Chapter 8 - Financial risk Flashcards
What is financial risk?
A risk of a change in a financial condition such as an exchange rate, credit rating of a customer, or price of a good
What is political risk?
The financial political risk is the risk arising from actions taken by a government that affect financial aspects of the business
What is interest rate risk?
Risk of gains or losses on assets and liabilities due to changes in interest rates
What is refinancing risk?
Risk that loans will not be renewed when needed, or only renewed at a higher interest rate. This is a type of interest rate risk.
How do we manage refinancing risks?
Longer term loans
Maintaining a high credit rating
Relying more on equity than debt
How do we manage interest rate risk?
Interest rate hedging
Fixed rate loans/investments
How do we manage political risk?
Researching the country’s current and historic political and economic stability
Entering into foreign joint ventures/part-ownership by foreign country’s investors
Obtaining agreements and contracts with overseas government
Using local financing
Making use of local suppliers and the local workforce
What is currency risk?
Risk that arises from possible future movements in an exchange rate
What are some examples of currency risk?
Transaction risk - risk that exchange rate moves between date of transaction and date of payment
Economic risk - long term exchange rate movements which impact the competitiveness of the business
Translation risk - risk of a gain or loss on the translation of foreign assets or liabilities in the year end accounts
How do we manage currency risk?
Hedging
Diversification - buy and sell in several different currencies
What is hedging?
Way of using financial instruments to reduce the risk of adverse price movements of an item
It can help companies to ‘fix’ the price of something they plan to buy or sell in the future.
What are the benefits of hedging?
Can provide certainty of cash flows
Risk will be reduced
Reduction in probability of financial collapse
May be perceived to be a more attractive employer to risk-averse managers
May reduce taxes
What are the arguments against hedging?
May harm interests of shareholders with diversified portfolios
Significant transaction costs
Lack of expertise within the business
Complexity of accounting and tax issues
For some risks, gains and losses may cancel out in the long run
What is a derivate?
Financial instrument whose value depends on the price of some other financial asset or underlying factor
Derivates can be used for hedging, speculation and/or arbitrage
Forwards, futures, options and swap are all examples of derivates
What is value at risk?
Assesses the scale of the likely loss in value of a portfolio in a specified time period at a defined level of profitability
