Managing Financial Risk

We've seen that price and rate volatility have increased in recent decades. Whether or not this is a cause for concern for a particular firm depends on the nature of the firm's operations and its financing. For example, an all-equity firm would not be as concerned about interest rate fluctuations as a highly leveraged one. Similarly, a firm with little or no international activity would not be overly concerned about exchange rate fluctuations.

To effectively manage financial risk, financial managers need to identify the types of price fluctuations that have the greatest impact on the value of the firm. Sometimes these will be obvious, but sometimes they will not be. For example, consider a forest products company. If interest rates increase, then its borrowing costs will clearly rise. Beyond this, however, the demand for housing typically declines as interest rates rise. As housing demand falls, so does demand for lumber. An increase in interest rates thus leads to increased financing costs and, at the same time, decreased revenues.

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