1 - Internal Control Frameworks Flashcards

1
Q

COSO issued the “internal Control - Integrated Framework” to assist organizations do what?

A

develop comprehensive assessments of IC effectiveness

This framework is also often referred to as “the framework”

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2
Q

How does the principles-based approach support an effective system o internal control under the COSO framework?

A

An EFFECTIVE system of IC requires the use of judgment in determining the sufficiency of controls, applying the proper controls, and assessing the effectiveness of the system of controls.

The principles-based approach of the COSO framework emphasizes the importance of MGT JUDGMENT

MS: One framework for controls does not fit all companies because every company is different (i.e. in size, its business, process, etc), and as such mgt must use judgment

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3
Q

Define “internal control”

A

a process that is designed and implemented by an organization’s management, board of directors, and other employees to provide REASONABLE ASSURANCE that the organization will achieve its OPERATING, REPORTING, and COMPLIANCE objectives

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4
Q

What are the objectives of internal controls

A
  1. financial Reporting
  2. effective & efficient Operations
  3. Compliance with laws & regulations
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5
Q

What is comprised in the “COSO Cube”

A

ORC - 3 main objectives
CRIME - 5 I/C components
Organizational structure

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6
Q

Describe the Operations objective

A

relates to the effectiveness and efficiency of an entity’s operations.

Want to ensure the assets of the org. are adequately safeguarded against potential losses

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7
Q

Describe the Reporting objective

A

pertains to the RELIABILITY, TIMELINESS, and TRANSPARENCY of an entity’s external & internal financial AND nonfinancial reporting as established by regulators

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8
Q

Describe the Compliance objective

A

established to ensure the entity is adhering to all applicable laws and regulations

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9
Q

What are the five components of internal control

A
Control environment
Risk assessment
Information & communication
Monitoring Controls
Existing Control activities

“CRIME”

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10
Q

What things are needed in order to achieve the 3 objectives of I/C?

A

ALL 5 components (CRIME) and the 17 principles that are relevant to be both PRESENT & FUNCTIONING

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11
Q

Describe Control Environment

A

Tone at the top - ethics

includes the processes, structures, and standards that provide the foundation for an entity to establish a system of I/C.

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12
Q

What are the principles related to Control Environment?

A

“EBOCA”

  1. Commitment to ETHICS & Integrity — establish standards/code of conduct
  2. Board Independence & Oversight — independent and knowledgeable
  3. Organizational Structure — reporting lines, the authority and responsibilities are all appropriate
  4. Commitment to Confidence — there is a commitment to hire, develop, and retain competent employees
  5. Accountability — establish performance measures, incentives, and rewards without excessive pressure
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13
Q

Describe Risk Assessment

A

an entity’s identification and analysis of risk to the achievement of its objectives

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14
Q

What principles are related to Risk Assessment

A

Make an entity “SAFR”

  1. Specify objectives — identify and assess risks related to those (not achieving ) objectives
  2. Identify and ASSESS Changes — the org identifies and assesses changes that could significantly affect I/C such as change in external environment, business model, and leadership
  3. Consider potential for FRAUD — assess fraud triangle
  4. Identify and analyze RISKS — determine how risks should me managed (Enterprise Risk Management)
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15
Q

Describe the Information & Communication component

A

these systems support the identification, capture, and exchange of information (b/t internal and external parties) in a timely and useful manner.

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16
Q

List the principles included in Information and Communication

A

“OIE”

  1. Obtain and use information — obtains or generates and uses RELEVANT, HIGH QUALITY information to support functioning of IC
  2. Internally communicate information – information necessary to support functioning of I/C is communicated in a flow of information up, down, and across the organization
  3. Communicate with external parties — two way external communication channels using a variety of methods and channels (i.e. CPA firm or consultants)
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17
Q

Describe Monitoring Activities

A

process of assessing the quality of I/C performance over time by assessing the design and operation of controls on a timely basis and taking the necessary corrective actions

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18
Q

What principles relate to Monitoring Activities

A

“SOD”

  1. SO = Ongoing and/or Separate Evaluations — on whether the comoponent’s of I/C are present and functioning (the frequency of testing is dictated by RISK)
  2. Communication of deficiencies —report deficiencies in a timely manner and make sure corrective action is taken
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19
Q

