The Impact of Derivatives on Cash Market

Revisions for the 7th edition by Eric D. Yordy, The W. A. Franke College of Business

This solutions manual provides the answers to all the review questions and end-of-chapter problems in Financial Management: Principles and Practice, by Timothy Gallagher. The answers and the steps taken to obtain the answers are shown. Readers are reminded that in finance there is often more than one answer to a question or to a problem, depending on one‘s viewpoint and assumptions. One answer is

This paper was conducted as a Discussion Board Post assigned by Professor J. Reinke of: Liberty University, Graduate School of Business, Lynchburg, Virginia 24515.

Mr. Brown readily admitted that he was not at ease discussing the most recent approaches to risk reduction or hedging. He had received his MBA from Harvard in the 1960s and had spent most of his career working for a company that had little international exposure. Moreover, he was not familiar with derivatives such as currency options, which until recently were not widely traded. However, Mr. Brown had recently hired an assistant, Mr. Dan Pross, who had some knowledge of hedging and derivatives. As a student at UCLA, Mr. Pross had traded various types of derivatives for his own portfolio and was familiar with how they were traded. Although Mr. Pross did not have a finance background, he was, in Mr. Brown’s opinion, extremely intelligent and highly capable. Mr. Brown suggested that Mr. Pross make a presentation to the senior management on the use of derivatives to reduce risk.

Derivative contracts were either negotiated with specific counterparties (over-the-counter) or were standardized contracts executed and traded on an exchange. Negotiated over-the-counter derivatives were comprised of forwards, swaps, and specialized options contracts. Over the counter derivatives can be tailored to meet the customers’ needs with respect to time and quantity and they are not traded in an organized exchange. On the other hand, standardized exchange-traded derivatives consisted of futures and options contracts. Even though over-the-counter derivatives were usually not traded like securities in an exchange, they might be terminated or assigned to an alternative counterparty. Standardized derivatives trade on an exchange and have time and quantity that are fixed.

Since the acceptance of Dozier Industries’ bid, the company CFO has been exploring the methods available to best manage the exchange risk associated with the award payment being dispersed in British Pounds (GBP). He originally considered a forward contract or a spot contract, but is now investigating how currency options could help hedge against uncertain foreign exchange exposure. The CFO needs to decide whether or not options contracts might provide some benefit to hedge the currency risk.

Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.

One must pretend to know the broad and yet differentiated world of banking and equity portfolios without bothering to actually learn about them. Use words such as ‘instability’, ‘hedging’, and ‘derivatives’ to inspire awe and trust among those who discuss these activities with you. Of utmost importance to Step Two, one must invest in only certain types of products to assure that one’s portfolio remains inflexible and susceptible to crashing.

The forward and money-market hedges are discussed in detail below. At this point, it is sufficient to acknowledge that these financial contracts do mitigate the risk. Other suggested contracts are beyond the scope of this case, but should be acknowledged.

Nestlé S.A. is a Swiss company and owns a prestigious position being the world’s leading nutrition, health and wellness group (Nestlé, 2016). According to its annual report (2015), this company is exposed to many risks caused by movements in foreign currency exchange rates, interest rate and market prices. The foreign exchange risk comes from transactions and translations of foreign operations in Swiss Francs (CHF). The interest rate risk faces the borrowings at fixed and variable rates. The market price risk comes from commodity price and equity price. The former risk arises from world commodity market for the supplies of coffee, cocoa beans, sugar and others. The later risk arises from the fluctuations of the prices of investments held. (Nestle annual reports, 2015). Thus, financial derivatives instruments are used by this multinational corporation in order to hedge these risks.

This document is authorized for use only by Albertina Dias at ISG Business School until September 2013. Copying

Brigham, Eugene F., and Joel F. Houston. Fundamentals of Financial Management. Thomson: South-Western Publishers, Eleventh Ed. 2007.

Among the most fundamental risks, associated with exchange-traded derivatives, is variable degree of risk. According to Ernst, Koziol, & Schweizer (2011), the transactions in

List of abbreviations List of tables Acknowledgements Abstract 1. 2. 3. 4. 5. 6. 7. 8. Introduction Problem statement Objectives and hypothesis of the study Literature review Structure and performance of the financial sector in

Carmen Cotei Department of Economics, Finance and Insurance University of Hartford, 200 Bloomfield Ave., West Hartford, CT, 06117, USA E-mail: cotei@hartford.edu Joseph Farhat Department of Finance Central Connecticut State University, 1615 Stanley St., New Britain, CT 06050, USA E-mail: farhatjob@ccsu.edu