PrinciplesofFinance-WEB-127

Prévia do material em texto

Alpha Beta
Alpha pays Beta floating rate -LIBOR +LIBOR
Payments and receipts
Net amount -6.25
Benefit 0.75 0.5
Table 20.5 Example of a Swap Agreement
Alpha borrows in the capital markets at a fixed rate of 5%. Beta chooses to borrow at a floating rate that equals
Beta also agrees to pay Alpha a fixed rate of 5.5%. In essence, Beta is paying 5.5% to
Alpha, 0.75% to its lender, and LIBOR to its lender.
In return, Alpha promises to pay Beta LIBOR. The exact amount that Alpha will pay to Beta fluctuates as LIBOR
fluctuates. However, from Beta’s perspective, the payment of LIBOR it receives from Alpha exactly offsets the
payment of LIBOR it makes to its lender. When LIBOR increases, the rate of that Beta is
paying to its lender increases, but the LIBOR rate it receives from Alpha also increases. When LIBOR decreases,
Beta receives less from Alpha, but it also pays less to its lender. Because the LIBOR it receives from Alpha is
exactly equal to the LIBOR it pays to its lender, Beta’s net amount of interest paid is 6.25%—the 5.5% it pays to
Alpha plus the 0.75% it pays to its lender.
Alpha is in the position of paying 5.0% to its lender and LIBOR to Beta while receiving 5.5% from Beta. This
means that Alpha’s net interest paid is Alpha is said to have swapped its fixed interest rate for
a floating rate. Because it is paying , it will experience fluctuating interest rates; however, as a
company with a AAA bond rating, it is a strong, creditworthy company that can withstand that interest rate
exposure. It would have cost Alpha to borrow the money from its lenders at a variable rate.
By participating in this swap arrangement, Alpha has been able to lower its interest rate by 0.75%.
Through this swap arrangement, Beta has been able to fix its interest rate at 6.25% rather than having a
variable rate. This predictability is a benefit for a company, especially one that is in a bit more precarious
position as far as its creditworthiness and stability. The 6.25% Beta pays as a result of this arrangement is 0.5%
below the 6.75% it would have paid if it simply borrowed from its lenders at a fixed rate.
20.4 • Interest Rate Risk 617
Summary
20.1 The Importance of Risk Management
Risk arises due to uncertainty. The future is unpredictable. One job of the financial manager is to manage the
risks of both cash inflows and cash outflows. Investors are risk-averse. The riskier a firm’s cash flows are, the
higher the rate of return investors require to provide capital to the company.
20.2 Commodity Price Risk
Companies do not know how much they will have to pay for raw materials in future months. The price of raw
materials will change as economic conditions change, impacting a company’s cost of goods sold and profits.
Some ways that a company can hedge this risk are through vertical integration, long-term contracts, and
futures contracts.
20.3 Exchange Rates and Risk
Exchange rates are unpredictable. This leads to transaction risk, translation risk, and economic risk as currency
values change. A forward contract is an agreement between two parties to make an exchange at a particular
rate on a given date in the future. Companies can use options to mitigate the risks. A call option gives the
holder the right, but not the obligation, to purchase an underlying asset. A put option give the holder the right,
but not the obligation, to sell an underlying asset.
20.4 Interest Rate Risk
When interest rates increase, the present value of future cash flows decreases. Duration is a measure of
interest rate risk. A swap involves two parties agreeing to exchange something, often specified payment
streams.
Key Terms
American option an option that the holder can exercise at any time up to and including the exercise date
appreciate when one unit of a currency will purchase more of a foreign currency than it did previously
call option an option that gives the owner the right, but not the obligation, to buy the underlying asset at a
specified price on some future date
depreciate when one unit of a currency will purchase less of a foreign currency than it did previously
derivative a security that derives its value from another asset
duration a measure of interest rate risk
economic risk the risk that a change in exchange rates will impact the number of customers a business has
or its sales
European option an option that the holder can exercise only on the expiration date
exchange rate the price of one currency in terms of another currency
exercise price (strike price) the price the option holder pays for the underlying asset when exercising an
option
exercising choosing to purchase or sell the asset underlying a held option according to the terms of the
option contract
expiration date the date an option contract expires
forward contract a contractual agreement between two parties to exchange a specified amount of assets on
a specified future date
futures contract a standardized contract to trade an asset on some future date at a price locked in today
hedging taking an action to reduce exposure to a risk
margin the collateral that must be posted to guarantee that a trader will honor a futures contract
marking to market a procedure by which cash flows are exchanged daily for a futures contract, rather than
at the end of the contract
618 20 • Summary
Access for free at openstax.org
natural hedge when a company offsets the risk that something will decrease in value by having a company
activity that would increase in value at the same time
option an agreement that gives the owner the right, but not the obligation, to purchase or sell an asset at a
specified price on some future date
option writer seller of a call or put option
premium the price a buyer of an option pays for the option contract
put option an option that gives the owner the right, but not the obligation, to sell the underlying asset at a
specified price on some future date
speculating attempting to profit by betting on the uncertain future, knowing that a risk of loss is involved
spot rate the current market exchange rate
strike price (exercise price) the price an option holder pays for the underlying asset when exercising the
option
swap an agreement between two parties to exchange something, such as their obligations to make specified
payment streams
transaction risk the risk that a change in exchange rates will impact the value of a business’s expected
receipts or expenses
translation risk the risk that a change in exchange rates will impact the value of items on a company’s
financial statements
vertical integration the merger of a company with its supplier
CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-institute-Level-I-Study-Session). Reference with permission of CFA Institute.
