Summary And Conclusions

This chapter has introduced some of the basic principles of financial risk management and financial engineering. The motivation for risk management and financial engineering stems from the fact that a firm will frequently have an undesirable exposure to some type of risk. This is particularly true today because of the increased volatility in key financial variables such as interest rates, exchange rates, and commodity prices.

We describe a firm's exposure to a particular risk with a risk profile. The goal of financial risk management is to alter the firm's risk profile through the buying and selling of derivative assets such as futures contracts, swap contracts, and options contracts. By finding instruments with appropriate payoff profiles, a firm can reduce or even eliminate its exposure to many types of risk.

Hedging cannot change the fundamental economic reality of a business. What it can do is allow a firm to avoid expensive and troublesome disruptions that might otherwise result from short-run, temporary price fluctuations. Hedging also gives a firm time to react and adapt to changing market conditions. Because of the price volatility and rapid economic change that characterize modern business, intelligently dealing with volatility has become an increasingly important task for financial managers.

There are many other option types available in addition to those we have discussed, and more are created every day. One very important aspect of financial risk management that we have not discussed is that options, forwards, futures, and swaps can be

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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