Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

23. Risk Management: An
    Introduction to Financial
    Engineering

(^804) © The McGraw−Hill
Companies, 2002
Corporate risk management often involves the buying and selling of derivative se-
curities. A derivative security is a financial asset that represents a claim to another fi-
nancial asset. For example, a stock option gives the owner the right to buy or sell stock,
a financial asset, so stock options are derivative securities.
Financial engineering frequently involves creating new derivative securities, or else
combining existing derivatives to accomplish specific hedging goals. In a world where
prices were very stable and changed only slowly, there would be very little demand for
financial engineering. As this is being written, however, financial engineering is very
much a growth industry. As we illustrate next, the reason is that the financial world has
become more risky.^1
Price Volatility: A Historical Perspective
In trying to understand why we claim that the financial world has become more risky,
you will find it useful to look back at the history of prices. Figure 23.1 provides a very
long-term view of price levels for England. The price-level series shown begins in 1666
and runs through the mid-1980s. The remarkable fact revealed by this series is that for
the first 250 years, prices changed very little (except in wartime). In contrast, in the last
30 or 40 years, prices have increased dramatically. As we saw in Chapter 12, the mod-
ern history of prices in the United States is similar.
As we also saw in Chapter 12, the rate of change in prices has slowed in recent years.
The important lesson, however, is that even though the inflation rate is now relatively low
in the United States, the uncertainty about the future rate of inflation remains. Beyond the
778 PART EIGHT Topics in Corporate Finance

FIGURE 23.1

$

1700

3,000

2,500

2,000

1,500

1,000

500

0 Year

1750 1800 1850 1900 1950

Source: Charles W. Smithson, Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and

Value Maximization,3rd ed. (New York: The McGraw-Hill Companies, 1998).

Price Levels in England (1850 100)

(^1) This discussion is based on Charles W. Smithson, Managing Financial Risk: A Guide to Derivative
Products, Financial Engineering, and Value Maximization,3rd ed. (New York: The McGraw-Hill
Companies, 1998).
The International Financial
Risk Institute (risk.ifci.ch)
promotes education on
risk management.
derivative security
A financial asset that
represents a claim to
another financial asset.