Risk Transfer: Derivatives in Theory and Practice

"Derivatives are an essential weapon in the corporate arsenal for managing risk, controlling cost, and increasing shareholder value. They are not weapons of mass destruction, but rather smart bombs that can be very precisely targeted at specific risk or areas of concern. Indeed, perhaps the greatest risk of derivatives to a firm is the risk of not using them when it is appropriate to do so."

–From the Preface

The use of derivatives to manage risk dates back nearly 4,000 years. And despite the current anti-derivatives uproar–fueled by the popular press, driven by well-regarded financiers like Warren Buffett and George Soros, and accompanied by government proposals to prohibit, limit, tax, or further regulate derivatives–these irreplaceable instruments are in truth straightforward and vital to numerous financial practitioners and companies.

Risk Transfer provides a basic understanding of the driving economic theory behind derivatives and risk transfer, then examines the advanced application and implementation of derivative instruments by corporations and institutional investors. Building the book around his popular University of Chicago graduate course, Professor Christopher L. Culp explores three fundamental areas in the structure and use of derivatives:

• PART I: The Economics of Risk Transfer

  Micro and macro foundations underlying risk transfer as a financial activity, and the evolution and use of derivatives as an efficient means of transferring risk

• PART II: Derivatives Valuation and Asset Lending

  The function of derivatives as intertemporal and interspatial resource allocation markets, with discussions of related concepts including own rates of interests, the cost of carry, backwardation and contango in the term structure of futures/forward prices, basis and spread relations, and more

• PART III: Speculation and Hedging

  The role of–and risk premium paid to–speculators, how firms determine their specific objectives and hedge ratios, and how hedging is affected by and can be used to address quality and calendar basis risks

While derivatives have always been–and will always be–a necessary tool in managing exposure to financial risk, professionals must understand the entire picture before they can successfully relate to its individual components. Risk Transfer helps researchers and practitioners to fill in that picture, providing a comprehensive examination of the theoretical foundations of derivatives as risk transfer instruments along with hands-on techniques and examples of how that theory can be successfully applied to the everyday practice of financial risk management.

CHRISTOPHER L. CULP is an Adjunct Professor of Finance at the University of Chicago’s Graduate School of Business, a Principal at Chicago Partners LLC, and, during the winter academic term, a Resident Guest Professor of Risk and Insurance in the Institut für Finanzmanagement at Universität Bern in Switzerland. Culp is an active consultant to various financial and non-financial firms on risk management, financial instrument selection, and capital allocation. In addition, he is an independent non-executive Director of Idaho Power Company, Inc., and IDACORP, Inc., where he is a member of the Audit and Governance Committees of both boards, and he is a Senior Fellow in Financial Regulation with the Competitive Enterprise Institute in Washington, D.C. Culp is the author of two previous books (both published by Wiley), The ART of Risk Management and The Risk Management Process. He recently coedited for Wiley (with William Niskanen) Corporate Aftershock: The Public Policy Lessons from the Collapse of Enron and Other Major Corporations. Culp holds a PhD in finance from the Graduate School of Business of the University of Chicago and a BA in economics from the Johns Hopkins University.