Chapter

In September 1998, EquiCredit, provider of home equity loans, sold $746 million in bonds backed by home equity loans, meaning that the income from a portfolio of home loans would be used to make the payments on the bonds. However, EquiCredit had a problem with this sale. Investors purchasing the securities wanted a floating-rate investment, while the bulk of the home equity loans backing the bonds carried fixed rates. To reduce its risk and complete the transaction, EquiCredit acted to convert its variable-rate securities into fixed-rate by entering into what is known as an interest rate swap. In such a deal, one firm essentially exchanges, or "swaps," interest payments with another. As we will see in this chapter, such agreements are just one of the tools used by firms to manage risk.

Since the early 1970s, prices for all types of goods and services have become increasingly volatile. This is a cause for concern because sudden and unexpected shifts in prices can create expensive disruptions in operating activities for even very well run firms. As a result, firms are increasingly taking steps to shield themselves from price volatility through the use of new and innovative financial arrangements.

The purpose of this chapter is to introduce you to some of the basics of financial risk management. The activities we discuss here are on the frontier of modern, real-world financial management. By describing one of the rapidly developing areas in corporate finance, we hope to leave you with a sense of how the art and practice of financial management evolve in response to changes in the financial environment.

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