Describe Existing Control Activities

A

the controls set forth by an entity’s policies and procedures to ensure that the directives initiated by mgt to mitigate risks are performed

Control activities may be detective or preventive

Segregation of duties is usually a big one

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20
Q

What principles relate to Existing Control Activities

A

“CAT PP”

  1. Select and develop CONTROL ACTIVITIES
  2. Select and develop TECHNOLOGY controls
  3. Deployment of POLICIES & PROCEDURES
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21
Q

Define present and functioning

A

present - included in the design and implementation of the I/C

functioning - operating as designed in the I/C system

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22
Q

What specific requirements must I/C have in order to be considered and EFFECTIVE SYSTEM?

A

Senior mgt and the board must have reasonable assurance that the entity:

  1. achieves effective and efficient operations
  2. complies with all applicable rules, regulations, laws, etc.
  3. prepares reports that are in conformity with the entitiy’s reporting objectives and standards.
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23
Q

What results when there is an ineffective I/C

A

= greater risk that ORC is not achieved

GAAS uses the terms “material weakness” and “Significant deficiency”

COSO uses the term “major deficiency”

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24
Q

Describe a “major deficiency” and what results if one exists

A

represents a material I/C deficiency that significantly reduces the likelihood that an organization can achieve its objectives

if identified, the entity may NOT conclude that it has met the requirements for an effective I/C system under the COSO framework

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25
Q

List some inherent I/C limitations

A
human failure
faulty or biased judgment
external events
collusion
mgt override
suitability of entity objectives
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26
Q

What is comprised in applying the internal control framework

A
  1. manage application
  2. evaluate effectiveness
  3. deficiency assertions
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27
Q

How will mgt use the COSO framework to document its IC assessment

A

“COPS”
Follow these steps:

Overall assessment
(which are supported by..)
Component evaluations (which are supported by…)
Principal evaluations (which serve as the source for isolating and defining internal control deficiencies)
Summary of IC deficiencies (if any)

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28
Q

What are the common risks normally identified using the COSO framework

A

material omission
fraud
mgt override of controls
illegal acts

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29
Q

What is the underlying premise of ERM

A

the underlying premise of ERM is that every entity exists to provide value for stakeholders and that all entities face risk in the pursuit of value for their stakeholders.

value = increased stock price and/or pay dividends

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30
Q

Define “risk” according to COSO

A

Risk is the possibility that events will occur and affect the achievement of strategy and business objectives

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31
Q

How is value developed

A

“CPER”

creation
preservation
erosion (don’t want this)
realization

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32
Q

Describe value creation

A

your benefit has to exceed your resource costs

ROIC > Cost of Capital
+NPV

need to create a profit

costs = people, financial capital, technology, process and brand and value must outweigh this

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33
Q

Describe value preservation

A

want to have SUSTAINABLE operating profit (not a one time deal, ongoing)

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34
Q

Describe value erosion

A

we don’t want the value of the business to go down (i.e when cost > benefit)

stock price goes down

ROIC < cost/hurdle rate

-NPV

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35
Q

Describe value realization

A

when benefits are received by stakeholders either monetary or nonmonetary in form

Dividends or stock price/capital gain
Customer satisfaction

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36
Q

Describe mission

A

represents the CORE PURPOSE of the entity. Represents the WHY the company exists and what it hopes to accomplish

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37
Q

Describe vision

A

represents the aspirations of the entity and WHAT it hopes to achieve over time (

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38
Q

Describe core values

A

represent an organization’s beliefs and ideals about what is good or bad

the HOW the org plans to achieve goals (ethics, culture, core values)

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39
Q

What elements are included in Enterprise Risk Managment

A

CCPIS

Culture
Capabilities (competitive advantage)
Practices
Integration with strategy setting and performance

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40
Q

Describe culture as it relates to ERM

A

represents COLLECTIVE THINKING of the people within an org.

