Managing Risk Flashcards
What is the definition of risk?
Risk is the probability/likelihood of an event happening where possible outcomes can be identified
Example: Rolling a dice.
What is uncertainty?
Uncertainty refers to not being able to identify possible outcomes or assess their likelihood of occurrence.
What is company risk?
Company risk is the total risk faced by shareholders or owners, consisting of systematic and non-systematic risk.
How is total risk calculated?
Total Risk = Systematic Risk + Non-Systematic Risk.
What is systematic risk?
Systematic risk affects all companies to varying extents and is largely due to macro-economic factors.
What are some examples of systematic risk factors?
- Inflation
- Taxation policy
- Interest rates
- Exchange rates.
What is non-systematic risk?
Non-systematic risk consists of company-specific risk factors.
What is the foreign exchange market?
The market where one currency is converted into another, known as the foreign exchange market or FOREX.
What is the significance of the foreign exchange market?
It is the most liquid market in the world due to high volume and frequency of trading.
Define bid price.
The bid price is the highest price a buyer will pay for a security.
Define ask price.
The ask price is the lowest price a seller will accept for a security.
What is the spread in trading?
The spread is the difference between the bid price and the ask price.
What is the direct quote in foreign exchange?
A direct quote gives the exchange rate in terms of the number of units of the home currency required to purchase one unit of the foreign currency.
What is the indirect quote in foreign exchange?
An indirect quote gives the price in terms of how many units of the foreign currency can be bought with one unit of the home currency.
What are the four types of foreign exchange risks for a company?
- Pre-transaction risk
- Transaction risk
- Translation risk
- Economic exposure.
What is pre-transaction risk?
Pre-transaction risk refers to possible exchange rate fluctuations between pricing a transaction and the moment it is agreed.
What is transaction risk?
Transaction risk is the risk that currency exchange rate fluctuations will change the value of a foreign transaction after it has been completed but not yet settled.
What is translation risk?
Translation risk is the risk that assets held abroad will lose value in the home currency due to exchange rate movements.
What is economic exposure?
Economic exposure refers to the risk to all future cash flows and overall business value due to exchange rate movements.
What are external risk hedging instruments?
- Forward contracts
- Futures contracts
- Option contracts.
What is a forward currency contract?
A forward currency contract is an agreement to exchange a specified amount of currency at a specified exchange rate on a future date.
What is a forward premium?
A forward premium occurs when the forward rate exceeds the existing spot rate.
What is a forward discount?
A forward discount occurs when the forward rate is less than the existing spot rate.
What is a futures contract?
A futures contract is similar to a forward contract but is tradable and can be bought and sold daily.
What is an option in foreign exchange?
An option gives the holder the right, but not the obligation, to buy or sell a specified amount of foreign currency at a fixed exchange rate.
What is a Forward Rate Agreement (FRA)?
An FRA is an agreement about the future level of interest rates, allowing the management of interest rate risk exposure.
What factors affect interest rates?
- Demand for money
- Supply of money
- Fiscal deficit and government borrowing
- Inflation
- Global interest rates.
What is a FRA?
An over-the-counter product enabling the management of an interest rate risk exposure
FRA stands for Forward Rate Agreement.
What is the purpose of a FRA?
To lock-in interest rates for borrowing or lending at a specified future date.
What does a company do if it expects interest rates to rise?
Enter into a FRA to secure a fixed interest rate.
What happens if the spot interest rate exceeds the FRA rate?
The company receives compensation from the FRA counterparty.
If the spot rate in six months is 8.5% and the FRA rate is 7%, what is the compensation amount?
£90,000.
What is the notional amount in a FRA?
The amount of loan on which interest is calculated.
What is the difference between the buyer and seller of a FRA?
Buyer borrows the notional sum (long position), seller lends the notional sum (short position).
What is the Reference Rate in a FRA?
The floating rate used in the FRA contract (e.g., SONIA, EURIBOR).
What is the FRA Rate?
The fixed interest rate the buyer of FRA pays or the price of the FRA.
What is the settlement date in a FRA?
The date on which the forward loan becomes effective and the FRA is cash settled.
What occurs if the market rate is less than the FRA rate on the settlement date?
The buyer pays the seller the difference.
What does a 3×6 FRA mean?
A 3-month loan beginning in 3 months.
What happens during settlement of a FRA if the market rate is greater than the FRA rate?
The seller pays the buyer the difference.
Calculate the saving for a long position with a FRA rate of 6% if the market rate is 8%.
£5,000.
What is the formula to calculate the present value of FRA payment?
FRA Payment = Savings / (1 + (Market Rate)(Days/360)).
What is a disadvantage of FRAs?
Lack of liquidity and subject to default risk.
What does the term ‘long position’ refer to in a FRA?
The party borrowing money under the FRA.
What does the term ‘short position’ refer to in a FRA?
The party lending money under the FRA.
Fill in the blank: The FRA market is characterized as _______.
[liquid and available with banks/dealers across major currencies].
What is the typical benchmark for FRAs that have been replaced?
SONIA (Sterling Overnight Index Average).
What is the main benefit of entering into a FRA?
Certainty over effective interest costs of borrowing in the future.
