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^813

Companies, 2002

HEDGING WITH FORWARD CONTRACTS

Forward contracts are among the oldest and most basic tools for managing financial
risk. Our goal in this section is to describe forward contracts and discuss how they are
used to hedge financial risk.

Forward Contracts: The Basics

Aforward contractis a legally binding agreement between two parties calling for the
sale of an asset or product in the future at a price agreed upon today. The terms of the
contract call for one party to deliver the goods to the other on a certain date in the future,
called the settlement date.The other party pays the previously agreed-upon forward
priceand takes the goods. Looking back, note that the agreement we discussed between
the wheat grower and the food processor was, in fact, a forward contract.
Forward contracts can be bought and sold. The buyerof a forward contract has the
obligation to take delivery and pay for the goods; the sellerhas the obligation to make
delivery and accept payment. The buyer of a forward contract benefits if prices increase
because the buyer will have locked in a lower price. Similarly, the seller wins if prices
fall because a higher selling price has been locked in. Note that one party to a forward
contract can win only at the expense of the other, so a forward contract is a zero-sum
game.

CONCEPT QUESTIONS

23.2a What is a risk profile? Describe the risk profiles with regard to oil prices for an

oil producer and a gasoline retailer.

23.2bWhat can a firm accomplish by hedging financial risk?

CHAPTER 23 Risk Management: An Introduction to Financial Engineering 787

23.3

FIGURE 23.7

V

B. Seller's perspective

Payoff

profile

V

Payoff

profile

A. Buyer's perspective

Poil

Payoff Profiles for a Forward Contract

forward contract

A legally binding

agreement between two

parties calling for the

sale of an asset or

product in the future at a

price agreed upon today.