MANAGING RISK

Events outside the control of a corporation can affect the firm and its financing decisions. For example, a change in the interest rate can suddenly make borrowing money very inexpensive or very costly. From 1975 to 1995, interest rates in the United States were as high as 15 percent and as low as 3 percent. Many economic factors, such as changes in the price of oil or the price of foreign currency, can affect businesses as well.
Corporate financial managers need to make sure that potential economic fluctuations do not threaten the firm. A variety of tools, known as derivatives, help manage the risk of such events occurring. Four important kinds of derivatives include (1) futures, (2) forwards, (3) options, and (4) swaps. Futures are promises to buy or sell something in the future at a price that is agreed upon today. For example, a candy manufacturer might commit to purchasing a specified quantity of cocoa at a specified price from the producer in six months. Futures are traded on organized futures exchanges, such as the Chicago Mercantile Exchange or the Chicago Board of Trade. Forwards are similar to futures, but they are arranged directly between a firm and a bank. Options give a firm the right to buy or sell something in the future at a price that is agreed upon today. For example, if the candy-manufacturer does not know how much cocoa will be needed in six months, it could take out an option to buy cocoa at a certain price. Swaps involve firms swapping one set of payments for another. For example, an American firm may agree to make a series of dollar payments to a Japanese bank, while the bank in return promises to make a series of yen payments.
Derivatives are very popular. For example, worldwide trading of futures amounts to about $35 trillion a year. Most firms use derivatives to reduce risk, but some use them to speculate by buying and selling derivatives in hopes of earning a profit. When these speculations don't work out, losses can be substantial. For example, the United Kingdom's Barings', one of the world's oldest banks, collapsed in 1995 when futures speculation by one of its traders in Singapore resulted in losses of over $1 billion.
Methods of corporate finance continually evolve as financial managers invent new ways to raise money and avoid risk. Smart investment and financing decisions are crucial to a firm's success.

Source : Microsoft ® Encarta ® 2006.