Chapter 23

Enterprise Risk Management

ANSWERS TO END-OF-CHAPTER QUESTIONS

23-1a.A derivative is an indirect claim security that derives its value, in whole or in part, by the market price (or interest rate) of some other security (or market). Derivatives include options, interest rate futures, exchange rate futures, commodity futures, and swaps.

b.According to COSO, enterprise risk management “is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” .

c.Financial futures provide for the purchase or sale of a financial asset at some time in the future, but at a price established today. Financial futures exist for Treasury bills, Treasury notes and bonds, CDs, Eurodollar deposits, foreign currencies, and stock indexes. While physical delivery of the underlying asset is virtually never taken, under forward contracts goods are actually delivered.

d.A hedge is a transaction that lowers a firm’s risk of damage due to fluctuating stock prices, interest rates, and exchange rates. A natural hedge is a transaction between two counterparties where both parties’ risks are reduced. The two basic types of hedges are long hedges, in which futures contracts are bought in anticipation of (or to guard against) price increases, and short hedges, in which futures contracts are sold to guard against price declines. A perfect hedge occurs when the gain or loss on the hedged transaction exactly offsets the loss or gain on the unhedged position. A symmetric hedge is one that protects against both upward and downward price changes. Futures contracts are frequently used for symmetric hedges. An asymmetric hedge protects against one direction price change more than the other. This type of hedge looks like insurance, hedging against a loss but not compromising a gain. Options are frequently used for asymmetric hedges.

e.A swap is an exchange of cash payment obligations, which usually occurs because the parties involved prefer someone else’s payment pattern or type. A structured note is a debt obligation derived from another debt obligation,and permits a partitioning of risks to give investors what they want.

f.Commodity futures are futures contracts which involve the sale or purchase of various commodities, including grains, oilseeds, livestock, meats, fiber, metals, and wood.

23-2If the elimination of volatile cash flows through risk management techniques does not significantly change a firm’s expected future cash flows and WACC, investors will be indifferent to holding a company with volatile cash flows versus a company with stable cash flows. Note that investors can reduce volatility themselves: (1) through portfolio diversification, or (2) through their own use of derivatives.

23-3The six reasons why risk management might increase the value of a firm is that it allows corporations to (1) increase their use of debt; (2) maintain their capital budget over time; (3) avoid costs associated with financial distress; (4) utilize their comparative advantages in hedging relative to the hedging ability of individual investors; (5) reduce both the risks and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from fluctuating earnings.

23-4There are several ways to reduce a firm's risk exposure. First, a firm can transfer its risk to an insurance company, which requires periodic premium payments established by the insurance company based on its perception of the firm's risk exposure. Second, the firm can transfer risk-producing functions to a third party. For example, contracting with a trucking company can in effect, pass the firm's risks from transportation to the trucking company. Third, the firm can purchase derivatives contracts to reduce input and financial risks. Fourth, the firm can take specific actions to reduce the probability of occurrence of adverse events. This includes replacing old electrical wiring or using fire resistant materials in areas with the greatest fire potential. Fifth, the firm can take actions to reduce the magnitude of the loss associated with adverse events,such as installing an automatic sprinkler system to suppress potential fires. Finally, the firm can totally avoid the activity that gives rise to the risk.

23-5The futures market can be used to guard against interest rate and input price risk through the use of hedging. If the firm were concerned that interest rates will rise, it would use a short hedge, or sell financial futures contracts. If interest rates do rise, losses on the issue due to the higher interest rates would be offset by gains realized from repurchase of the futures at maturity--because of the increase in interest rates, the value of the futures would be less than at the time of issue. If the firm were concerned that the price of an input will rise, it would use a long hedge, or buy commodity futures. At the future's maturity date, the firm will be able to purchase the input at the original contract price, even if market prices have risen in the interim.

23-6Swaps allow firms to reduce their financial risk by exchanging their debt for another party's debt, usually because the parties prefer the other's debt contract terms. There are several ways in which swaps reduce risk. Currency swaps, where firms exchange debt obligations denominated in different currencies, can eliminate the exchange rate risk created when currency must first be converted to another currency before making scheduled debt payments. Interest rate swaps, where counterparties trade fixed-rate debt for floating rate debt, can reduce risk for both parties based on their individual views concerning future interest rates.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

23-1If Zhao issues fixed rate debt and then swaps, its net cash flows will be: −7% + 6.8% − LIBOR = −(LIBOR + 0.2%).

23-2The price of the hypothetical bond is $1,000(89 + 8/32)/100 = $892.50. Using a financial calculator, we can solve for rd as follows:

N = 40; PV = -892.50; PMT = 30; FV = 1000; solve for I/YR = 3.504. The annual value of rdis 3.504% 2  7.01%.