Culture plays an important role in SHAPING DECISIONS regarding risk

correlate with core values

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41
Q

Describe capabilities as it relates to ERM

A

Competitive advantage

produces value for an entity

exploitation of competitve advantage and adaptation to change are skill sets embedded within ERM

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42
Q

Describe practices as it relates to ERM

A

continually applied at all levels of the entity (not just the board or officers, the entire entity)

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43
Q

Describe integration with strategy setting and performance as it relates to ERM

A

Why do you exist? Ie what is your mission?
&
What’s your vision? strategy?

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44
Q

Describe risk appetite

A

represents the types and amounts of risk, on a broad level, than an organization is willing to accept in pursuit of value
it’s a range rather than a specific limit and provides guidance encouraging a firm to pursue or not pursue certain endeavors

expressed first in mission and vision

varies between products, business units, or over time

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45
Q

what is the relationship of value and risk appetite

A

directly related

Greater the risk, greater the expected return

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46
Q

What is the application of ERM intended to do?

A

provide management with a REASONABLE EXPECTATION of success

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47
Q

Define risk inventory

A

all risk that could impact an entity

could be societal, economic, demographic, or legal risk etc

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48
Q

Define reasonable expectation as it relates to ERM

A

the amount of risk of having strategy and business objectives that is appropriate for an entity, recognizing that no one can predict risk with precision

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49
Q

Define risk profile

A

a composite view of the risk assumed at a PARTICULAR level of the entity or aspect of the business (product line, geographic area, customer) to consider the TYPES, SEVERITY, & INTERDEPENDENCE of risk

50
Q

describe portfolio view

A

entity wide risks

more of a holistic view

are we diversified

at the parents as opposed to the product level

51
Q

organization sustainability

A

the ability of an entity to withstand the impact of a large-scale event

i.e. financial crisis

52
Q

What are the components of ERM

A

5 components

“GO PRO”

  1. Governance and culture (similar to control environment, tone at the top)
  2. Strategy and objective -setting (mission/vission, define your risk appetite)
  3. Performance (evaluate, id and respond to risk using ARTS)
  4. Review and Revision
  5. Information, communication, and Reporting (ongoing)
53
Q

What are the principles of ERM

A

20!

See pg 20 in the book. Have to write it to remember it. Not worth making flashcards for but you HAVE to review it

54
Q

What are Risk Responses as it relates to ERM

A

ARTS

Avoid (high frequency & high severity risks)

Reduce (high frequency & low severity) - hedge/derivatives/security alarms

Transfer/Share (High severity and low frequency) - buy insurance

Self-insure/Accept (Low frequency and low severity) - you chose to be in that industry

55
Q

What are the three main components of the Sarbanes Oxley Act of 2002?

A

Corporate Responsibility
Enhanced Disclosures
Fraud - how to deal with it

56
Q

Who does Sarbanes Oxley affect

A

the financial reporting of PUBLIC companies

57
Q

Who is typically included in “Corporate Responsibility”?

A

Audit Committee
and
CEO/CFO representations

58
Q

Who does the auditor of an engagement report to?

A

the audit committee

59
Q

What are the responsibilities of the audit committee?

A

it is directly responsible for the appointment, compensation, and oversight of the work of the public accounting firm employed by the public company

also responsible for resolving disputes between the auditor and management

are to be members of the issuer’s board of directors BUT are otherwise completely INDEPENDENT (they may not accept compensation from the issuer for consulting/advisory services)

Must establish procedures to accept reports of complaints regarding regarding things (whistleblower hotlines)

60
Q

What representations must the CEO and/or CFO sign regarding annual and quarterly reports?

A
  • they have reviewed the report
  • the report does not contain untrue statements or omit material information
  • the F/S fairly present in all material respects the financial condition and results of operations of the issuer
  • **CEO and CFO sign off that THEY are responsible for internal controls (regarding I/C DESIGN, EVALUATIONS of effectiveness, their CONCLUSIONS as to the EFFECTIVENESS of I/C based on evaluation)
  • **CEO and CFO sign of that they made disclosures to the issuer’s auditors and audit committee regarding (1) all SD and MW in the design or operation of I/C that might adversely affect F/S and (2) ANY fraud regardless of materiality that involves management or any other employee with a significant role in I/C
  • **CEO and CFO must also disclose any significant changes to internal controls
61
Q

What does the improper influence on the conduct of audits relate to

A

No officer or director may take any action that would fraudulently influence, coerce, mislead or manipulate the auditor in a manner that would make the F/S materially misstatement

in other words, they must cooperate with the auditor

62
Q

If an issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement, what happens?

