FRM2 - How Do Firms Manage Financial Risk?

Question 1

Compare different strategies a firm can use to manage its risk exposures and explain situations in which a firm would want to use each strategy

Answer 1

Firm can choose to accept, avoid, mitigate, or transfer risk

Question 2

Explain the relationship between risk appetite and a firm’s risk management decisions

Answer 2

Risk appetite is amount and types of risks a firm is willing to accept, informs the risk management procedures in place

Question 3

Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy

Answer 3

+ improves revenue stability
+ can lock in price for key inputs to a product so stable costs and prices
- risk managers could use hedging to meet short term goals which affect future prospects
- can be expensive or actually increase exposure

Question 4

Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency, and interest rate risk

Answer 4

Interest rate / foreign currency’s fundamental tool is to avoid taking too much debt at high interest rates and minimise exposure to FX risk

This balance is informed by the firm’s risk appetite

Pricing can be mitigated by forwards on key supply items to lock in production costs

Question 5

Assess the impact of risk management tools and instruments, including risk limits and derivatives

Answer 5

Firms must decide how much they are willing to pay to preserve flexibility in production

This can then bring risk exposures in line with limits in the risk appetite