Summary

Risk arises due to uncertainty. The future is unpredictable. One job of the financial manager is to manage the risks of both cash inflows and cash outflows. Investors are risk-averse. The riskier a firm’s cash flows are, the higher the rate of return investors require to provide capital to the company.

Companies do not know how much they will have to pay for raw materials in future months. The price of raw materials will change as economic conditions change, impacting a company’s cost of goods sold and profits. Some ways that a company can hedge this risk are through vertical integration, long-term contracts, and futures contracts.

Exchange rates are unpredictable. This leads to transaction risk, translation risk, and economic risk as currency values change. A forward contract is an agreement between two parties to make an exchange at a particular rate on a given date in the future. Companies can use options to mitigate the risks. A call option gives the holder the right, but not the obligation, to purchase an underlying asset. A put option give the holder the right, but not the obligation, to sell an underlying asset.

When interest rates increase, the present value of future cash flows decreases. Duration is a measure of interest rate risk. A swap involves two parties agreeing to exchange something, often specified payment streams.