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

© The McGraw−Hill^805

Companies, 2002

unexpected changes in overall price levels, there are three specific areas of particular im-
portance to businesses in which volatility has also increased dramatically: interest rates,
exchange rates, and commodity prices.

Interest Rate Volatility

We know that debt is a vital source of financing for corporations, and interest rates are
a key component of a firm’s cost of capital. Up until 1979, interest rates in the United
States were relatively stable because the Federal Reserve actively managed rates to keep
them that way. This goal has since been abandoned, and interest rate volatility has in-
creased sharply. Figure 23.2 illustrates this increase by plotting the changes in five-year
Treasury bond rates. The increase in volatility following 1979 is readily apparent.
Before 1979, U.S. firms were able to plan for and predict their future borrowing costs
with some confidence. In today’s financial world, because of the increased uncertainty
surrounding interest rates, this is no longer the case.

Exchange Rate Volatility

As we discuss in an earlier chapter, international operations have become increasingly
important to U.S. businesses. Consequently, exchange rates and exchange rate volatility
have also become increasingly important. Figure 23.3 plots percentage changes in the
deutsche mark–U.S. dollar exchange rate and illustrates that exchange rate volatility has
increased enormously since the early 1970s.

CHAPTER 23 Risk Management: An Introduction to Financial Engineering 779

FIGURE 23.2

 200

 250

 150

 100

 50

0

50

100

150

200

Basis points

1960 1965 1970 1975 1980 1985 1990 1995

The rate changes in this figure are changes in month-end and are measured in basis points,

where one basis point is 1 percent of 1 percent, that is .0001.

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).

Changes in Five-Year Treasury Bond Rates: 1960–97