A

the CEO and CFO may be required to reimburse the issuer for:

  • –bonuses or incentive-based or equity-based compensation
  • –gains on sale of securities during that 12 month period
63
Q

What are “enhanced financial disclosures” otherwise known as

A

Title IV

64
Q

What are the enhanced financial disclosures for Periodic reports (quarterly or annually)

A
  • all material correcting adjustments identified by the auditor
  • all material OFF-BALANCE SHEET transactions (operating leases, contingent obligations, relationships with unconsolidated subsidiaries (equity method))
65
Q

What are the enhanced financial disclosures for conflicts of interest

A

issuers are generally prohibited from making personal loans to directors or executive officers
–exceptions apply when credit loans are made in the ordinary course of business

66
Q

Descibr the enhanced financial disclosure for transactions involving management and principal stockholders

A

related parties!!

disclosures are required for persons who generally have direct or indirect ownership of more than 10% ownership of the company

67
Q

Descibe Section 404

A

Each annual report is required to contain a report that includes:

    • statement that management is repsonsible for establishing and maintaining adequate internal control structure and procedures for financial reporting
    • an assessment as of the most recent fiscal year of the issuer, of the effectiveness of I/C structure and procedures for financial reporting
68
Q

What should be included in the code of conduct/ethics? (be familiar!)

A
  • honest and ethical conduct (including handling of conflicts of interest)
  • full, fair, accurate, and timely disclosures in periodic financial reports (FACT)
  • compliance with laws, rules, and regulations
69
Q

Describe the disclosure of audit committee financial expert

A

at least one member of the audit committee should be a financial expert. The issuers financial reports must disclose the EXISTENCE of a financial expert on the committee OR the reasons why the committee does not have one (i.e. the guy just died)

70
Q

What knowledge must the “financial expert(s)” on the audit committee have?

A
  • understanding of GAAP
  • experience in the preparation or auditing of financial statements for comparable issuers
  • application of GAAP
  • experience with I/C
  • understanding of audit committee functions

this experience with allow the to help resolve disputes between management and the auditor

71
Q

What are the responsibilities of the SEC as it relates to disclosures?

A

SEC is required to review disclosures made by ISSUERS, including those in from 10k, on a regular and systematic basis for the protection of investors

72
Q

How frequently should the SEC schedule reviews?

A

SEC should consider

  • historically has the issuer had a material restatements
  • has the issuer experienced significant volatility in their stock price compared to other issuers
  • issuers with large market cap
  • issuers whose operations significantly affect any material sector of the economy (“too big to fail”) – big insurance co’s/banks etc.
  • -emerging companies with disparities in PE ratios
73
Q

What happens when individuals alter destroy, conceal, cover up, falsify, etc. with the intent to impede, obstruct, or influence an investigation?

A

They will be fined, imprisoned for not more than 20 years or both

74
Q

How long should auditors of issuers retain audit and review workpapers?

A

seven years from the end of the fiscal period in which the audit or review was conducted

failure to do so will result in a fine, imprisonment (for not more than 10 years or both)

75
Q

What is the statue for securities fraud?

A

no later than the EARLIER OF 2 years after the discovery of the facts constituting the violation or 5 years after the violation

2+5

76
Q

Describe whistle-blower protection

A

a whistleblower who lawfull provides evidence of fraud may NOT be discharged, demoted, suspended, threatened, harassed, or in any other matter discriminated against for providing such information.

If the above occurs, the employee may be provided compensatory damages including:

  • reinstatement with the same seniority status they would have had
  • back pay with interest
  • compensation for any special damages (i.e. litiation costs, expert witness fees, reasonable attorney fees)
77
Q

Any issuer F/S filed with the SEC must be accompanied by what?

A
  • a WRITTEN statement that the periodic report fully complies with the Sec. Exchange act of 1934
  • a WRITTEN statement that the info contined in report FAIRLY presents, in all material respects, the financial condition and operating results of the issuer
  • the WRITTEN statements above must be signed by the CEO and CFO
78
Q

if someoe certifies a periodic financial report KNOWING that it does not satisfy all the requriements, what are the repercussions?

