Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
© The McGraw−Hill^827
Companies, 2002increases in interest rates beyond the ceiling by the cap. However, if interest rates drop
below the floor, the put will be exercised against the firm. The result is that the rate the
firm pays will not drop below the floor rate. In other words, the rate the firm pays will
always be between the floor and the ceiling.
Other Interest Rate Options We will close out our chapter by briefly mentioning
two relatively new types of interest rate options. Suppose a firm has a floating-rate loan.
The firm is comfortable with its floating-rate loan, but it would like to have the right to
convert it to a fixed-rate loan in the future.
What can the firm do? What it wants is the right, but not the obligation, to swap its
floating-rate loan for a fixed-rate loan. In other words, the firm needs to buy an option
on a swap. Swap options exist, and they have the charming name swaptions.
We’ve seen that there are options on futures contracts and options on swap contracts,
but what about options on options? Such options are called compoundoptions. As we
have just discussed, a cap is a call option on interest rates. Suppose a firm thinks that,
depending on interest rates, it might like to buy a cap in the future. As you can probably
guess, in this case, what the firm might want to do today is buy an option on a cap. In-
evitably, it seems, an option on a cap is called a caption,and there is a large market for
these instruments.
SUMMARY AND CONCLUSIONS
This chapter has introduced some of the basic principles of financial risk management
and financial engineering. The motivation for risk management and financial engineer-
ing stems from the fact that a firm will frequently have an undesirable exposure to some
type of risk. This is particularly true today because of the increased volatility in key fi-
nancial variables such as interest rates, exchange rates, and commodity prices.
We describe a firm’s exposure to a particular risk with a risk profile. The goal of fi-
nancial risk management is to alter the firm’s risk profile through the buying and selling
of derivative assets such as futures contracts, swap contracts, and options contracts. By
finding instruments with appropriate payoff profiles, a firm can reduce or even eliminate
its exposure to many types of risk.
Hedging cannot change the fundamental economic reality of a business. What it can
do is allow a firm to avoid expensive and troublesome disruptions that might otherwise
result from short-run, temporary price fluctuations. Hedging also gives a firm time to re-
act and adapt to changing market conditions. Because of the price volatility and rapid
economic change that characterize modern business, intelligently dealing with volatility
has become an increasingly important task for financial managers.
There are many other option types available in addition to those we have discussed,
and more are created every day. One very important aspect of financial risk manage-
ment that we have not discussed is that options, forwards, futures, and swaps can be
CONCEPT QUESTIONS
23.6a Suppose that the unhedged risk profile in Figure 23.13 sloped down instead of
up. What option-based hedging strategy would be suitable in this case?
23.6bWhat is a futures option?
23.6c What is a caption? Who might want to buy one?CHAPTER 23 Risk Management: An Introduction to Financial Engineering 801