Risk is an inherent part of business, and managing its potential conse

Risk is an inherent part of business, and managing its potential consequences means anticipating those events that could generate adverse and costly outcomes for an organization, while taking actions to advert and/or diminish the effects of such events. Futures contracts, forward contracts, swaps, inverse floaters and options are a group of financial instruments called derivatives that are available to hedge against financial risk. These securities are an agreement to buy or sell an asset whose value is set by the market price or interest rate of some other security. Derivatives are useful in corporate risk management, yet because they are complex, highly leveraged and complicated they can lead to significant losses if not properly exercised.

Inappropriate uses of derivatives have led to highly publicized failures. For instance, Britain’s Barings Bank, which financed America’s 1803 Louisiana Purchase, collapsed in 1995 when one of its derivatives traders lost $1.4 billion. For nearly 20 years, California’s Orange County successfully managed an investment fund that generated outstanding returns as long as interest rates declined; but when interest rates increased, the purchase of very risky derivative products resulted in the fund losing about $2 billion. Still when properly implemented, such as hedging rather than speculating to increase profits, derivatives have significant benefits, which is why a high percentage of American companies use derivatives regularly.

A particular derivative known as futures is useful for managing and reducing a variety of risks related to interest rate, stock price and exchange rate fluctuations. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines. The futures markets allow a firm to be protected against changes that occur between when a decision is made and when a transaction is completed. A firm’s risk aversion and its ability to assume the risk in consideration influence its decision to hedge, and the futures markets allow a firm flexibility in the timing of its financial transactions.

1. Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

2. According to information contained in the passage, which of following is accurately supported?

a. Derivatives are too complex to be soundly used.
b. Derivatives are one of the best financial tools available for managing the risks associated with interest rate, stock price and exchange rate variability.
c. Derivatives are beneficial to circumvent potential risks a company may face.
d. A firm needs to have flexibility in the timing of its financial transactions.
e. In spite of their pitfalls, derivatives are necessary to help a company speculate against risks

3. Which of the following statements is NOT supported about derivatives and their use?

(A) Because derivatives are complicated and highly leveraged, these financial instruments need to be carefully scrutinized.
(B) Derivatives are best implemented when a company is speculating to maximize its profits.
(C) Companies use derivatives because of their potential benefits.
(D) Many firms employ derivatives as a vehicle to manage inherent risks.
(E) Whether a firm decides to hedge may be influenced by its willingness to assume certain risks.

4. The author’s discussion of Baring Bank and Orange County is meant to

(A) Ignite continued research into the mechanism of derivatives
(B) Provide supporting evidence of the controversy surrounding derivatives
(C) Demonstrate the potential risks of using derivatives
(D) Advocate the application of derivatives in spite of the financial fallouts some companies have experienced
(E) Refute the conclusions some may have on not using derivatives

5. Which of the following best states the passage’s primary intention?

(A) Derivatives, while useful, can be financially detrimental to a firm if mismanaged.
(B) Risk management is an important ingredient for running a successful business.
(C) Futures are a most potent financial vehicle in managing a firm’s risk.
(D) If used properly, derivatives can be an important tool in the art of risk management.
(E) Interest rate, stock price and exchange rate fluctuations present viable risks to any corporation.