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Fundamentals of Corporate Finance

Stephen A. Ross; Randolph W. Westerfield; Bradford D. Jordan

Chapter 23

ENTERPRISE RISK MANAGEMENT - all with Video Answers

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Chapter Questions

Problem 1

If a firm is selling futures contracts on lumber as a hedging strategy, what must be true about the firm's exposure to lumber prices?

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03:37

Problem 2

If a firm is buying call options on pork belly futures as a hedging strategy, what must be true about the firm's exposure to pork belly prices?

Jennifer Stoner
Jennifer Stoner
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Problem 3

What is the difference between a forward contract and a futures contract? Why do you think that futures contracts are much more common? Are there any circumstances under which you might prefer to use forwards instead of futures? Explain.

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04:57

Problem 4

Bubbling Crude Corporation, a large Texas oil producer, would like to hedge against adverse movements in the price of oil because this is the firm's primary source of revenue. What should the firm do? Provide at least two reasons why it probably will not be possible to achieve a completely flat risk profile with respect to oil prices.

Yang Su
Yang Su
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00:31

Problem 5

A company produces an energy-intensive product and uses natural gas as the energy source. The competition primarily uses oil. Explain why this company is exposed to fluctuations in both oil and natural gas prices.

Niamat Khuda
Niamat Khuda
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Problem 6

If a textile manufacturer wanted to hedge against adverse movements in cotton prices, it could buy cotton futures contracts or buy call options on cotton futures contracts. What would be the pros and cons of the two approaches?

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Problem 7

Explain why a put option on a bond is conceptually the same as a call option on interest rates.

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01:29

Problem 8

A company has a large bond issue maturing in one year. When it matures, the company will float a new issue. Current interest rates are attractive, and the company is concerned that rates next year will be higher. What are some hedging strategies that the company might use in this case?

Rashmi Sinha
Rashmi Sinha
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Problem 9

Explain why a swap is effectively a series of forward contracts. Suppose a firm enters into a swap agreement with a swap dealer. Describe the nature of the default risk faced by both parties.

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03:06

Problem 10

Suppose a firm enters into a fixed-for-floating interest rate swap with a swap dealer. Describe the cash flows that will occur as a result of the swap.

Jennifer Stoner
Jennifer Stoner
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Problem 11

What is the difference between transactions and economic exposure? Which can be hedged more easily? Why?

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02:03

Problem 12

If a U.S. company exports its goods to Japan, how would it use a futures contract on Japanese yen to hedge its exchange rate risk? Would it buy or sell yen futures? In answering, assume that the exchange rate quoted in the futures contract is quoted as dollars per yen.

Pragya Ahuja
Pragya Ahuja
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Problem 13

For the following scenarios, describe a hedging strategy using futures contracts that might be considered. If you think that a crosshedge would be appropriate, discuss the reasons for your choice of contract.
a. A public utility is concerned about rising costs.
b. A candy manufacturer is concerned about rising costs.
c. A corn farmer fears that this year's harvest will be at record high levels across the country.
d. A manufacturer of photographic film is concerned about rising costs.
e. A natural gas producer believes there will be excess supply in the market this year.
f. A bank derives all its Page 787 income from long-term, Pag fixed-rate residential mortgages.
g. A stock mutual fund invests in largecompany blue-chip stocks and is concerned about a decline in the stock market.
h. A U.S. importer of Swiss Army knives will pay for its order in six months in Swiss francs.
i. A U.S. exporter of construction equipment has agreed to sell some cranes to a German construction firm. The U.S. firm will be paid in euros in three months.

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Problem 14

In 2009 and 2010, investment banks were under fire for interest rate swaps sold to municipalities and nonprofits. For example, California's water resource authority paid about $$\$ 305$$ million, North Carolina paid about $$\$ 60$$ million, and Harvard University paid about $$\$ 923$$ million to unwind swaps agreements. To unwind a swaps position, you make a reverse trade. For example, if you had agreed to a fixed-for-variable swap, you would enter a variable-for-fixed swap. The controversy was caused because many people felt that investment banks had taken advantage of municipalities and nonprofits. Is this argument correct? Why or why not?

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Problem 15

Suppose you own a home that costs $$\$ 200,000$$ and you buy homeowner's insurance to cover your house against fire, wind, tornados, and other disasters. One way to view your insurance is that you purchased an option. What type of option is the homeowner's policy? As the homeowner, are you buying or selling this option?

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01:00

Problem 16

With some insurance policies, the value of the asset to be replaced is the current market value. For example, if you bought a couch five years ago for $$\$ 1,000$$, and the current value of the couch is $$\$ 300$$, you would only get $$\$ 300$$ if the couch were destroyed. However, many insurance companies offer a "rider" that gives full replacement. In this case, if a comparable new couch were now $$\$ 1,200$$, you would get the full $$\$ 1,200$$ if your couch were destroyed. How would you view this rider in option terms?

AG
Ankit Gupta
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