B6: Financial Risk Mangament Flashcards
Risk Preference
Risk Indifferent
- simply want highest return period
- increase in lvl or risk does not result in increase in mgmt’s required rate of return
Risk-Averse
- general most ppl and managers are risk averse
- increase in lvl of risk results in increase in mgmt’s required rate of return
Risk-Seeking
- increase in lvl of risk results in decrease in mgmt’s required rate of return
- rare
Diversification
selecting investments of different (or offsetting) risks
- reduces risk
- not all risk can be managed through diversification
- Diversifiable Risk
- unique to a specific business
- aka nonmarket, unsystematic, or firm-specific
- can be eliminated through diversification - Nondiversifiable Risk
- impacts everyone
- aka market or systematic risk
- cannot be eliminated through diversification
- war, inflation, political events, etc
- * the only relevant risk bc any investor can eliminate diversifiable risk
Various Types of Risk
- Interest Rate Risk (yield risk)
- exposure to fluctuations in value of instrument in response to changes in interst rates
- IR ^, value of fixed rate bond v - Market Risk
- exposure of operating within an economy
- aka nondiversifiable risk - Credit Risk
- affects borrowers
- as credit rating declines, the IR demanded ^ - Default Risk
- affects lenders
- risk debtor may not repay principal or interest due on a timely basis - Liquidity Risk
- affects lenders
- desire to sell a security but can’t in a timely manner or when material price concessions have to be made to do so
Return
= yield
- compensates investors and creditors for assumed risk
- often stated or measured by interest rates
Stated Interest Rate
rate charged before any adjustment for compounding or market factors
- rate shown in agreement
Effective Interest Rate
actual finance charge associated w a borrowing after reducing loan proceeds for charges and fees related to a loan origination
- divide amt of interest paid based on the loan agreement by the net proceeds received
Annual Percentage Rate
= effective periodic rate * # of compounding periods
- noncompounded version of the effective annual percentage rate
- not APR, effective annual is APR
Effective Annual Percentage Rate (APR)
stated interest rate adjusted for the # of compounding periods per year
= [1 + (i/p)]^p-1
- i: stated interest rate
- p: compounding periods per year
Simple Interest
interest paid only on the original amt of principal w/o regard to compounding
= principal * interest rate * # of periods
Compound Interest
interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense
= principal * (1 + i)^p
Required Rate of Return
risk-free rate + adding risk premiums:
- Maturity Risk Premium (MRP)
- compensation investors demand for exposure to interest rate risk over time - Purchasing Power Risk or Inflation Premium (IP)
- risk that price lvls will change and affect asset values or purchasing power of invested dollars - Liquidity Risk Premium (LP)
- add. compensation demanded by lenders for risk that an investment security cannot be sold on short notice w/o making significant price concessions - Default Risk Premium (DRP)
- add. compensation demanded for risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis
Types of Probability
Objective Probability
- based on past outcomes
- # of times an event will occur / total # of possible outcomes
Subjective Probability
- based on an individual’s belief
- based on judgment and past experience
Expected Value
weighted-average of the probable outcomes
- multiply possible outcomes by their respective probabilities and add
EV of Perfect Information
- difference b/w the expected payoff under certainty and expected monetary value of the best alternative under uncertainty
Shortcomings of Probability and EV
- EV based on repetitive trials, not one trial
- EV represents the avg outcomes, not outcome that is actually observed
Benefits of Probability and EV
- provides an objective framework for assessing risks and probable outcomes and are useful in decision making
Exchange Rate Risk
International Risks
Exchange rate (FX) risk exists bc relationship b/w domestic and foreign currencies may be subject to volatility - financial mgrs must understand these risk factors and mitigate the FX risk exposures
Risk Factors
- Trade Factor (demand for goods)
a) Relative Inflation Rates:
b) Relative Income Levels: US income ^, they wanna go on vacay in mexico, so demand for peso drives it ^
