Chp 7: Financial Risk

Question 1

What is Purchase Power Parity (PPP) theory?

Answer 1

The impact of higher inflation is to decrease the purchasing power of the foreign currency which over time will reduce it’s value on foreign currency markets

Question 2

What are the two types of currency risk?

Answer 2

1. Transaction Risk - the risk that a transaction in a foreign currnecy is recorded at one rate but settled at a different rate (timing issues)
2. Translation Risk - when producing company accounts, all assets and liabilites need to be recorded in the domestic currency, which could result in losses due to exchange rates.

Question 3

What is Value at Risk (VaR)?

Answer 3

VaR measures the maximum loss possible due to normal market movements in a given period of time for a given probability.

Often used for: value of foreign currency subject to exchange rate movements and the values of a portfolio of shares subject to market fluctuations.

Question 4

VaR = confidence interval value x standard deviation

Explain the calculation

Answer 4

Confidence interval value comes from the normal distribution table (if they’re looking for the 95% VaR, find 0.45 on the table and work out the Z score, this is the CIV)

Standard deviation may come from the question as the daily/weekly standard deviation as a percentage (eg. 5%). So multiply that percentage by the by the overall value to get your standard deviation in £, $ etc.

Question 5

How do you calculate the daily standard deviation if it is gien for a longer period?

Caluclation

Answer 5

Daily (sigma) = Given (sigma) / sqroot(number of days covered)

Question 6

What are the two drawbacks of Value at Risk (VaR)?

Answer 6

1. VaR is based on normal distribution which assumes that virtually all possible outcomes will be within three standard deviations of the mean
2. That success and failure are equally likely

Neither is likely to be true for a one off project