A. Define the term risk management.

B. A firms cash flows are risky for several reasons. Identify and discuss five sources of risk or volatility in firm cash flows.

C. The Specialty Chemical Company operates a crude oil refinery located in New Iberia, Louisiana. The company refines crude oil and sells the by-products to companies that make plastic bottles and jugs. The firm is currently planning for its refining needs for one year hence. Specifically, the firms analysts estimate that Specialty will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feedstock for its refining needs for the coming year. The 1 million barrels of crude oil will be converted into by- products at an average cost of $40 per barrel, and Specialty expects to sell these by-products for $170 million, or $170 per barrel of crude oil used. The current spot price of oil is $125 per barrel, and Specialty has been offered a forward contract by its investment banker that will allow it to purchase the needed oil in one year for a delivery price of $130 per barrel.

1- Ignoring taxes, what will Specialtys profits be if oil prices in one year are as low as $110 and as high as $150, if the firm does not enter the forward contract?

2- If the firm does enter the forward contract, demonstrate how this effectively locks in the firms cost of fuel today, thus hedging the risk that fluctuating crude oil prices pose for the firms profits for the next year.