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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A firm's operating cash flow next year is 50 million with probability 0.5 and 90 million with probability 0.5. Financial distress costs of 20 million are incurred whenever cash flow is below 60 million. A forward hedge fixes the cash flow at 70 million for certain, with a hedging cost of 2 million deducted. Ignoring discounting and taxes, what is the expected change in cash flow after distress costs from hedging?</br>

Hedging raises expected net cash flow by 8 million. Unhedged value is 70 minus expected distress cost of 10, or 60. Hedged value is 70 minus the 2 million hedging cost, or 68, with no distress. The difference is 8 million.

  1. AIncrease of 8 millionCorrect
  2. BIncrease of 10 million
  3. CIncrease of 12 million
  4. DIncrease of 6 million

Explanation

Unhedged: expected cash flow is 70, less expected distress cost 0.5 x 20 = 10, giving 60. Hedged: 70 - 2 = 68 with no distress. Change is 68 - 60 = +8 million. Ignoring the hedge cost gives 10, which is the key distractor error.

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