FE 535: Introduction to Financial Risk Management Final Term Review April 29, 2020

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FE 535: Introduction to Financial Risk Management Final Term Review Majeed Simaan April 29, 2020 Abstract The following is a list of review questions along with answers and explanation. The quest... ions are mainly from Jorion’s textbook along with FRM’s past exams. Introduction to Derivatives 1. By reducing the risk of financial distress and bankruptcy, a firm’s use of derivatives contracts to hedge its cash flow uncertainty will: (a) Lower its value due to the transaction costs of derivatives trading. (b) Enhance its value since investors cannot hedge such risks by themselves. (c) Have no impact on its value as investors can costlessly diversify this risk. (d) Have no impact as only systematic risks can be hedged with derivatives. Answer B Explanation In perfect market, the level of debt that the company incurs is irrelevant. This is known as the irrelevance theory by Modigliani and Miller - see Chapter 1.5 from the textbook. However, marker are not perfect and frictions do exist in reality. Hence, the more debt the company has the more likely it would default. As a result, to encourage investors to lend money, the company has to deliver higher returns. Hence, it is more costly for the company to raise capital. The company, therefore, tries to mitigate such distress to encourage investors finance the company’s operation. To gain the trust of the investors, the firm can hedge uncertainty about its cash flows and deliver the needed compensation, mitigating possible large losses in the future and, hence, avoid bankruptcy. Therefore, by reducing the cash flow volatility, firms can decrease the expected financial distress, thereby enhancing the present value of expected future cash flows. This is line with answer B. Answer A implies its costly to trade derivatives. If the company engages in speculation, then writing option, for instance, can be costly. Nonetheless, longing futures, which are liquid and traded on [Show More]

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