A

he or she will be fined and/or imprisoned. Specifically a party who:

  • certifies & knows it doesn’t comply = $1M fine and/or imprisoned no more than 10 years
  • WILLINGLY certifes & knows it doesn’t comply (fraud, intentional) = $5M fine and/or nor more than 20 years imprisoned
79
Q

What relationship does risk and return have?

A

directly related

80
Q

What are risk and return a function of?

A

Both market conditions AND the risk preferences

81
Q

What are the basic risk preference behaviors

A

Risk-indifferent behavior
Risk-averse behavior
Risk-seeking behavior

82
Q

Describe risk-indifferent behavior

A

you’re the exception if this is your behavior.

an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return

You seek the highest rate of return

83
Q

Describe risk-averse behavior

A

the general rule

most people exude this behavior

an attitude toward risk in which an increase in the level of risk results in an increase in managements’s required rate of return

84
Q

Describe risk-seeking behavior

A

exception - VERY unusual

attitude toward risk in which an increase in the level of risk results in a DECREASE in management’s required rate of return

very rare

85
Q

Interest rate risk

A

aka “Yield Risk”

As the interest rate increases, the value of fixed income goes down (inverse relationship)

Fluctuations in the value of the instrument in response to changes in interest rates (ex: I have a bond that pays a fixed rate. If interest rates go, other people can get bonds that pay out higher rates. As such, the value of my bond will go down)

86
Q

Market/Systematic/Nondiversifiable Risk

A

fluctuations in value as a result of operating within an economy

Unavoidable

Ex: war, inflatiion, international incident, political events

87
Q

Unsystematic/firm-specific/diversifiable risk

A

nonmarket

represents the portion of a firm’s or industry’s risk that is associated with random causes and can be eliminated through DIVERSIFICATION

Attributed to firm-specific/industry-specific events

Ex: strikes, lawsuits, regulatory actions, or the loss of a key account

88
Q

Credit risk

A

affects borrowers (the cost of borrowing)

Includes a company’s inability to secure financing OR secure favorable credit terms as a result of poor credit ratings.

Relationships:

As credit risk goes up, the cost of borrowing goes up.

If your credit rating goes down, you’re a greater credit risk and your cost of borrowing goes up

If you have a poor credit rating, lenders will demand a higher interest rate (collateral may also be required)

89
Q

Default risk

A

affects lenders

the possibility that debtors may not repay the principal or interest as it becomes due on a timely basis

historically, US treasury securities have the lowest default risk (i.e. risk free rate = tbill)

90
Q

Liquidity risk

A

affects lenders (investors)

lenders/investors are exposed to liquidity risk when they desire to sell their security but cannot do so in a timely manner OR when material PRICE CONCESSIONS have to be made to do do

Ex: “not publicly traded” items, real estate

91
Q

Price risk

A

affects investors

the exposure that investors have to a decline in the value of their individual securities or portfolios

price risk is diversifiable (can be diversified away)

92
Q

Stated rate general characteristics

A

given

aka nominal rate

always on an annual basis and before any compounding

93
Q

Effective interest rate characteristics

A

periodic rate - can be paid annual (1), semiannual (2), quarterly (4), etc.

94
Q

compute effective interest rate

A

= interest paid per period / net proceeds of loan

interest paid per period = (Price X stated rate) / # periods

95
Q

Define Maturity Risk Premium (MRP)

A

risk increases with the term to maturity

longer the term to maturity = the higher the required rate of return

the longer the maturity = more risk because you have greater exposure to interest rate risk over time

96
Q

Define Purchasing Power Risk or Inflation Premium

A

used to calculate the nominal risk free rate

the compensation investors require to bear the risk that price levels will change and affect asset values

97
Q

Describe liquidity risk premium

A

the risk an investment security cannot be sold on a short notice without making significant price concessions

98
Q

describe default risk premium

A

risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis

99
Q

What can diversification help with?

A

unsystematic (firm-specific) risk

100
Q

What is considered nondiversifiable risks?