23-3Futures contract settled at 100 16/32% of $100,000 contract value, so PV = 1.005  $1,000 = $1,005  100 bonds = $100,500. Using a financial calculator, we can solve for rd as follows:

N = 40; PV = -1005; PMT = 30; FV = 1000; solve for I = rd = 2.9784%  2 = 5.9569%  5.96%.

If interest rates increase to 6.9569%, then we would solve for PV as follows: N = 40; I = 6.9569/2 = 3.47845; PMT = 30; FV = 1000; solve for PV = $897.4842  100 = $89,748.42. Thus, the contract’s value has decreased from $100,500 to $89,748.42.

23-4If Carter issues floating rate debt and then swaps, its net cash flows will be: -(LIBOR + 2%) – 7.95% + LIBOR = -9.95%. This is less than the 10% rate at which it could directly issue fixed rate debt, so the swap is good for Carter.

If Brence issues fixed rate debt and then swaps, its net cash flows will be: -11% + 7.95% - LIBOR = -(LIBOR + 3.05%). This is less than the rate at which it could directly issue floating rate debt (LIBOR + 3.1%), so the swap is good for Brence.

23-5a.In this situation, the firm would be hurt if interest rates were to rise by June, so it would use a short hedge, or sell futures contracts. Since futures maturing in June are selling for 95 17/32 of par, and futures contracts are for $100,000 in Treasury bonds, the value of 1 contract is $95,531.25. This means the firm must sell 10,000,000/ $95,531.25 = 104.678 ≈ 105 contracts to cover the planned $10,000,000 June bond issue. Should interest rates rise by June, Zinn Company will be able to repurchase the futures contracts at a lower cost, which will help offset their loss from financing at the higher interest rate. Thus, the firm has hedged against rising interest rates.

b.The firm would now pay 13 percent on the bonds. With an 11 percent coupon rate, the bond issue would bring in only $8,585,447.31:

N = 40; I = 13/2 = 6.5; PMT = −0.11/2  10,000,000 = −550000; FV = −10000000; and solve for PV = $8,585,447.31.

The firm would lose $10,000,000 − $8,585,447.31= $1,414,552.69 on the bond issue.

However, the firm will make money on its futures contracts. The implied yield at the time the futures contracts were entered is found by inputting N = 40; PMT = 3000; FV = 100000; PV = -95531.25; solving for I/YR = 3.199616% per six months. The nominal annual yield is 2(3.199616%) = 6.399232%. (Note that the futures contracts are on hypothetical 20-year, 6 percent semiannual coupon bonds which are yielding 6.399232%.)

Now, if interest rates increased by 200 basis points, to 8.399232%, the value of each futures contract will drop to $76,945.56, found by inputting N = 40; I = 8.399232/2 = 4.199616; PMT = −3000; FV = −100000; and solving for PV = $76,945.56.

The value of all of the futures contracts will drop to $76,945.56(105) = $8,079,283.80.

However, the value of the short futures position began at $95,531.25(105) = $10,030,781.25. Since Zinn Company sold the futures contracts for $10,030,781.25, and will, in effect, buy them back at $8,079,283.80, the firm would make a $10,030,781.25 - $8,079,283.80 = $1,951,497.45 profit on the transaction ignoring transaction costs.

Thus, the firm gained $1,951,497.45on its futures position, but lost $1,414,552.69on its underlying bond issue. On net, it gained $1,951,497.45- $1,414,552.69= $536,944.76.

c.In a perfect hedge, the gains on futures contracts exactly offset losses due to rising interest rates. For a perfect hedge to exist, the underlying asset must be identical to the futures asset. Using the Zinn Company example, a futures contract must have existed on Zinn's own debt (it existed on Treasury bonds) for the company to have an opportunity to create a perfect hedge. In reality, it is virtually impossible to create a perfect hedge, since in most cases the underlying asset is not identical to the futures asset.

SOLUTION TO SPREADSHEET PROBLEM

23-6The detailed solution for the spreadsheet problem, Ch23 P06 Build a ModelSolution.xls, is available on the textbook’s Web site.

Answers and Solutions: 23 - 1

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MINI CASE

Assume that you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that specializes in creating exotic sauces from imported fruits and vegetables. The firm's CEO, Bill Stooksbury, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the pressing need for smaller companies to institute corporate risk management programs. Since no one at Tennessee Sunshine is familiar with the basics of derivatives and corporate risk management, Stooksbury has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and corporate risk management and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

a.Why might stockholders be indifferent whether or not a firm reduces the volatility of its cash flows?

Answer:If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Also, if a company decided to hedge away the risk associated with the volatility of its cash flows, the company would have to pass on the costs of hedging to the investors. Sophisticated investors can hedge risks themselves and thus they are indifferent as to who actually does the hedging.

b.What are six reasons risk management might increase the value of a corporation?

