Risk Management Flashcards
Learn about risk and hedging
Risk management
It involves identifying potential events or situations that could negatively impact an organization, analyzing their potential consequences, and taking proactive measures to minimize or control the impact of these risks.
Financial Exposure
The potential financial impact that a company may face due to changes in market conditions, interest rates, currency exchange rates, or commodity prices.
Credit Risk
The risk of financial loss resulting from the failure of a counterparty to fulfill its contractual obligations. Credit risk is particularly relevant in lending and trade relationships.
Market risk
The risk of financial loss due to changes in market prices, including equity prices, interest rates, foreign exchange rates, and commodity prices.
Foreign exchange risk
The risk of financial loss due to fluctuations in exchange rates when a company engages in international trade or has foreign currency-denominated assets or liabilities.
Operational risk
The risk of financial loss arising from inadequate or failed internal processes, systems, people, or external events. Operational risk includes risks related to technology, human error, and fraud.
Liquidity risk
The risk that a company may not be able to meet its short-term financial obligations due to insufficient liquidity. Liquidity risk is associated with the ease of converting assets into cash.
Counterparty risk
The risk associated with the financial stability of counterparties in transactions. Counterparty risk is particularly relevant in derivatives and financial contracts.
Risk mitigation
Implementing strategies and measures to reduce or control the impact of identified risks. Mitigation measures may include preventive actions, risk transfer (e.g., insurance), and contingency planning.
Hedging
Using financial instruments or strategies to offset or reduce the impact of adverse movements in market prices, interest rates, exchange rates, or commodity prices.
Hedge accounting
The primary purpose of hedge accounting is to align the recognition of gains or losses on hedging instruments and the items being hedged, thereby providing a more accurate representation of a company’s financial position and performance.
Derivatives
Financial instruments whose value is derived from an underlying asset, index, or rate. Common derivatives include futures, options, and swaps, which can be used for risk management purposes.
Swap
A financial derivative contract between two parties who agree to exchange cash flows or other financial instruments over a specified period. Swaps are commonly used for risk management, hedging, or to gain exposure to specific financial markets. The two main types of swaps are interest rate swaps and currency swaps, although there are other variations as well.
Interest rate swap
In an interest rate swap, two parties agree to exchange interest rate cash flows on a notional principal amount. One party pays a fixed interest rate, while the other pays a floating interest rate based on a reference interest rate (e.g., LIBOR or the U.S. Treasury rate). Interest rate swaps are often used to manage or hedge interest rate risk.
Example: In a typical interest rate swap, Party A may agree to pay Party B a fixed interest rate of 4%, while Party B agrees to pay Party A a floating interest rate based on the 3-month LIBOR. The notional principal is used for calculating the cash flow, but it is not actually exchanged.
Currency swap
A currency swap involves the exchange of cash flows denominated in different currencies. The purpose of a currency swap is often to hedge against currency exchange rate risk or to obtain a more favorable borrowing rate in a foreign currency.
Example: Suppose Company A, based in the United States, needs to borrow in euros, while Company B, based in the Eurozone, needs to borrow in U.S. dollars. They may enter into a currency swap where Company A borrows in euros and Company B borrows in U.S. dollars. The interest and principal payments are then exchanged.
