Introduction to Corporate Finance

23: Introduction to Financial Risk Management

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

describe the types of financial risks that

can adversely affect a company’s cash

flows and explain why companies might

choose to hedge those risks

calculate the price of a forward contract

and illustrate how to use such a contract to

hedge a financial risk exposure

explain the differences between forward

and futures contracts

describe the basic features of options and

swaps and explain how they can be used

to hedge financial risk exposure.

LO23.1

LO23.2

LO23.3

LO23.4

Trading in virtually all types of financial

instruments has increased over the past two

decades, but no markets have experienced

growth rates as explosive as those for the

financial instruments used for hedging and risk

management. Since the collapse of the Bretton

Woods fixed exchange rate regime in 1973,

corporations have been exposed to extreme

fluctuations in interest rates, exchange rates

and the prices of important raw materials.

This increased risk has led to a mushrooming

demand for financial instruments and strategies

that corporations can use to hedge, or offset,

their underlying operating and financial

exposures.

More recently, following a financial crisis and

subsequent recession, CFOs and corporate risk

managers report that the risks their companies face

have increased dramatically. Figure 23.1 shows

the results from a survey of 1,161 corporate risk

managers from around the world. This group of

managers was asked to indicate whether specific

types of risk had increased, remained the same

or decreased since 2006. As you can see in the

figure, a majority of respondents indicated that

risks associated with foreign exchange movements,

interest rate fluctuations and commodity price

volatility had all increased in recent years.

This chapter discusses risk management and

financial engineering in the modern corporation.

Financial risk management refers to the process of

identifying, measuring and managing all types of

risk exposures, including interest rate, commodity

and currency risk exposures. There are three ways to

minimise a company’s risk exposures: diversifying,

insuring and hedging. This chapter focuses on

hedging. Derivative securities, including forwards,

futures, options and swaps, are the financial

instruments commonly used for hedging and risk

management.

Though the financial press often portrays

derivatives in a negative light, these securities can

be an effective means of hedging risk exposures.

We will discuss several different types of derivative

instruments, but we begin with an overview of risk

management. Next, we describe each of the major

types of derivative securities and discuss how each

can be used to manage a company’s risk exposures.

Finally, we discuss financial engineering, which is the

application of finance principles to design securities

and strategies that help companies manage their

risk exposures.

financial risk

management

The process of identifying,

measuring and managing

all types of risk exposures,

including interest rate,

commodity and currency risk

exposures

financial engineering

The application of finance

principles to design securities

and strategies that help

companies manage their risk

exposures