Financial Risk Management

Question 1

Risk and return are a function of both market conditions and the risk preferences of the parties involved

Answer 1

risk - the change of financial loss

return - the total gain or loss experienced on behalf of the owner of an asset over a given period; typically, greater risk yields greater return

Question 2

What are the 3 basic risk preference behaviors?

Answer 2

risk-indifferent - reflects an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return

risk-averse - reflects an attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return; these managers require higher expected returns to compensate for greater risk (most managers fall into this category)

risk-seeking - reflects an attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return; these managers are willing to settle for lower expected returns as the level of risk increases

Question 3

What is interest rate risk (yield risk)?

Answer 3

often used in the context of financial instruments and represents the exposure of the owner of the instrument to fluctuations in the value of the instrument in response to changes in interest rates

Question 4

What is market/systematic/nondiversifiable risk?

Answer 4

this refers to fluctuations in value as a result of operating within an economy; sometimes referred to as nondiversifiable risk because it is a risk inherent in operating within the economy; it is attributable to factors such as war, inflation international incidents, and political events

Question 5

What is unsystematic/firm-specific/diversifiable risk?

Answer 5

this represents the portion of a firm’s risk that is associated with random causes and can be eliminated through diversification; it is attributable to firm or industry specific events like strikes, lawsuits, regulatory actions, or the loss of a key account

Question 6

What is credit risk?

Answer 6

this affects borrowers; exposure to this includes a company’s inability to secure financing or secure favorable credit terms as a result of poor credit ratings; as credit ratings decline, the interest rat demanded by lenders increases, collateral may be required, and other terms are generally less favorable to the borrower

Question 7

What is default risk?

Answer 7

this affects lenders; creditors are exposed to default risk to the extent that it is possible that its debtors may not repay the principal or interest due on their indebtedness on a timely basis

Question 8

What is liquidity risk?

Answer 8

this affects lenders/investors; they are exposed to this when they desire to sell their security, but cannot do so in a timely manner or when material price concessions have to be made to do so

Question 9

What is price risk?

Answer 9

the exposure that investors have to a decline in the value of their individual securities or portfolios; factors unique to individual investments and/or portfolios contribute to price risk, which becomes an even greater concern with increased market volatility; this is also related to diversifiable (unsystematic) risk

Question 10

What is the stated (nominal) interest rate?

Answer 10

it represents the rate of interest charged before any adjustment for compounding or market factors; it is the rate shown in the agreement of indebtedness

Question 11

What is the effective interest rate?

Answer 11

it represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees related to a loan origination; it is computed by dividing the amount of interest paid based on the loan agreement by the net proceeds received

Question 12

What is annual percentage rate?

Answer 12

it represents a non-compounded version of the effective interest rate; it is the rate required for disclosure by federal regulations; it is computed as the effective periodic interest rate times the number of periods in a year; it emphasizes the amount paid relative to funds available

Question 13

What is effective annual percentage rate?

Answer 13

it represents the stated interest rate adjusted for the number of compounding periods per year; it is computed as follows:

effective annual interest rate = [1 + (i/p)]^p - 1
i = stated interest rate
p = compounding periods per year

Question 14

What is simple interest (amount)?

Answer 14

it is the amount represented by interest paid only on the original amount of principal without regard to compounding; it is computed as follows:

simple interst = P(i)(p)

P = original principal
i = interest rate per time period
n = number of time periods

Question 15

What is compound interest (amount)?

Answer 15

it is the amount represented by interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense; interest earnings or expense, therefore, compounds and yields an amount higher than simple interest; it is calculated as follows:

future value = P (1 + i)^n

P = original principal
i = interest rate
n = number of periods

Question 16

What is required rate of return?

Answer 16

it is calculated by adding the following risk premiums to the risk-free rate:

maturity risk premium - the compensation that investors demand for exposure to interest rate risk over time; this risk increases with the term to maturity

purchasing power risk or inflation premium - the compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars

liquidity risk premium - the additional compensation demanded by lenders (investors) for the risk that an investment security cannot be sold on a short notice without making significant price concessions; liquidity is defined as the ability to quickly convert an asset to cash at fair market value

default risk premium - the additional compensation demanded by lenders (investors) for bearing the risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis

Question 17

Mitigating and controlling financial risk

Answer 17

business entities must be able to not only identify and assess various financial risks, but also implement strategies to mitigate and control the impact these risks can have on their operations and finances; a diversified investors should be concerned only with non-diversifiable (systematic) risk because, in theory, an investor can create a portfolio of assets that eliminates all (or virtually all) diversifiable risk

Question 18

What are some strategies to mitigate and control specific financial risks?

