Reducing Risk Exposure

Fluctuations in the price of any particular good or service can have very different effects on different types of firms. Going back to wheat prices, we now consider the case of a food processing operation. The food processor buys large quantities of wheat and has a risk profile like that illustrated in Figure 23.6. As with the agricultural products firm, the value of this firm is sensitive to wheat prices, but, because wheat is an input, increases in wheat prices lead to decreases in firm value.

Both the agricultural products firm and the food processor are exposed to wheat price fluctuations, but any fluctuations have opposite effects for the two firms. If these two firms get together, then much of the risk can be eliminated. The grower and the processor can simply agree that, at set dates in the future, the grower will deliver a certain quantity of wheat, and the processor will pay a set price. Once the agreement is signed, both firms will have locked in the price of wheat for as long as the contract is in effect, and both of their risk profiles with regard to wheat prices will be completely flat during that time.

We should note that, in reality, a firm that hedges financial risk usually won't be able to create a completely flat risk profile. For example, our wheat grower doesn't actually risk profile

A plot showing how the value of the firm is affected by changes in prices or rates.

Erisk is an online publication dealing with risk management (www.erisk.com).

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

23. Risk Management: An Introduction to Financial Engineering

© The McGraw-Hill Companies, 2002

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