Deel 1: Financial Risk Management

Question 1

What is risk?

Answer 1

= the probability of loss.

Question 2

What is exposure?

Answer 2

= the possibility of loss. (boolean)

Risk arises as a result of exposure.

Question 3

How does financial risk arise?

Answer 3

There are three main sources:

• Change in market prices (interest rates, exchange rates, commodity prices)
• Transactions with other organizations (vendors, suppliers, customers,…)
• Internal organizational failures

Question 4

What is financial risk management?

Answer 4

Financial risk management is a process to deal with financial uncertainties.

It involves assessing the financial risks facing an organization and developing management strategies accordingly.

=> addressing financial risk proactively

Question 5

Describe briefly the Risk Management Process.

Answer 5

1. Identify and prioritize key financial risks.
2. Determine an appropriate level of risk tolerance.
3. Implement risk management strategy in accordance with policy.
4. Measure, report, monitor, and refine as needed.

The risk management process involves both internal and external analysis.

Question 6

What is diversification?

Answer 6

A diversified portfolio contains assets whose returns are dissimilar, in other words, weakly or negatively correlated with one another.

Although the risk of loss still exists, diversification may reduce the magnitude of loss.

Diversification means spreading out assets, vendors, suppliers,… to reduce the impact of risk (if one supplier fails to deliver, there are others to fall back on, if one asset is failing or dropping, there are other assets to reduce the total loss).

Question 7

What are three alternatives for managing risks?

Answer 7

1. Do nothing and actively, or passively by default, accept all risks.
2. Hedge a portion of exposures by determining which exposures can and should be hedged.
3. Hedge all exposures possible.

to hedge = indekken

Question 8

What are factors that affect market interest rates?

Answer 8

• Expected levels of inflation
• General economic conditions
• Monetary policy and the stance of the central bank
• Foreign exchange market activity
• Foreign investor demand for debt securities
• Levels of sovereign debt outstanding
• Financial and political stability

Question 9

What are factors that affect commodity prices?

Answer 9

Physical commodity prices are strongly influenced by supply and demand.

Unlike financial assets, the value of commodities is also affected by attributes such as physical quality and location.

• Expected levels of inflation, particularly for precious metals
• Interest rates
• Exchange rates, depending on how prices are determined
• General economic conditions
• Costs of production and ability to deliver to buyers
• Availability of substitutes and shifts in taste and consumption patterns
• Weather, particularly for agricultural commodities and energy
• Political stability, particularly for energy and precious metals

commodity = handelsartikel

Question 10

What are the factors that affect foreign exchange rates?

Answer 10

Foreign exchange rates are determined by supply and demand for currencies.

Supply and demand, in turn, are influenced by factors in the economy, foreign trade, and the activities of international investors.

Some of the key drivers that affect exchange rates include:

• Interest rate differentials net of expected inflation
• Trading activity in other currencies
• International capital and trade flows
• International institutional investor sentiment
• Financial and political stability
• Monetary policy and the central bank
• Domestic debt levels (e.g., debt-to-GDP ratio)
• Economic fundamentals

Question 11

What are “interest rates”?

Answer 11

Interest rates reveals the cost of borrowing money. If interest rates are low, money is cheap.

This makes that interest rates are reflective of the supply and demand for money.

Question 12

What is “interest rate risk”?

Answer 12

The probability of an adverse impact on profitability or asset value as a result of interest rate changes

Question 13

What are the sources of interest rate risk?

Answer 13

• Changes in the level of interest rates (absolute interest rate risk)
• Changes in the shape of the yield curve (yield curve risk)
• Mismatches between exposure and the risk management strategies undertaken (basis risk)

Question 14

What is “absolute interest rate risk”?

Answer 14

Absolute interest rate risk results from the possibility of a directional, up or down, change in interest rates.

Question 15

What are the most common methods of hedging “absolute interest rate risk”?

