Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance23. Risk Management: An Introduction to Financial Engineering
© The McGraw−Hill^809
Companies, 2002MANAGING FINANCIAL RISK
We’ve seen that price and rate volatility have increased in recent decades. Whether or not
this is a cause for concern for a particular firm depends on the nature of the firm’s oper-
ations and its financing. For example, an all-equity firm would not be as concerned about
interest rate fluctuations as a highly leveraged one. Similarly, a firm with little or no in-
ternational activity would not be overly concerned about exchange rate fluctuations.
To effectively manage financial risk, financial managers need to identify the types of
price fluctuations that have the greatest impact on the value of the firm. Sometimes
these will be obvious, but sometimes they will not be. For example, consider a forest
products company. If interest rates increase, then its borrowing costs will clearly rise.
Beyond this, however, the demand for housing typically declines as interest rates rise.
As housing demand falls, so does demand for lumber. An increase in interest rates thus
leads to increased financing costs and, at the same time, decreased revenues.
The Risk Profile
The basic tool for identifying and measuring a firm’s exposure to financial risk is the
risk profile. The risk profile is a plot showing the relationship between changes in the
price of some good, service, or rate and changes in the value of the firm. Constructing a
risk profile is conceptually very similar to performing a sensitivity analysis (described
in Chapter 11).
To illustrate, consider an agricultural products company that has a large-scale wheat-
farming operation. Because wheat prices can be very volatile, we might wish to investi-
gate the firm’s exposure to wheat price fluctuations, that is, its risk profile with regard
to wheat prices. To do this, we plot changes in the value of the firm (V) versus unex-
pected changes in wheat prices (Pwheat). Figure 23.5 shows the result.
The risk profile in Figure 23.5 tells us two things. First, because the line slopes up,
increases in wheat prices will increase the value of the firm. Because wheat is an output,
this comes as no surprise. Second, because the line has a fairly steep slope, this firm has
a significant exposure to wheat price fluctuations, and it may wish to take steps to re-
duce that exposure.
Reducing Risk Exposure
Fluctuations in the price of any particular good or service can have very different effects
on different types of firms. Going back to wheat prices, we now consider the case of a
food processing operation. The food processor buys large quantities of wheat and has a
risk profile like that illustrated in Figure 23.6. As with the agricultural products firm, the
value of this firm is sensitive to wheat prices, but, because wheat is an input, increases
in wheat prices lead to decreases in firm value.
Both the agricultural products firm and the food processor are exposed to wheat price
fluctuations, but any fluctuations have opposite effects for the two firms. If these two firms
get together, then much of the risk can be eliminated. The grower and the processor can
simply agree that, at set dates in the future, the grower will deliver a certain quantity of
wheat, and the processor will pay a set price. Once the agreement is signed, both firms will
have locked in the price of wheat for as long as the contract is in effect, and both of their
risk profiles with regard to wheat prices will be completely flat during that time.
We should note that, in reality, a firm that hedges financial risk usually won’t be able
to create a completely flat risk profile. For example, our wheat grower doesn’t actually
CHAPTER 23 Risk Management: An Introduction to Financial Engineering 78323.2
risk profile
A plot showing how the
value of the firm is
affected by changes in
prices or rates.Erisk is an online
publication dealing with
risk management
(www.erisk.com).