Econ 4 - Financial Risk Management Flashcards
Interest Rate Risk affects
both small and large organizations
Risks for small firms include
- inability to use broader capital markets
- unable to diversify operations
- inability access more suppliers
Operations Risk is
the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
In negotiating a loan, the more favorable type of interest for the bank is _____ and the more favorable type of interest for the customer is ______
bank = compound interest customer = simple interest
Over an extended period of time, how does interest on LT debt compare to interest on ST debt?
Interest on LT debt cost more
Effective Annual Interest Rate =
Total Interest / Obligation Amount
*be careful of the method of compounding other than yearly
Per FASB ASC 815, if an entity engages in a hedge against the exposure to variable cash flow of a forecasted transaction, the entity would
recognize the effective portion of the derivative’s gain or loss initially as a component of other comprehensive income, and subsequently reclassify it into earnings when the forecasted transaction affects earnings.
Effective Rate of Interest (interest paid on a discount basis) =
Interest Paid / Usable Funds or [Loan amt - Discounted Interest - Compensating Balance]
Discount Interest is
a situation where all interest on a loan is paid at once and the interest amount is deducted from the amount the borrower will receive at the beginning of the loan
The Effective Annual Interest Rate will = Nominal or Stated Rate if compounding is done
annually
The highest Effective Interest Rate occurs when compounding is done
continuously
The TRUE rate of interest is the same as the
Effective Rate
Financial Risk Mgmt is a component of ERM and includes risks such as:
- Business risk
- Operations risk
- Supply-chain risk
- Product liability risk
- Political and Economic risk
In the risk mgmt process, what strategies does the firm have to manage its risk?
Accept, transfer, or manage
If the dollar price of the euro rises
the dollar depreciates against the euro and the euro will buy more US goods
FV of an Investment using compound interest will always be ____ the same investment using simple interest
more than
Market Rate of Interest =
Risk Free Interest Rate + Inflation Premium
What would encourage a company to use short-term loans to retire 10-yr bonds that have 5-yrs to maturity?
Interest rates declined over the last 5 years (assuming they continue to decline, pay less interest)
Freely fluctuating (floating) exchange rates do what?
Auto-correct a lack of equilibrium in the balance of payments
When banks allow a customer to refinance a mortgage loan at any time without a prepayment penalty, they engage in
option risk
Allowing a customer to prepay a mortgage without a prepayment penalty gives the customer a call option, i.e., the right to pay the mortgage in full at any time during the mortgage term, thus changing the cash flow stream the firm receives from the mortgage.
The risk management process includes both internal and external controls and involves
- Identifying and prioritizing risks and understanding their relevance
- Understanding the stakeholder’s objectives and their tolerance for risk
- Developing and implementing appropriate strategies in the context of a risk management policy
Usury Laws are
regulations governing the max amount of interest that can be charged on a loan
One negative consequence of Usury Law regulations from the borrower’s perspective is
less creditworthy customers are excluded from the market
Credit Union was offering fixed rate mortgages to its members but decides it can longer afford to offer this service and instead decides to offer variable rate mortgages with the interest rate tied to an index and adjusted yearly. The interest rate risk has been
transferred (from the credit union to the member)
Key elements of Financial Risk Management include
- Interest rate risk
- Foreign currency risk
- Credit risk
Assuming a 360-day year, the current price of a $100 U.S. Treasury bill due in 180 days on a 6% discount basis is:
Price = Face amount - Interest $97 = $100 - (100 x 0.06 x (180/360))
When a US parent company reviews the Cash Flow from its international subsidiaries, the primary considerations are
exchange rate risk and repatriation restrictions (repatriation restrictions limit the parent’s ability to receive cash from international subsidiaries)
The future value of $100 invested today for three years at an annual interest rate of 8% using the simple interest method is
$124
Total = Principal + Interest $124 = $100 + ($100 x 0.08 x 3)
Individuals who would be most hurt by inflation include
- those on fixed income (same $ have be stretched further)
- those who lent money on a fixed interest rate (they will be paid back in cheaper $)
- those who save cash dollars (purchase power of $ decreases)
Zoo Supply Company borrowed $100,000 from a local bank to purchase equipment. The annual interest rate on the 5-year loan was 10%. Over the 5-year period, Zoo paid $50,000 of interest. This interest was calculated as
simple interest
Effective Interest Rate (w/ compensating balance, checking account interest, and typical balance kept) =
[(Loan amount x Interest %) - ((Compensating Balance - Typical Bank Balance) x Checking Account Interest %)] / (Loan amount - Compensating Balance + Typical Bank Balance)
Current Ratio =
Current Assets / Current Liabilities. # > benchmark = more liquid
When economists are concerned about the Liquidity Preference (LP) Function they are interested in
the relationship of the demand for money and the rate of interest.