Answer:There are no studies proving that risk management either does or does not add value. However, there are six reasons why risk management might increase the value of a firm. Risk management allows corporations to (1) increase their use of debt; (2) maintain their capital budget over time; (3) avoid costs associated with financial distress; (4) utilize their comparative advantages in hedging relative to the hedging ability of individual investors; (5) reduce both the risks and costs of borrowing by using swaps; and (6) reduce the higher taxes that result from fluctuating earnings.

c.What is COSO? How does COSO define enterprise risk management?

Answer:The Committee of Sponsoring Organizations of the Treadway Commission, is a group of private accounting firms that put together a framework for internal control systems to prevent accounting fraud. They extended this framework to include enterprise risk management (ERM) and define ERM as “a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” (We added italics for emphasis.) .

Here are some key points. ERM is an ongoing process, not something a company does once and then is finished. ERM requires involvement from the board, to executives, to managers, to workers. It is broad, and includes strategic choices as well as operating tactics. It is applied at all levels in the organization, from the corporate level all the way to the individual operating units. Its steps include risk identification risk, risk assessment, and risk responses. The company must explicitly articulate its tolerance for risk, which is called its risk appetite. There must be a reliable and timely reporting and monitoring system.

d.Describe the eight components of the COSO ERM framework.

Answer:The COSO ERM framework has eight components.

1.Internal environment. This includes the company’s mission, culture, and risk appetite.

2. Objective setting. Explicit objectives must be set at all levels in organization.

3.Risky event identification. An event is something that affects the achievement of an objective.

4.Risky event assessment. How likely is the event and how bad could it be?

5.Risky event responses. These include prevention and should correspond with the previously identified risk appetite. Responses should consider the portfolio of risky events and not just each event in isolation.

6.Control activities. These are ways to ensure that people apply the previously identified responses. Control activities includehandbooks, guidelines, policies, etc.

7.Information & Communication. A successful ERM system requires reliable and timely information regarding risk events and responses.

8.Monitoring.

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e.Describe some of the risks events within the following major categories of risk:

Answer:1.Strategy and reputation. A company’s strategic choices simultaneously influence and respond to its competitors’ actions, corporate social responsibilities, the public’s perception of its activities, and its reputation among suppliers, peers, and customers.

2.Control and compliance. This category includes risk events related to regulatory requirements, litigation risks, intellectual property rights, reporting accuracy, and internal control systems

3.Hazards.These include fires, floods, riots, acts of terrorism, and other natural or man-made disasters.

4.Human resources. These addresses risk events related to employees, including recruiting, succession planning, employee health, and employee safety.

5.Operations. Risk events include supply chain disruptions, equipment failures, product recalls, and changes in customer demand.

6.Technology. These include risk events related to innovations, technological failures, and IT reliability and security

7.Financial management.This category includes risk events related to (1) foreign exchange risk, (2) commodity price risk, (3) interest rate risk, (4) project selection risk (including major capital expenditures, mergers, and acquisitions), (5) liquidity risk (the risk of not having access to financing when needed), (6) customer credit risk, and (7) portfolio risk (the risk that a portfolio of financial assets will decrease in value).

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f.What are some actions that companies can take to minimize or reduce risk exposures?

Answer:There are several actions that companies can take to minimize or reduce their risk exposure. First, companies can transfer risk to an insurance company by paying periodic premiums. Second, companies can transfer functions that produce risk to third parties, such as eliminating risks associated with transportation by contracting with a trucking company. Third, purchase derivatives contracts to reduce input and financial risk. Fourth, companies can take actions to reduce the probability of occurrence of an adverse event, such as replacing old wiring to reduce the possibility of fire. Fifth, actions can be taken to reduce the magnitude of the loss associated with adverse events, such as installing automatic sprinkler systems. Finally, companies can simply avoid the activities that give rise to risk.

g.What are forward contracts? How can they be used to manage foreign exchange risk?

Answer:A forward contract is an agreement between two parties. One party agrees to sell a specified item at a specified price on a specified date, and the other party agrees to purchase the item under the same terms

If a company knows it is going to have a future cash flow denominated in a different currency, it can use a forward contract to lock in a price. For example, suppose a U.S. retailer is going to import ¥1 million of electronic games from Japan and the current exchange rate is 70 yen per dollar. The company might be able to take a position in a forward contract to buy one million yen at 70 yen per dollar. This locks in the dollar cost of the purchase.

Banks often act as the counterparty in forward contracts.

h.Describe how commodity futures markets can be used to reduce input price risk.

Answer:Futures markets involve contracts that call for the purchase or sale of a financial (or real) asset at some future date, but at a price which is fixed today.

Futures are similar to forwards, except futures require daily marking-to-market, futures cover many more types of assets (agriculture, livestock, metals, indexes, currencies, interest rates, energy), and futures are standardized contracts that trade on exchanges, such as CBO.

Thus, these markets provide the opportunity to reduce financial risk exposure.

Essentially, the purchase of a commodity futures contract will allow a firm to make a future purchase of the input material at today's price, even if the market price on the good has risen substantially in the interim.