Answer 15

• to match the duration of assets and liabilities
• replace floating interest rate borrowing or investments with fixed interest rate debt or investments.
• use interest rate caps, use forward rate agreements, …

Question 16

What is “yield curve risk”?

Answer 16

Yield curve risk results from changes in the relationship between short and long-term interest rates.

The steepening or flattening of the yield curve changes the interest rate differential between maturities, which can impact borrowing and investment decisions and therefore profitability.

When the yield curve steepens, interest rates for longer maturities increase more than interest rates for shorter terms as demand for longer-term financing increases.

A steeper yield curve results in a greater interest rate differential between short-term and long-term interest rates, which makes rolling debt forward more expensive.

Question 17

What is basis risk?

Answer 17

Basis risk is the risk that a hedge does not move with the direction or magnitude to offset the underlying exposure.

It is a concern whenever there is a mismatch between the exposed risk and strategy.

Basis risk may occur when one hedging product is used as a proxy hedge for the underlying exposure, possibly because an appropriate hedge is expensive or impossible to find. The basis may narrow or widen, with potential for gains or losses as a result.

Question 18

What is “Foreign Exchange Risk”?

Answer 18

The risk of an investment’s value changing due to changes in currency exchange rates.

Question 19

How does “foreign exchange risk” arise?

Answer 19

Foreign exchange risk arises through transaction, translation and economic exposures.

Question 20

What is “transaction exposure”?

Answer 20

Transaction exposure arises from the ordinary transactions of an organization, including purchases from suppliers and vendors, contractual payments in other currencies, sales to customers in currencies other than the domestic one.

Organizations that buy or sell products and services denominated in a foreign currency typically have transaction exposure.

Question 21

What is “translation exposure”?

Answer 21

Translation exposure results wherever assets, liabilities, or profits are translated from the operating currency into a reporting currency.

Example: an international company reports its income in USD, but does most business in €.

Question 22

Explain foreign exchange risk from commodity prices.

Answer 22

Since many commodities are priced and traded internationally in U.S. dollars, exposure to commodities prices may indirectly result in foreign exchange exposure for non-U.S. organizations.

Even when purchases or sales are made in the domestic currency, exchange rates may be embedded in, and a component of, the commodity price.

Question 23

What is “strategic exposure”?

Answer 23

The location and activities of major competitors may be an important determinant of foreign exchange exposure.

Strategic or economic exposure affects an organization’s competitive position as a result of changes in exchange rates.

For example, a firm whose domestic currency has appreciated dramatically may find its products are too expensive in international markets despite its efforts to reduce costs of production and minimize prices. The prices of goods exported by the firm’s competitors, who are coincidentally located in a weak-currency environment, become cheaper by comparison without any action on their part.

Question 24

What is “commodity risk”?

Answer 24

Commodity risk refers to the uncertainties of future market values, and the size of future income, caused by the fluctuation in the prices of commodities.

Commodity risk has two components:

• commodity price risk
• commodity quantity risk

Question 25

What is “commodity price risk”?

Answer 25

Commodity price risk occurs when there is potential for changes in the price of a commodity that must be purchased or sold.

Question 26

What is “commodity quantity risk”?

Answer 26

Organizations have exposure to quantity risk through the demand for commodity assets.

Quantity risk remains a risk with commodities since supply and demand are critical with physical commodities.

For example, if a farmer expects demand for product to be high and plans the season accordingly, there is a risk that the quantity the market demands will be less than has been produced. Demand may be less for a number of reasons, all of which are out of the control of the farmer. If so, the farmer may suffer a loss by being unable to sell all the product, even if prices do not change dramatically.

Question 27

In which ways differs commodities from financial assets?

Answer 27

Commodities differ from financial contracts in several significant ways, primarily due to the fact that most have the potential to involve physical delivery.

Commodities involve issues such as quality, delivery location, transportation, spoilage, shortages, and storability, and these issues affect price and trading activity.