c) Government Controls: suppress the natural forces of supply and demand affecting exchange rates - Financial Factors (demand for securities)
- relative interest rates and capital flows
Risk Exposures
- Transaction Exposure
- possible change upon settlement of individual transactions bc of change in exchange rate
- 2 steps: 1. net AR and AP then 2. estimate the variability (risk) associated w the foreign currency - Economic Exposure
- possible change in PV of an org’s cash flow bc of change in exchange rates
- currency appreciation: AR v (bad); AP v (good)
- currency depreciation: AR ^ (good); AP ^ (bad) - Translation Exposure
- a foreign subsidiary will change as a result of change in exchange rates
- translation exposure increases as proportion of foreign involvement by subsidiaries increases
- depends on location of foreign investments
Measuring Specific Net Transaction Exposure
Risk Management- Exchange Rate Transaction Exposure
amt of gain or loss that might result from either a favorable or unfavorable settlement of a transaction
- Selective Hedging
- acquire a financial instrument that behaves in the opposite manner from the hedged item
- reduce risk - Identifying Net Transaction Exposure
- accumulate inflows (AR) and outflows (AP) of foreign currencies by subsidiary
- consolidate: net AR and AP
- compute net effect in total: appropriately hedge - Adjusting Invoice Policies
- international companies may hedge transactions w/o complex instruments by timing the payment for imports w the collection from exports
Techniques for Transaction Exposure Mitigation
Risk Management- Exchange Rate Transaction Exposure
these hedge transactions are used to mitigate exchange rate risk presented by foreign currency transaction exposure
- Futures Hedge
- entitled to purchase or sell a particular # of currency units for a negotiated price on a stated date
- denominated in standard amts
- used for smaller transactions - Forward Hedge
- similar to futures, but contracts b/w business and commercial banks and normally are larger transactions
- anticipates a company’s needs to either buy or sell a foreign currency at a particular point - Money Market Hedge
- uses international money markets to plan to meet future currency requirements
- uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables
- B6-50
Currency Options Hedges
Risk Management- Exchange Rate Transaction Exposure
gives option of executing the option contract (same principals as forward hedge and money market) or purely settling its original transaction w/o benefit of the hedge, depending on which result is most favorable
- used to mitigate transaction exposure associated w exchange rate risk for payables
- Payables
- call option to buy - Receivables
- put option to sell
B6-51
Other Techniques- LT Transactions
Risk Management- Exchange Rate Transaction Exposure
- LT Forward Contracts
- set up to stabilize transaction exposure over long periods - Currency Swaps
- two firms may agree to swap currencies in a future period at a specified exchange rate
- typically financial intermediaries are contracted to broker - Parallel Loan
- two firms may exchange or swap their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date
Other Techniques- Alternative Hedging Techniques
Risk Management- Exchange Rate Transaction Exposure
- Leading and Lagging
- transactions b/w subsidiary and parent
- entity owed may bill in advance if exchange rate warrants (leading) or possibly wait until exchange rate is favorable before settling (lagging) - Cross-Hedging
- hedging one instrument’s risk w a diff instrument by taking a position in a related derivatives contract
- often done when no derivatives contract for instrument being hedged or when market is highly illiquid - Currency Diversification
- diversify foreign currency holdings
Risk Management- Economic and Translation Exposure
skipped B6-54 to B6-55
Transfer Pricing
B6-55
ST Financing Strategies
Characteristics
- lower rates; presumes greater liquidity
- anticipate higher lvls of temporary working capital that require greater agility and flexibility
Advantages
- increased liquidity
- increased profitability: rapid conversion of operating cycle
- decreased financing cost: bc ST rates lower
Disadvantages
- increased interest rate risk: interest rates may abruptly change
- decreased capital availability: lender evaluation of creditworthiness may change making it hard to finance
LT Financing Strategies
opposite of ST Financing B6-58 summary chart
