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^807

Companies, 2002

home mortgage loans. Before the increases in interest rate volatility came about, short-
term interest rates were almost always lower than long-term rates, so the S&Ls simply
profited from the spread.
When short-term interest rates became highly volatile, they exceeded long-term rates
on various occasions, sometimes by substantial amounts. Suddenly, the S&L business
got very complicated. Depositors removed their funds because higher rates were avail-
able elsewhere, but home owners held on to their low-interest-rate mortgages. S&Ls
were forced into borrowing over the short term at very high rates. They began taking
greater risks in lending in an attempt to earn higher returns, but this frequently resulted
in much higher default rates, another problem with which the S&Ls were unfamiliar.
There were other economic and political factors that contributed to the astounding
size of the S&L disaster, but the root cause was the increase in interest rate volatility. To-
day, financial institutions take specific steps to insulate themselves from interest rate
volatility.

CONCEPT QUESTIONS

23.1a What is hedging?

23.1bWhy do firms place greater emphasis on hedging now than they did in the past?

CHAPTER 23 Risk Management: An Introduction to Financial Engineering 781

FIGURE 23.4

 40

 20

140

1960 1965 1970 1975 1980 1985 1990 1995

0

20

40

60

80

100

120

Percent change

The percentage changes in this figure are based on beginning-of-month prices.

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).

Percentage Changes in Oil Prices: 1960–97