In addition, market demand and the availability of substitutes may be important considerations.

Question 28

What is “process & procedural risk” in context of operational risk?

Answer 28

Processes and procedural risk includes the risk of adverse consequences as the result of missing or ineffective processes, procedures, controls, or checks and balances.

The use of inadequate controls is an example of a procedural risk.

Question 29

What is “technology & systems risk” in context of operational risk?

Answer 29

Technology and systems risk incorporates the operational risks arising from technology and systems that support the processes and transactions of an organization.

Question 30

What are “embedded options”?

Answer 30

Embedded options are granted to securities holders or contract participants and provide them with certain rights.

For example, the ability to repay a loan prior to its maturity is an option. If the borrower must pay a fee to repay the loan, the option has a cost. If the loan can be repaid without a fee, the option is free to the borrower, at least explicitly. The value of the option is likely to be at least partially embedded in the interest rate on the loan.

Question 31

What is “systematic risk”?

Answer 31

Systemic risk is the risk that the failure of a major financial institution could trigger a domino effect and many subsequent organizational failures, threatening the integrity of the financial system.

Systemic risk can also arise from technological failure or a major disaster.

Question 32

What is “liduiqidity risk”?

Answer 32

Liquidity affects the ability to purchase or sell a security or obligation.

Another form of liquidity risk is the risk that an organization has insufficient liquidity to maintain its day-to-day operations.

Question 33

What is “equity price risk”?

Answer 33

Equity price risk affects corporate investors with equities or other assets of which the performance is tied to equity prices.

*Firms may have equity exposure through pension fund investments, for example, where the return depends on a stream of dividends and favorable equity price movements to provide capital gains. *

Question 34

What is “operational risk”?

Answer 34

Operational risk arises from human error and fraud, processes and procedures, and technology and systems.

Internal fraud – tax evasion, bribery…
External fraud – theft of information, hacking damage…
Software failures, utility disruptions
Product defects, market manipulation,…

Question 35

What is “global cash netting”?

Answer 35

When an organization has cash flows in multiple currencies, some parts of the organization may have excess cash while others may need to draw down on available lines of credit.

On a centralized basis, it may be possible to pool funds from divisions or subsidiaries and make them available to other parts of the organization.

Question 36

What is “asset-liability management”?

Answer 36

Asset–liability management involves the pairing or matching of assets and liabilities so that changes in interest rates do not adversely impact the organization.

This practice is commonly known as gap management and often involves duration matching.

Question 37

What is a “forward rate agreement”?

Answer 37

A forward rate agreement (FRA) is an over-the-counter agreement between two parties, similar to a futures contract, to lock in an interest rate for a short period of time.

The period is typically one month or three months, beginning at a future date.

A borrower buys an FRA to protect against rising interest rates, while a lender sells an FRA to protect against declining interest rates.

Question 38

What is an “interest rate future”?

Answer 38

Interest rate futures are exchange-traded forwards.

They permit an organization to manage exposure to interest rates or fixed income prices by locking in a price or rate for a future date.

Transacted through a broker, there are commissions to buy or sell and margin requirements.

Question 39

What is a “bond future”?

Answer 39

A bond future is a contractual obligation for the contract holder to purchase or sell a bond on a specified date at a predetermined price. This means the price of the underlying bond (the actual price) may change drastically, but the paid price is fixed and therefore doesn’t change.

Question 40

What are “swaps”?

Answer 40

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time.

The most common swap is an interest rate swap.

The most popular swaps are those that change payments from a fixed interest rate to a floating interest rate, and those that exchange a cash inflow in one currency to another currency.

In such an agreement, party A agrees to pay party B a predetermined, fixed rate of interest on the amount. Meanwhile, party B agrees to make payments based on a floating interest rate to party A (for the same period).

Swaps permit a change to the effective nature of an asset or liability without changing the underlying exposure.

