Chapter 11 - Risk Management

Question 1

What is the exchange rate risk?

Answer 1

Risk faced by importers/exporters of changing exchange rates. Exchange rates increases is bad for importers, while decreases are bad for exporters.

Question 2

What is a long/short position in exchange rates?

Answer 2

Short position: company holds more liabilities than assets denominated in foreign currencies

Long position: company holds more assets than liabilities denominated in foreign currencies

Question 3

What is the interest rate risk? And what is the risk positions?

Long/short
Fixed/floating

Answer 3

Capital risk: risk of decrease in asset value due to the change of interest rate

What is the risk positions of the interest rate risk?

Decrease in interest rate results in losses when the position is short/fixed and long/floating

Increase in interest rate results in losses when the position is short/floating and long/fixed

The opposite positions of the ones named above will result in gains.

Question 4

What is credit risk?

Answer 4

An asset is exposed to credit risk if the default of counterparty will cause a loss or the market value depends on the credit quality of the counterparty.

Interest rate commanded by the market is an increasing function of default risk 
The highest (lowest) credit ratings gives the lowest (highest) interest rates.

Question 5

What is the capital risk?

Answer 5

An interest rate risk of decrease in asset values due to decreases in interest rates. Related to fixed-rate loans and bonds (not important for borrowers).

Question 6

What is the coupon risk?

Answer 6

Coupon decrease due to decrease in interest rates. Important for floating rate debt holders and issuers.

Question 7

What influences the risk of a bond?

Answer 7

Time to maturity - the longer the time to maturity, the more risk is associated with the bond.

Coupon rate - the lower the coupon rate, the more sensitive the bond