A

market, systematic risk

101
Q

How to mitigate interest rate risk

A

can mitigate by investing in floating rate debt securities (i.e. rather than invest in fixed income, invest in variable securities)

can mitigate by investing derivatives (.e. forwards or interest rate swaps)
-interest rate swaps –> if you think rates are going to go up (and hence, you’re fixed income will be worth less, you’ve want to enter into an agreement where you pay a fixed rate (ex: 8%) and the other party pays you a variable rate (ex: LIBOR + 1%)

102
Q

how to mitigate market risk

A

very difficult because it’s inherent in the market and economy

aka systematic risk

it is nondiversifiable

investing in derivatives where you could profit when the market declines (and hence offset your losses) - SHORTS

103
Q

how to mitigate unsystematic risk

A

minimized through diversification

-want to invest in assets that are either uncorrelated or inversely correlated

104
Q

how to mitigate credit risk

A

how to reduce the cost of borrowing (from the borrowing/debtor’s perspective)

how do I mitigate the risk that my credit rating goes down and I can’t favorable loans

ratio analysis (i.e. a high current ratio results in a higher credit rating) - want to improve your credit ratings. A high credit means you’re very credit worthy and will get loans at a lower interest rate.

105
Q

how to mitigate default riskq

A

from the Lendor/Creditor perspective

an entity may choose to lend only to borrowers with low risk of default

another option, adjust the interest rate charged to better reflect the risk of each borrower (a riskier borrower will have to pay a higher interest rate on the loan you give them)

106
Q

how to mitigate liquidity risk

A

mitigate by allocating a greater percentage of capital to investments that trade on ACTIVE MARKETS (invest more in stocks and bonds rather than real estate, which is not publicly traded)

107
Q

how to mitigate price risk

A

mitigate through…

diversification

short selling or derivatives (hedging, put options - you buy the right to sell at a certain price)

108
Q

Why does exchange rate risk exist

A

exists because of the relationship between domestic and foreign currencies may be subject to volatility

109
Q

What are the factors that influence exchange rates

A

trade factors and financial factors

110
Q

Describe the “Trade Factor” relative to inflation rates

A

relative to inflation rates

when domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the PURCHASING POWER of their money (ex: my USD 1 can buy me more in another country. I’m going to that country for vacation).

the increase in demand for foreign currency forces the value of the foreign currency to rise in relation to domestic currency

111
Q

Describe the “trade factor” relative to income levels

A

as income increases in one country realtive to another, exchange rates chase as a result of increased demand for foreign currencies in the country in which income is increasing

112
Q

Describe trade factor - government controls

A

as opposed to freely fluctuating equilibrium

various trade and exchange barriers that artificially suppress the natural forces of supply and demand affect exchange rates.

ex: tariffs on imported goods would have the effect of discouraging the purchase of those imported goods thereby reducing the demand for that currency

113
Q

Describe financial factors - relative interest rates and capital flows

A

interest rates create demand for currencies by motivating either domestic or foreign investments.

currency with the higher interest rate attracts investments thus there is greater demand for the currency, and the value of the currency goes up

114
Q

What are the trade related factors as it relates to impacts on exchange rates

A

relative inflation rates
relative income levels
government controls (trade restrictions)

115
Q

What are the financial factors as it relates to impacts on exchange rates

A

relative interest rates

capital flow

116
Q

Define “Transaction Exposure”

A

Gain/Loss

the potential that an org could suffer economic loss or gain upon settlement of an INDIVIDUAL as a result of exchange rates

117
Q

Define “Economic Exposure”

A

the potential that the PRESENT VALUE of an organization’s cash flows could increase or decrease as a result of changes in exchange rates

118
Q

In terms of changes in foreign currency, what specifically does present value and G/L relate to

A

PV - Economic exposure

G/L - Transaction exposure

119
Q

Define “Translation Exposure”

A

the risk that assets, liabilities, equity, or income of a CONSOLIDATED organization that includes foreign subsidiaries will change as a result of changes in exchange rates

120
Q

What affects translation exposure?

A

the degree of foreign involvement (more = more risk)

Locations of foreign investments (the more volatile the exchange rate = the higher the translation risk)