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^811

Companies, 2002

Short-run price changes can drive a business into financial distress even though, in the
long run, the business is fundamentally sound. This happens when a firm finds itself with
sudden cost increases that it cannot pass on to its customers immediately. A negative cash
flow position is created, and the firm may be unable to meet its financial obligations.
For example, wheat crops might be much larger than expected in a particular year
because of unusually good growing conditions. At harvest time, wheat prices will be un-
expectedly low. By that time, a wheat farmer will have already incurred most of the
costs of production. If prices drop too low, revenues from the crop will be insufficient to
cover the costs, and financial distress may result.
Short-run financial risk is often called transactions exposure. This name stems from
the fact that short-term financial exposure typically arises because a firm must make
transactions in the near future at uncertain prices or rates. With our wheat farmer, for ex-
ample, the crop must be sold at the end of the harvest, but the wheat price is uncertain.
Alternatively, a firm may have a bond issue that will mature next year that it will need
to replace, but the interest rate that the firm will have to pay is not known.
As we will see, short-run financial risk can be managed in a variety of ways. The op-
portunities for short-term hedging have grown tremendously in recent years, and firms
in the United States are increasingly hedging away transitory price changes.

Cash Flow Hedging: A Cautionary Note

One thing to notice is that, in our discussion thus far, we have talked conceptually about
hedging the value of the firm. In our example concerning wheat prices, however, what

CHAPTER 23 Risk Management: An Introduction to Financial Engineering 785

FIGURE 23.6

Risk Profile for a Wheat

Buyer

For a buyer, unexpected increases in wheat prices decrease the value

of the firm.

V

Pwheat

Risk profile

transactions exposure

Short-run financial risk

arising from the need to

buy or sell at uncertain

prices or rates in the

near future.