Interest rates fall = Qty $ demanded increases
Interest rates rise = Qty $ demanded decreases
The simple interest method of calculating interest on loans does not consider
interest on interest
When the dollar depreciates, the effect on prices of US imports and exports is
An increase in Import prices and A decrease in Export prices
Purpose of hedging foreign exchange risk is to
insulate the firm from exposure to exchange rates
Control cycle approach to risk management includes
- modeling expected results using a set of initial assumptions
- doing a profit test to determine if the product provides a contribution margin
- measuring actual results
- determining in quantitative and qualitative terms an understandable explanation of difference in expected and actual results
- determining what actions need to be taken with respect to the product
- using findings to strengthen the model and update the assumption as needed with feedback
Type of risk that can be reduced by diversification:
Labor strikes; Since different industries and countries experience different risks of labor strikes, diversification between industries and countries can reduce company risk.
In the modern world economy, balance-of-payments deficits and surpluses can be eliminated:
through the market mechanism of flexible exchange rates
Management finds that the key interest rate risk the firm is facing is related to movements in short-term interest rates. Management decides that the rate on the 20-year bond is too attractive to pass up. They issue the bond and then choose to develop ________ to offset their interest rate risk.
an interest rate swap transaction
Assuming that exchange rates are allowed to fluctuate freely, a nation’s currency would appreciate on the foreign exchange market when
a slower rate of growth in income occurred relative to other countries, which causes imports to lag behind exports
Per the FFIEC, in a stress test the basis risk is dealing with
changes in the relationship between key market interest rates
Per the FFIEC, in a stress test the yield curve risk is dealing with
changes in the shape and slope of the yield curve
Per the FFIEC, in a stress test the instantaneous rate shock is dealing with
instantaneous and significant changes in the levels of interest rates
Per the FFIEC, in a stress test the prolonged rate shock is dealing with
substantial changes in interest rates over time
Examples of financial instruments that are derivatives
- interest rate futures
- agreement to buy a piece of equipment in six months at a price determined today
- a contract to purchase a commodity in six months at a price determined today
Platinum Co. has a receivable due in 30 days for 30,000 euros. The treasurer is concerned that the value of the euro relative to the dollar will drop before the payment is received. To reduce risk
enter into a forward contract to sell 30,000 euros in 30 days
Consider a world consisting of only two countries, Canada and Italy. Inflation in Canada in one year was 5%, and in Italy 10%. The Canadian Dollar will
appreciate by 5%
The dominant reason why countries devalue their currencies is to
improve the balance of trade
If the central bank of a country raises interest rates sharply, the country’s currency will most likely
increase in relative value
A U.S firm sold $3 million in finished goods to a firm in Thailand for delivery in six months with the contract to be invoiced in dollars. In the ensuing period, the value of the bhat declined by 80%, which meant that Thai firm could not afford to purchase the dollars necessary to fulfill the contract. This is an example of
economic exposure
In relation to the role of capital in mitigating financial risk, it has been strongly suggested that in the new regulatory environment, regulators treat capital:
as a shock absorber and allow firms to draw down capital during periods of market stress that would be expected to be replenished when market conditions improve.
