Risk Management & Financial Derivatives | Chapter 27 – Principles of Corporate Finance (14th)

This chapter from Principles of Corporate Finance provides a comprehensive analysis of how corporations manage risk through the use of financial contracts, operating on the premise that while risk cannot be eliminated, it can be strategically transferred to other parties better suited to bear it. The discussion begins by challenging the theoretical notion that risk management is irrelevant in perfect markets, arguing instead that real-world factors such as the high costs of financial distress, potential tax benefits, and the need to align managerial incentives provide compelling reasons for firms to hedge. The text systematically examines the primary tools for risk transfer, starting with insurance, where companies pool risks to protect against specific hazards, though they must contend with economic frictions like administrative costs, adverse selection, and moral hazard. A major focus is placed on derivative instruments, distinguishing between forward contracts, which are private agreements to buy or sell assets at a future date, and futures contracts, which are standardized products traded on exchanges that utilize margin accounts and daily marking to market to virtually eliminate counterparty risk. The chapter explains the pricing mechanics of these instruments, detailing the relationship between spot prices, interest rates, storage costs, and convenience yields, and defines market conditions such as contango and backwardation. The utility of financial options is also highlighted, showing how they offer companies a way to establish a floor on losses without sacrificing the potential for gains, unlike forwards which lock in a specific price. The text explores the vast market for swaps, particularly interest rate swaps and currency swaps, which allow firms to exchange cash flow obligations, such as trading fixed-rate debt payments for floating-rate ones, to better match their revenue streams or financing strategies. Practical implementation of these hedging strategies is covered in depth, introducing the calculation of the hedge ratio or delta to determine the optimal position size, and addressing the challenge of basis risk that arises when the hedging instrument does not perfectly correlate with the underlying exposure. Furthermore, the chapter details duration hedging as a technique to immunize portfolios against interest rate fluctuations by matching the duration of assets and liabilities, noting that such hedges often require dynamic rebalancing. The chapter concludes by differentiating between prudent risk management and dangerous speculation, warning that while derivatives are powerful tools for stability, they require robust internal controls and governance to prevent unauthorized trading and catastrophic financial losses.


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