

manage risk.

ince the early 1970S, prices for all types of goods and services have become in-

creasingly volatile. This is a cause for concern because sudden and unexpected

shifts in prices can create expensive disruptions in operating activities for even very

well run firms. As a result, firms are increasingly taking steps to shield themselves

from price volatility through the use of new and innovative financial arrangements.

The purpose of this chapter is to introduce you to some of the basics of financial risk

management. The activities we discuss here are on the frontier of modern, real-world fi-

nancial management. By describing one of the rapidly developing areas in corporate fi-

nance, we hope to leave you with a sense of how the art and practice of financial

management evolve in response to changes in the financial environment.

HEDGING AND PRICE VOLATILITY

In broad terms, reducing a firm’s exposure to price or rate fluctuations is called hedg-

ing. The term immunizationis sometimes used as well. As we will discuss, there are

many different types of hedging and many different techniques. Frequently, when a firm

desires to hedge a particular risk, there will be no direct way of doing so. The financial

manager’s job in such cases is to create a way by using available financial instruments

to create new ones. This process has come to be called financial engineering.

S

777

Check out the “Internet

Resource for Derivatives”

for information on

derivative instruments

and markets at

http://www.numa.com.

23.1

hedging

Reducing a firm’s

exposure to price or rate

fluctuations. Also,

immunization.