Multiple Choice
1. Which of the following does a financial manager want to do to maximize the value of the firm?
a. Decrease the speed of money coming into the firm
b. Speed up cash going out and slow down cash coming in
c. Decrease the riskiness of cash inflows and cash outflows
d. Increase the volatility and speed of cash going out of the firm
2. In finance, risk is ________.
a. the same thing as profit
b. ignored because it is inevitable
c. thought of as uncertainty or unpredictability
d. something that financial managers should strive to increase and maximize
3. American Jeans Corp. purchases a cotton farm. The cotton grown on the farm will be used to make denim
cloth for the company’s jeans. This is an example of ________.
a. striking a price
b. vertical integration
c. a forward contract
d. an American option
4. The price that a holder of an option pays to buy the underlying asset when exercising a call option is
known as ________.
a. the strike price
b. the maturity price
20 • CFA Institute 619
https://openstax.org/r/cfa-institute-Level-I-Study-Session
https://openstax.org/r/cfa-institute-Level-I-Study-Session
c. the exchange price
d. the underlyingpremium
5. Which of the following gives the holder the right, but not the obligation, to purchase an underlying asset?
a. A call option
b. A forward contract
c. A European put option
d. An American put option
6. An American option allows the holder to ________.
a. exercise the option only on the expiration date
b. exercise the option at any time up to and including the expiration date
c. sell stocks, and a European option allows the holder to purchase stocks
d. purchase stocks, and a European option allows the holder to purchase bonds
7. The holder of a(n) ________ has the right to buy and the holder of a(n) ________ has the right to sell an
underlying asset.
a. call option; put option
b. put option; call option
c. American option; European option
d. European option; American option
8. The three main categories of foreign exchange risk a company faces are ________.
a. economic risk, business risk, and exposure risk
b. exposure risk, fluctuation risk, and forward risk
c. transaction risk, translation risk, and economic risk
d. appreciation risk, depreciation risk, and duplication risk
9. In January, the exchange rate between the South Korean won and the US dollar was
. Three months later, the exchange rate was . This means that
________.
a. the Korean won appreciated relative to the US dollar
b. the Korean won depreciated relative to the US dollar
c. the US dollar depreciated relative to the Korean won
d. both the Korean won and the US dollar appreciated
10. In January, the exchange rate between the South Korean won and the US dollar was
. Three months later, the exchange rate was . This means
that ________.
a. it will cost US companies more to purchase raw materials from South Korea
b. it will cost Korean companies more to purchase raw materials from the United States
c. US companies that sell their products in South Korea will find their revenue has increased
d. Korean companies that sell their products in the United States will find that their revenue has
decreased
11. A foreign exchange forward contract ________.
a. is a standardized contract that is inflexible
b. occurs when a company swaps its translation exposure for transaction exposure
c. is a contractual agreement between two parties to exchange a specified amount of currencies on a
future date
620 20 • Multiple Choice
Access for free at openstax.org
d. states the date on which a trade will take place, but the price for the trade will be determined at the
time the trade occurs
12. Which of the following is a measure of interest rate risk?
a. LIBOR
b. Duration
c. Translation exposure
d. Contract inflexibility
13. A swap occurs when ________.
a. a company exchanges obligations with another company to make specified payment streams
b. a company purchases commodities from a company in another country, exposing it to both
commodity and currency risk
c. a company chooses a local supplier over an international supplier to avoid currency exposure
d. a company chooses a foreign supplier so that its commodity risk will be offset by its currency risk
Review Questions
1. What is the difference between someone using a derivative security to hedge risk and someone using a
derivative security to speculate?
2. Explain how vertical integration may be used as a method of hedging against commodity price risk.
3. What is the difference between a forward contract and a futures contract?
4. You are considering purchasing a call option to purchase Mexican pesos in three months with a strike
price of MXN 20/USD. The premium for this call option is MXN 2. Show the payoff you will receive at
various prices in a diagram.
5. You are considering writing a call option to purchase Mexican pesos in three months with a strike price of
MXN 20/USD. The premium for this call option is MXN 2. Show the payoff you will receive at various prices
in a diagram.
6. Why are options considered to be a “zero-sum game”?
Problems
1. The Olive Orchard is a US retail outlet for high-quality olive oils. One of the major suppliers of olive oil for
the company is a farm in Greece. The Olive Orchard must pay the Greek farm 5.00 euros per liter of olive
oil it purchases. The Olive Orchard would like to purchase 7,000 liters of the Greek farm’s olive oil next
year. Currently, it costs 0.900 euros to purchase 1 US dollar. If the exchange rate remains constant, how
much will it cost the Olive Orchard (in US dollars) to purchase the 7,000 liters? If the exchange rate
changes so that it costs 0.8599 euros to purchase 1 US dollar, how much will it cost to purchase the 7,000
liters of olive oil?
2. International Automobile Parts (IAP) holds a call option to purchase US dollars. The strike price on the call
option is JPY 115/USD. IAP paid JPY 10 for the option. The spot price is JPY 120/USD, and the option expires
today. Should IAP exercise the option? What is IAP’s payoff?
3. Global Producers (GP) holds a put option to sell US dollars. The strike price on the put option is JPY 114/
USD. GP paid JPY 10 for the option. The spot price is JPY 120/USD, and the option expires today. Should GP
exercise the option? What is GP’s payoff?
20 • Review Questions 621
	Chapter 20 Risk Management and the Financial Manager
	Summary
	Key Terms
	CFA Institute
	Multiple Choice
	Review Questions
	Problems