A US company wants to expand to Europe, where it is less known. It will likely receive more financing terms in the US than in Europe. By then using a currency swap, the firm ends up with the euros it needs to fund its expansion.

Question 41

What is the difference between “forward rate agreements” and “interest rate futures”?

Answer 41

Futures are settled (paid) at the settlement price fixed on the last trading date of the contract (at the end), whilst forwards are settled at the forward price agreed on the trade date (at the start).

Futures are exchange-traded.

Forwards are over-the-counter agreements between two parties.

Question 42

Explain “margin” and “markt-to-market” in a futures contract context.

Answer 42

Margin is a performance bond, required by both buyers and sellers, to ensure their performance to the contract. Exchanges determine minimum initial and maintenance margin.

Margin cash is deposited with the broker that facilitated the transaction. Futures contracts are repriced daily to their present market value (marked-to-market), and each margin account is debited or credited with the day’s losses or gains. When the market value of a futures position declines and losses are incurred, additional margin may be required to maintain the position. Failure to respond to a margin call will result in the position being closed out at the cost of the account holder.

Question 43

What is “currency netting”?

Answer 43

When a large company has subsidiaries in multiple countries that actively trade with each other. They have both receivable and payable accounts with each other, which could make things very risky for changing exchange rates.

It may be possible to reduce the amount of hedging activity through currency netting, where the corporate parent offsets all account receivable and payable against each other to determine the net amount of foreign exchange transactions that actually require hedges.

Question 44

What is “credit risk”?

Answer 44

Credit risk is a concern when an organization is owed money or must rely on another organization to make a payment to it or on its behalf.

A consumer may fail to make payments due on a mortgage loan
A company is unable to repay debt
A business or consumer does not pay a trade invoice when due
A business does not employ its employees when due
A bank won’t return the funds to a depositor

Question 45

How does credit risk arises?

Answer 45

Credit risk arises through lending, investing, credit granting and general business operations.

Also poor economic conditions and high interest rates contribute to the likelihood of default for many organizations.

Question 46

How can you control credit risk?

Answer 46

There are several ways to manage credit exposure:

• Deal with high-quality counterparties
• Use collateral where appropriate
• Use netting agreements where possible
  
  • if A owes B $5.000 and B owes A $6.000, only $1.000 has to change hands.
• Monitor and limit market value of outstanding contracts
• Diversify your suppliers, borrowers, vendors,…

Question 47

What is “default risk”?

Answer 47

Default risk is the probability that companies or individuals will be unable to make the required payments on their debt obligations.

Often lenders charge interest rates that correspond the debtor’s level of default risk. The higher the risk, the higher the required return and vice versa.

Question 48

How does operational risk arises?

Answer 48

Operational exposure arises from the possibility of fraud, error, or system or procedural problems.

The three main sources for operational risk are people, processes and technology.

• Internal fraud – tax evasion, bribery…
• External fraud – theft of information, hacking damage…
• Software failures, utility disruptions
• Product defects, market manipulation,…

Question 49

Can you explain what Group of 31 means in this context?

Answer 49

It’s a group of 31 large multinationals with foreign exchange exposure that have been surveyed. It discovered that these companies use 12 core principles for managing foreign exposure.

• Hire well qualified and experienced personnel
• Adopt uniform procedures
• Measure hedging performance
• …

It’s all about managing the risk – not only foreign exchange exposure – but also operational risks. If you hire well-trained personnel, chances of fraud drop, if you have uniform procedures there is less room for errors and so on…

Question 50

What is “value-at-risk”?

Answer 50

Value-at-risk is a systematic methodology to quantify potential financial loss based on statistical estimates of probability.

Value-at-risk attempts to answer the question “how much money might I lose”

Question 51

How can value-at-risk be measured?

Answer 51

Historical simulation:
This is one of the simplest ways to determine the value-at-risk. It uses past outcomes of investments and risks and with that data it can generate 95% of 99% percent probability intervals for the outcomes (a very commonly used statistical method).