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Managing Financial Risk 24.2

• Hedging (immunization) – Reducing a firm’s exposure to price or rate fluctuations

• Derivative – A financial asset that represents a claim to another asset. It derives its value from that other asset

• Instruments have been developed to hedge the following types of volatility• Interest Rate• Exchange Rate• Commodity Price

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Risk Profiles

• Basic tool for identifying and measuring exposure to risk

• Graph showing the relationship between changes in price versus changes in firm value

• Similar to graphing the results from a sensitivity analysis

• The steeper the slope of the risk profile, the greater the exposure and the more a firm needs to manage that risk

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Figure 24.1 – Risk Profile for a Wheat Grower

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Figure 24.2 – Risk Profile for a Wheat Buyer

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Reducing Risk Exposure

• The goal of hedging is to lessen the slope of the risk profile

• Hedging will not normally reduce risk completely• Only price risk can be hedged, not quantity

risk• You may not want to reduce risk completely

because you miss out on the potential upside as well

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Timing

• Short-run exposure (transactions exposure) – can be managed in a variety of ways

• Long-run exposure (economic exposure) – almost impossible to hedge, requires the firm to be flexible and adapt to permanent changes in the business climate

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