Financial Risk Management

Question 1

Interest Risk (yield risk)

Answer 1

Losses in underlying asset value or increases in underlying liability value as a result of changes market interest rates.
**Investor

Question 2

Risk definition

Answer 2

Exposure to loss

Question 3

Market Risk

Answer 3

Losses in trading value of asset or liability in markets. Market risk is a non-diversifiable risk.
**Investor

Question 4

Credit risk

Answer 4

Inability to secure debt financing in a timely and affordable manner.
** Borrower

Question 5

Default risk

Answer 5

Possibility that the debtor may not pay the principal or interest due on their debt obligation on a timely manner.
**Creditor / lender

Question 6

Liquidity risk

Answer 6

Investor may not be able to sell a security on a timely basis or without incurring losses.
**Investor

Question 7

What’s risk-free rate?

Answer 7

Compensates for the time value of money.

Question 8

The required rate of return (RRR)consists of:

Answer 8

Risk free premium
\+ market risk premium 
\+ inflation premium
\+ Liquidity risk premium 
\+ default risk premium

Question 9

Probability vs expected value

Answer 9

Probability represents a chance (expressed as a %) that an event will occur from 0 - 100. Heads or tails (50% - or 1 in 2 chances)
Expected value is the weighted average of the probability assigned to each expected outcome.

Question 10

Circumstances creating exchanges fluctuations.

Answer 10

Exchange rate fluctuations are generally caused by 2 factors: 
TRADE FACTORS
> inflation rate
> income levels
> government controls 
and FINANCIAL FACTORS
> interest rates
> cash flows

Question 11

What are the risk exposures implied by exchange rate fluctuations?

Answer 11

Transaction exposures, economic exposures, and translation exposures.
TRANSACTION > gain/loss on settlement of a transaction in a foreign currency.
ECONOMIC > cash flow may fluctuate as a result of changes in exchange rates (overall company exposure - not individual)
TRANSLATION > potential that the consolidation of FS of domestic parents with foreign subs will result in changes in account balances and income due to exchange rate fluctuations. (Remeasurement)

Question 12

What is hedging

Answer 12

Is a financial risk management technique in which an entity, that is attempting to mitigate the risk fluctuations in exposure, acquires a financial instrument that behaves in the opposite manner from the hedged item.

Question 13

What type of hedges can be used to mitigate TRANSACTION exposure from AP and AR?

Answer 13

Futures, Forwards, money market, currency option, long-term forward, currency swap.

Question 14

What is a futures hedge?

Answer 14

Futures hedge entitles the holder to either PURCHASE OR SELL A NUMBER OF CURRENCY UNITS FOR A NEGOTIATED PRICE ON A STATED DATE. Used for SMALLER AMOUNTS.

Question 15

What is a forward hedge?

Answer 15

Same as futures, but the owner of the contract is entitled to buy or sell volumes at a point in time. Forward contracts identify groups of transactions for LARGER AMOUNTS.

Question 16

What is a money market hedge?

Answer 16

It uses foreign money markets to meet future cash flow needs and mitigate exchange rate risk by INVESTMENT IN FINANCIAL INSTITUTIONS OF THE FOREIGN ECONOMY. Executed with either excess cash discounted and invested in foreign economy or through simultaneous borrowing in reinvesting the foreign economy.

Question 17

What is a currency option hedge?

Answer 17

Owner has option (and not the obligation) to execute the hedge transaction. The acquisition of an option requires PAYMENT OF CONSIDERATION (PREMIUM).

Question 18

What is a long-term forward hedge?

Answer 18

Like forwards contracts, but it is used to stabilize transaction over long periods. May be used to hedge LONG-TERM PURCHASE CONTRACTS.

Question 19

What is a currency swap?

Answer 19

Can be used to mitigate transaction exposure for longer term transactions. Ex.: 2 firms may enter into a currency swap where they agree to swap their currencies received at a future date for negotiated exchange rates.

Question 20

What type of hedges can be used to mitigate ECONOMIC and TRANSLATION exposure?

Answer 20

Fluctuations can be mitigated by restructuring the sources of income and expense to the consolidated entity.
If an entity wants less economic exposure or less translation exposure, they need less investment in foreign entities and less inflows of foreign currencies. That may not be the option, but the way to mitigate this exposure is to reduce the number of currency transactions, or the number of investment in subsidiaries whose FS are denominated in foreign currencies.

Question 21

What is the primary reason for developing transfer pricing between domestic parents and foreign subs?

Answer 21

is to minimize local taxation.

Question 22

How are cash transfers are managed?

Answer 22

Through leading and lagging transfer policies
Subs with a STRONG CASH POSITION tend to follow a “LEADING” transfer policy and PAY OTHER SUBS IN ADVANCE.
Subs with a WEAK CASH position tend to follow a “LAGGING” transfer policy under which they would PAY RICHER SUBS LONG AFTER OBLIGATIONS WERE INCURRED AS A MEANS OF PRESERVING CASH.