One United States dollar is being quoted at 120 Japanese yen on the spot market and at 123 Japanese yen on the 90-day forward market, hence the annual effect in the forward market is the
USD at a premium of 10%.
The difference between the spot market and 90-day forward market price of a dollar in terms of yen, is 3 yen. Over a 360-day year, this 90-day difference of 3 yen translates into 12 yen, which is 10% of the spot market quote of 120 yen. The forward market quote is higher than that in the spot market, hence it is expected that the dollar will appreciate, and the U.S. dollar is at a premium of 10%.
According to IRS Tax code, methods allowed to control transfer pricing manipulation include
- comparable uncontrolled price
- resale price
- cost-plus approach
When exchange rates change, the values of a foreign subsidiary’s assets and liabilities change when looked at from the perspective of the parent firm. Thus, there must be some method for a multinational company to consolidate the subsidiary’s activities that logically deals with changes in exchange rates. This best describes:
translation exposure
Put option is
the right (but not the obligation) to sell a specific security at fixed conditions of price and time. Typically purchased if price is expected to decrease over the option period.
Call option is
the right (but not the obligation) to buy a specific security at fixed conditions of price and time. Typically purchased if price is expected to rise over the option period.
The recommended derivative instrument for a company with several LT floating rate bonds outstanding, stable cash flow, and the desire to hedge interest rate risk is a
swap agreement
Immunizing a portfolio from interest rate risk by matching the duration of assets to the duration of liabilities might be ineffective and/or inappropriate because
duration matching is effective in immunizing portfolios from parallel shifts in the yield curve
When two companies are both members of a Multinational Corporation (MNC) and the purchasing subsidiary wants to buy a component part of the selling subsidiary, the acceptable range for transfer pricing is $300-600. The purchasing sub has a home tax rate of 50% and the selling sub has a home tax rate of 20%. The optimal transfer price will affect whom and be what amount?
Selling sub and MNC will max earnings by setting the transfer price at $600 per unit
If an institution is developing a capital position that is designed to cover risk beyond what is considered necessary for its best estimate reserves, the institution would be creating a
risk margin
Hedging approach to financing is when
each asset is offset with a financing instrument of the same approximate maturity or duration
A company manufactures goods in Esland for sale to consumers in Woostland. Currently, the economy of Esland is booming and imports are rising rapidly. Woostland is experiencing an economic recession, and its imports are declining. How will the Esland currency, $E, react with respect to the Woostland currency, $W?
The $E will decline with respect to the $W
The U.S. inflation rate is expected to be 5% per annum while the Italian lira is expected to depreciate against the U.S. dollar by 10% during the same period. During the next year, an Italian firm importing from its U.S. parent can expect its lira cost for these imports to:
Increase by about 15%
100 x 1.05 = 105.0
105 x 1.10 = 115.5
(115.5 - 100) / 100 = 15.5%
If a CPA’s client expected a high inflation rate in the future, the CPA would suggest to the client an investment in
precious metals
One of the key reasons one might use an option rather than an interest rate swap to mitigate interest rate risk would be because
a swap binds the user to the rate when it is set, whereas an option gives the buyer the right to walk away anytime during the transaction period if it would be less expensive to do so
An American importer expects to pay a British supplier 500,000 British pounds in three months. The best hedge for the importer to fix the price in dollars is to
buy British pound call options
Factors contributing to the decline in demand for the dollar during 2002-2004
- large US current account deficit
- relatively high inflation rates in the US compared to major trading partners
- Relatively high growth rates in US compared to Europe and Japan
Debt-servicing problems of less developed countries that primarily sell raw materials to the United States would be eased by
an expanding US economy with stable money supply growth because it would maintain a steady demand for their raw materials and the money from the sale would aid in servicing their debt
When a foreign competitor’s currency weakens compared to the USD
the foreign company will have an advantage in the US market
