L10- Risk Management Flashcards
Is reducing risk a corporate objective in itself?
Reducing risk is not a corporate objective in itself
If it was, then risk would be part of project evaluation, but it is not (apart
from risk-adjusted discounting)
What are the main reasons firms manage risk?
–Reducing the Risk of Cash Shortfalls or Financial Distress: Transactions that reduce
risk make financial planning simpler and reduce the odds of an embarrassing cash
shortfall.
–Reducing agency costs (performance vs luck)
–Taxes
What is market-based risk management?
contracts that fix prices of raw materials or
output, at least for the near future. A survey of the world’s 500 largest companies found that most of them use derivatives to manage their risk
How does insurance help firms manage risk?
When a firm takes out insurance, it is simply transferring the risk to the insurance company. Reducingthe financial impact of unexpected losses
What is a Forward contract
A forward contract is a private agreement between two parties to buy or sell an asset at a fixed price on a future date.
Example of a forward contract
if you and I agree today that I’ll sell you 100 kilograms of wheat for $500 in 3 months,
What makes forward contracts customizable?
–The amount of the asset
–The price
–The delivery date
What is the main risk of forward contracts?
If I don’t deliver or you don’t pay, there’s no third party to ensure the deal happens.
Counterparty risk
How are forward contracts settled?
contract expires, either by:
–delivering the goods OR
–By paying the agreed price
What is a futures contract?
A futures contract is a standardized agreement to buy or sell an asset at a fixed price on a future date, traded on an exchange.
What does “marked to market” mean in futures trading?
means that the value of the futures contract is adjusted daily based on current market prices. This makes it easier to exit the deal
before the delivery date
What role does the clearinghouse play in futures contracts?
There’s less risk because the exchange has a clearinghouse that guarantees
the deal. If one party can’t pay, the clearinghouse steps in.
Define Hedge Ratio
Tells you how much of the hedge instrument you should buy or sell
based on the relationship between the volatility of the asset you’re hedging and
the correlation with the hedge instrument.
Hedge Ratio Formula
[Cov(z,x)]/var(x)
–𝑥 is the cash flow to be hedged
–𝑧 is the hedge-instrument
–𝒄𝒐𝒗(𝒛, 𝒙) : covariance between the returns of the hedge instrument z and the
asset x (the cash flow to be hedged).
–var(x) is the variance of the returns of x
Define Covariance
Covariance measures how two assets move in relation to each other.
Define Variance
measures how much the CF of asset fluctuates. Higher variance means that 𝑥 is more volatile.
How does the hedge ratio help in risk management?
The hedge ratio tells how much of the hedge instrument is needed to offset risk in the asset being hedged.
For every unit of 𝑥 owned, sell ℎ units of the hedge instrument.
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