1.2 - How Firms Manage Financial Risk

Question 1

What are the key risk management components that need to be re-evaluated regularly?

Answer 1

Risk appetite, business activity and risk environment, and new tools or tactics.

Question 2

How can the C-suite support a strong risk culture?

Answer 2

By regularly communicating about risk, responding to warning signs, testing risk understanding, and integrating risk into strategy.

Question 3

What is risk appetite in practical terms?

Answer 3

It is the firm’s willingness to take risks in pursuit of business goals and how it links this to daily risk management.

Question 4

What factors drive interest rate risk management?

Answer 4

Firm risk appetite, market practicalities, changing business needs, regulations, taxes, and market behavior.

Question 5

What are the two main reasons modern firms prioritize financial risk management?

Answer 5

Increased market volatility since the 1970s and the rise of financial risk management instruments.

Question 6

What are some hedging tips for conservative end users?

Answer 6

Keep instruments simple, set clear goals, disclose strategy, stress test, and use early warning indicators.

Question 7

Why do firms make financial risk management a priority?

Answer 7

Market volatility and globalization introduced new financial risks and hedging opportunities.

Question 8

What commodity derivatives might a brewery use to manage risk?

Answer 8

Aluminum swaps, natural gas derivatives, and wheat futures.

Question 9

What are some ways a firm can transfer risk to a third party?

Answer 9

Insurance contracts and financial derivatives.

Question 10

Why is trading with exchange-based derivatives advantageous over OTC derivatives?

Answer 10

Exchange-based derivatives reduce counterparty credit risk.

Question 11

How do airlines hedge jet fuel price risk?

Answer 11

By using swaps, call options, collars, and futures contracts.

Question 12

Why did MGRM’s hedging strategy fail?

Answer 12

A shift from backwardation to contango led to severe margin calls and cash drain.

Question 13

Why must risk appetite be defined before operationalizing it?

Answer 13

Because it involves understanding the firm’s identity and stakeholder expectations.

Question 14

What is the difference between risk appetite and risk capacity?

Answer 14

Risk appetite is the amount of risk the firm is willing to bear, while risk capacity is the total risk the firm could bear without insolvency.

Question 15

How can counterparty credit exposure be minimized?

Answer 15

Through margin requirements and netting arrangements.

Question 16

Why is there no universal agreement that airlines should hedge jet fuel risk?

Answer 16

Because hedging strategy depends on risk appetite, market conditions, and firm objectives.

Question 17

Should firms always hedge every risk they face?

Answer 17

No, firms must evaluate cost-benefit trade-offs and strategic goals before hedging.

Question 18

How do brewers hedge wheat price exposure?

Answer 18

By buying futures contracts and either holding them until maturity or selling them near delivery and purchasing wheat from suppliers.

Question 19

What is the significance of a risk appetite statement?

Answer 19

It must be approved by the board and guides the firm’s risk management strategy.

Question 20

When did agricultural futures first list on the CBOT?

Answer 20

In the 1860s.