Economic Concepts and Analysis Financial Risk Management

Question 1

With a compensating balance of $10,000 for a loan of $100,000 at 10%, discounted:

Effective interest = Interest paid / Usable funds
= (10% x $100,000) / ($100,000 - $10,000 - $10,000)
= $10,000 / $80,000
= .125 or 12.5%

Answer 1

Usable funds = Loan amount - discounted interest - compensating balance

Question 2

What is the market rate of interest on a 1-year U.S. Treasury bill?

Answer 2

The market rate of interest includes the risk-free interest rate of 2% plus the inflation premium of 1%, for a total of 3%.

Question 3

The risk management process includes both internal and external controls and involves the following:

Answer 3

・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

Question 4

financial markets. In relation to such risk, management has the ability to:

Answer 4

accept, transfer, or manage the risk.

Question 5

When economists are concerned about the liquidity preference function they are interested in:

the relationship of the demand for money and the rate of interest.

Answer 5

The demand for money varies inversely with the rate of interest. The liquidity preference (LP) function relates money demand to the rate of interest. As interest rates fall, the quantity of money demanded increases. As rates rise, the quantity of money demanded decreases.

Question 6

When dealing with operations risk, management should focus on the:

Answer 6

risk of loss resulting from inadequate or failed internal processes, people, and systems.

Operations risk deals with factors within the production process; thus, this risk area would include such items as loss resulting from downtime, engineering of the production process, the efficient use of energy, and the training of personnel

Question 7

A U.S. parent company is reviewing the cash flows from its international subsidiaries. In addition to exchange rate risk, which of the following items would be a primary consideration in the company’s cash flow analysis?

Answer 7

Repatriation restrictions

because repatriation restrictions limit the parent’s ability to receive cash from international subsidiaries, a prime consideration in its cash flow analysis.

Question 8

Option risk occurs when

Answer 8

a firm gives the customer the right (but not the obligation) to change the stream from assets, liabilities, or off-balance sheet items. 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.

Question 9

Re-pricing risk occurs

Answer 9

when a firm deliberately mismatches in an upsloping yield curve environment by holding assets with a longer duration than that of the liabilities used to fund them.

Question 10

An example of basis risk would be found in the situation where a bank’s interest margins are generally spontaneously enhanced in a period of rising interest rates as loan rates tend to adjust upward more rapidly than the rates on deposits.

Answer 10

However, at some point, as interest rate increases peak and rates begin to decline, this process reverses itself and there would be increasing pressure on interest rate margins.

Question 11

Yield curve risk arises when

Answer 11

the underlying shape of the yield curve changes (e.g., steepens, flattens, becomes inverted). These changes tend to accentuate any asset-liability mismatches the firm has.

Question 12

The $E will decline with respect to the $W.

Answer 12

The demand for Esland products decreases as imports to Woostland decrease. The decline of interest in purchasing Esland products decreases the demand for that country’s currency. As the demand for Esland currency decreases, the price of Esland currency will depreciate, or decline.

Question 13

In the modern world economy, balance-of-payments deficits and surpluses can be eliminated:

Answer 13

through the market mechanism of flexible exchange rates.

Flexible exchange rates automatically adjust so as to eliminate balance of payments surpluses and deficits. In the case of a deficit, the supply of the home currency and demand for the foreign currency increase. This causes the home currency to depreciate against the foreign currency. Hence the home country’s goods become cheaper relative to foreign goods and the country’s exports increase and imports decrease, eventually eliminating the deficit.

Question 14

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:

Answer 14

duration matching is effective in immunizing portfolios from parallel shifts in the yield curve.

Conventional duration strategies assume a flat yield curve.

Immunization only protects the nominal value of the terminal liabilities and does not adjust for inflation.

Question 15

The Federal Financial Institutions Examination Council (FFIEC) has suggested that regulated institutions should engage in scenario planning and undertake stress tests

a test for basis risk

Answer 15

changes in the relationship between key market interest rates.

Question 16

other stress tests

・tests for instantaneous rate shocks that deal with instantaneous and significant changes in the level of interest rates;

・ prolonged rate shocks that deal with substantial changes in rates over a longer period of time;

Answer 16

・and yield curve risk that deals with the impact of a changing shape of the yield curve

※ tests of interest rate shocks of significant magnitude should be run by all institutions, regardless of the institution’s size or complexity.

Question 17

translation exposure.

Answer 17

・The exposure of a multinational corporation’s consolidated financial statements to foreign exchange fluctuations
・Subsidiary earnings that are translated into the reporting currency on the consolidated income statement are subject to changes in exchange rates.

Question 18

A money market hedge involves：

Answer 18

borrowing an amount equal to the discounted value of the receivable (1.2B yen ÷ 1.05 = 1.143 billion yen). The proceeds of the loan would be converted to dollars at the current spot rate (1.143B yen ÷ 120 = $9,524,810), and the proceeds would then be invested in the United States. When the receivable is paid, the firm will use the proceeds to pay off the loan balance in Japan and collect the proceeds of the U.S. investment ($9,524,810 × 1.08 = $10,285,714). This would be the guaranteed proceeds from the Japanese sale that were created by using a money market hedge.

Question 19

Key elements of the control cycle approach to risk management include the following:

Answer 19

・Modeling the expected results using a set of initial assumptions
・Doing a profit test to determine if the product provides a contribution margin
・Measuring the actual results
・Determining, both in quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results
・Determining what actions need to be taken with respect to the product, including possible adjustments to reserves
・Using the findings to strengthen the model and update the assumptions as needed with feedback from the process

Question 20

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:

Answer 20

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.

Question 21

Regulators are looking to be more proactive in dealing with potential bubbles in financial markets and, as a result, are looking at primary capital to serve as a “shock absorber” as early warning signs that a bubble might occur.

Answer 21

・Regulators are concerned about the need to increase capital requirements for any market participant where remuneration and incentives focus excessively on short-term results.
・Risk margin capital is designed to be available in the event of high uncertainty or the occurrence of “black swan” events.

Question 22

Which of the following describes the hedging approach to financing?

Answer 22

Each asset is offset with a financing instrument of the same approximate maturity or duration.

Under the hedging approach the length of the financing term is matched to the maturity or duration of assets financed. Long-term debt is used to finance long-term assets and short-term debt is used to finance short-term assets.

Thus, each asset is offset with a financing instrument of the same approximate maturity.

Question 23

urrently, the U.S. tax code requires that transfer prices for multinational corporations are “arms length transactions.

・the comparable uncontrolled price. This method is based on the philosophy that what is a reasonable price for one customer is reasonable for another customer.

Answer 23

・the resale price. This method assumes that the price at which the items can be resold by the distribution affiliate less an amount to cover overhead head costs and a reasonable profit is a realistic transfer price.

・the cost-plus approach. This method entails adding an appropriate profit to the costs of the manufacturing affiliate in order to achieve a reasonable transfer price.