Answer 18

mitigating interest rate risk - this can be done by investing in floating rate debt securities, which do not change in value when interest rates change and also generate higher coupon payments when interest rates rise; derivatives such as forward rate agreements or interest rate swaps can also be used

mitigating market risk - this is not easy to mitigate and cannot be done through diversification since it is inherent to the marketplace and the economy overall; it can be controlled by investing in derivatives that provide gains to the investor when the market declines; short selling (selling an investment in the hopes of buying it back at a lower price later) is another strategy that provides returns when the market declines

mitigating unsystematic risk - this can be minimized through diversification; a broad portfolio would take less of a hit than one that has more focused investments

mitigating credit risk - this can be managed through improvements in credit ratings; when ratings are higher, borrowing can occur at more favorable terms (such as lower interest rates); there are many factors that determine credit ratings and while management has various degrees of control over them, awareness of them and understanding ow changes can affect credit ratings are crucial to controlling this risk

mitigating default risk - this can be done in several ways; as a lender, an entity may choose to end only to borrowers with low risk of default; another option is to adjust the interest rates charged to better reflect the risk of each borrower

mitigating liquidity risk - this risk is higher for investments that don’t have active markets; it can be mitigated by allocating a greater percentage of capital to investments that trade on active markets

mitigating price risk - this risk can be minimized through diversification; it can also be mitigated through short selling or derivatives (such as put options)

Question 19

Factors influencing exchange rates

Answer 19

trade factor: relative inflation rates - when domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money; the increase in demand for foreign currency forces the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange between the domestic and foreign currency

trade factor: relative income levels - as income increases in one country relative to another, exchange rates change as a result of increased demand for foreign currencies in the country in which income is increasing

trade factor: government controls - various trade and exchange barriers that artificially suppress the natural forces of supply and demand affect exchange rates

financial factors: relative interest rates and capital flows - interest rates create demand for currencies by motivating either domestic or foreign investments; the forces of supply and demand create changes in the exchange rate as investors seek fixed returns; the effect of interest rates is directly affected by the volume of capital that is allowed to flow between countries

Question 20

Risk exposure categories

Answer 20

transaction exposure - the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates; measurement of transaction exposure is generally done in two steps: project foreign currency inflows and foreign currency outflows & estimate the variability (risk) associated with the foreign currency

economic exposure - the potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates; it is generally defined through local currency appreciation or depreciation and is measured in relation to organization earnings and cash flows; currency appreciation (depreciation) refers to the strengthening (weakening) of a currency in relation to other currencies; the economic exposure created by domestic currency appreciation or deprecation with respect to a foreign currency depends on the net inflow or outflow of foreign currency

effect of currency appreciation: as a domestic currency appreciates in value or becomes stronger, it becomes more expensive in terms of a foreign currency; inflows (of foreign currency payments) tend to decline as exports become more expensive, whereas outflows (to foreign vendors) tend to increase as imports become less expensive

effect of currency depreciation: as a domestic currency depreciates in value or becomes weaker, it becomes less expensive in terms of a foreign currency; inflows (of foreign currency payments) tend to increase as exports become less expensive, whereas outflows (to foreign vendors) tend to decrease as imports become more expensive

translation exposure - the risk that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates; translation exposure is generally defined by the degree of foreign involvement, the location of foreign subsidiaries, and the accounting methods used and measured in relation to the effect on the organization’s earnings or comprehensive income; translation exposure increases as the proportion of foreign involvement by subsidiaries increases

Question 21

What is selective hedging?

Answer 21

hedging is a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial instrument that behaves in the opposite manner from the hedged item; in effect, hedging is a process of reducing the uncertainty of the future value of a transaction or position by actively engaging in various derivative investments

Question 22

What is a futures hedge?

Answer 22

it entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date; futures hedges are denominated in standard amounts and tend to be used for smaller transactions

Question 23

What is a forward hedge?

Answer 23

it is similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point; although futures hedges tend to be used for smaller transactions, forward hedges are contracts between businesses and commercial banks and are normally larger transactions; although a futures hedge might hedge a particular transaction, a forward hedge is used based on an anticipated company need to either buy or sell a foreign currency at a particular point

Question 24

What is a money market hedge?

Answer 24

it uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables

firms with excess cash use money market hedges to lock in the exchange rate associated with the foreign currency needed to satisfy payables when they come due

firms that do not have excess cash follow the same basic procedure for a money market hedge on payables, except that they first borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency

a money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans; foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency; borrowed foreign currency amounts are converted into the domestic currency

Question 25

What is a currency option hedge?

Answer 25

it gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is most favorable

currency option hedges: payables - a call option (an option to buy) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables

currency option hedges: receivables - a put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for receivables

Question 26

Mitigating transaction exposure: long-term transactions

Answer 26

long-term forward contracts - they deal with the same issues as any other forward contracts, but they are set up to stabilize transaction exposure over long periods; long-term purchase contracts may be hedged with long-term forward contracts

currency swaps - transaction exposure associated with exchange rate risk for longer-term transactions can be mitigated with currency swaps

two firms with coincidental needs for international currencies may agree to swap currencies collected in a future period at a specified exchange rate; the two entities essentially swap their currencies in an exchange negotiation completed years in advance of their receipts of the currencies

two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date

Question 27

Mitigating transaction exposure: alternative hedging techniques

Answer 27

leading and lagging - these represent transactions between subsidiaries or a subsidiary and a parent; the entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until the exchange rate is favorable before settling (lagging)

cross-hedging - this involves hedging one instrument’s risk with a different instrument by taking a position in a related derivatives contract; this is often done when there is no derivatives contract for the instrument being hedged, or when a suitable derivatives contract exists but the market is highly illiquid

currency diversification - the simplest hedge for long-term transactions is to diversify foreign currency holdings over time; a substantial decline in the value of one currency would not affect the overall dollar value of the firm if the currency represented only one of many foreign currencies

Question 28

T/F: restructuring tends to be more difficult than ordinary hedges

Answer 28

True; economic exposures to exchange rate fluctuations are viewed as more difficult to manage than transaction exposures