Econ 4 - Financial Risk Management

Question 1

Interest Rate Risk affects

Answer 1

both small and large organizations

Question 2

Risks for small firms include

Answer 2

• inability to use broader capital markets
• unable to diversify operations
• inability access more suppliers

Question 3

Operations Risk is

Answer 3

the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events

Question 4

In negotiating a loan, the more favorable type of interest for the bank is _____ and the more favorable type of interest for the customer is ______

Answer 4

bank = compound interest
customer = simple interest

Question 5

Over an extended period of time, how does interest on LT debt compare to interest on ST debt?

Answer 5

Interest on LT debt cost more

Question 6

Effective Annual Interest Rate =

Answer 6

Total Interest / Obligation Amount

*be careful of the method of compounding other than yearly

Question 7

Per FASB ASC 815, if an entity engages in a hedge against the exposure to variable cash flow of a forecasted transaction, the entity would

Answer 7

recognize the effective portion of the derivative’s gain or loss initially as a component of other comprehensive income, and subsequently reclassify it into earnings when the forecasted transaction affects earnings.

Question 8

Effective Rate of Interest (interest paid on a discount basis) =

Answer 8

Interest Paid / Usable Funds or [Loan amt - Discounted Interest - Compensating Balance]

Question 9

Discount Interest is

Answer 9

a situation where all interest on a loan is paid at once and the interest amount is deducted from the amount the borrower will receive at the beginning of the loan

Question 10

The Effective Annual Interest Rate will = Nominal or Stated Rate if compounding is done

Answer 10

annually

Question 11

The highest Effective Interest Rate occurs when compounding is done

Answer 11

continuously

Question 12

The TRUE rate of interest is the same as the

Answer 12

Effective Rate

Question 13

Financial Risk Mgmt is a component of ERM and includes risks such as:

Answer 13

• Business risk
• Operations risk
• Supply-chain risk
• Product liability risk
• Political and Economic risk

Question 14

In the risk mgmt process, what strategies does the firm have to manage its risk?

Answer 14

Accept, transfer, or manage

Question 15

If the dollar price of the euro rises

Answer 15

the dollar depreciates against the euro and the euro will buy more US goods

Question 16

FV of an Investment using compound interest will always be ____ the same investment using simple interest

Answer 16

more than

Question 17

Market Rate of Interest =

Answer 17

Risk Free Interest Rate + Inflation Premium

Question 18

What would encourage a company to use short-term loans to retire 10-yr bonds that have 5-yrs to maturity?

Answer 18

Interest rates declined over the last 5 years (assuming they continue to decline, pay less interest)

Question 19

Freely fluctuating (floating) exchange rates do what?

Answer 19

Auto-correct a lack of equilibrium in the balance of payments

Question 20

When banks allow a customer to refinance a mortgage loan at any time without a prepayment penalty, they engage in

Answer 20

option risk

Allowing a customer to prepay a mortgage without a prepayment penalty gives the customer a call option, i.e., the right to pay the mortgage in full at any time during the mortgage term, thus changing the cash flow stream the firm receives from the mortgage.

Question 21

The risk management process includes both internal and external controls and involves

Answer 21

• Identifying and prioritizing risks and understanding their relevance
• Understanding the stakeholder’s objectives and their tolerance for risk
• Developing and implementing appropriate strategies in the context of a risk management policy

Question 22

Usury Laws are

Answer 22

regulations governing the max amount of interest that can be charged on a loan

Question 23

One negative consequence of Usury Law regulations from the borrower’s perspective is

Answer 23

less creditworthy customers are excluded from the market

Question 24

Credit Union was offering fixed rate mortgages to its members but decides it can longer afford to offer this service and instead decides to offer variable rate mortgages with the interest rate tied to an index and adjusted yearly. The interest rate risk has been

Answer 24

transferred (from the credit union to the member)

Question 25

Key elements of Financial Risk Management include

Answer 25

- Interest rate risk - Foreign currency risk - Credit risk

Question 26

Assuming a 360-day year, the current price of a $100 U.S. Treasury bill due in 180 days on a 6% discount basis is:

Answer 26

``` Price = Face amount - Interest $97 = $100 - (100 x 0.06 x (180/360)) ```

Question 27

When a US parent company reviews the Cash Flow from its international subsidiaries, the primary considerations are

Answer 27

exchange rate risk and repatriation restrictions (repatriation restrictions limit the parent’s ability to receive cash from international subsidiaries)

Question 28

The future value of $100 invested today for three years at an annual interest rate of 8% using the simple interest method is

Answer 28

$124 ``` Total = Principal + Interest $124 = $100 + ($100 x 0.08 x 3) ```

Question 29

Individuals who would be most hurt by inflation include

Answer 29

- those on fixed income (same $ have be stretched further) - those who lent money on a fixed interest rate (they will be paid back in cheaper $) - those who save cash dollars (purchase power of $ decreases)

Question 30

Zoo Supply Company borrowed $100,000 from a local bank to purchase equipment. The annual interest rate on the 5-year loan was 10%. Over the 5-year period, Zoo paid $50,000 of interest. This interest was calculated as

Answer 30

simple interest

Question 31

Effective Interest Rate (w/ compensating balance, checking account interest, and typical balance kept) =

Answer 31

[(Loan amount x Interest %) - ((Compensating Balance - Typical Bank Balance) x Checking Account Interest %)] / (Loan amount - Compensating Balance + Typical Bank Balance)

Question 32

Current Ratio =

Answer 32

``` Current Assets / Current Liabilities. # > benchmark = more liquid ```

Question 33

When economists are concerned about the Liquidity Preference (LP) Function they are interested in

Answer 33

the relationship of the demand for money and the rate of interest. Interest rates fall = Qty $ demanded increases Interest rates rise = Qty $ demanded decreases

Question 34

The simple interest method of calculating interest on loans does not consider

Answer 34

interest on interest

Question 35

When the dollar depreciates, the effect on prices of US imports and exports is

Answer 35

An increase in Import prices and A decrease in Export prices

Question 36

Purpose of hedging foreign exchange risk is to

Answer 36

insulate the firm from exposure to exchange rates

Question 37

Control cycle approach to risk management includes

Answer 37

- modeling expected results using a set of initial assumptions - doing a profit test to determine if the product provides a contribution margin - measuring actual results - determining in quantitative and qualitative terms an understandable explanation of difference in expected and actual results - determining what actions need to be taken with respect to the product - using findings to strengthen the model and update the assumption as needed with feedback

Question 38

Type of risk that can be reduced by diversification:

Answer 38

Labor strikes; Since different industries and countries experience different risks of labor strikes, diversification between industries and countries can reduce company risk.

Question 39

In the modern world economy, balance-of-payments deficits and surpluses can be eliminated:

Answer 39

through the market mechanism of flexible exchange rates

Question 40

Management finds that the key interest rate risk the firm is facing is related to movements in short-term interest rates. Management decides that the rate on the 20-year bond is too attractive to pass up. They issue the bond and then choose to develop ________ to offset their interest rate risk.

Answer 40

an interest rate swap transaction

Question 41

Assuming that exchange rates are allowed to fluctuate freely, a nation's currency would appreciate on the foreign exchange market when

Answer 41

a slower rate of growth in income occurred relative to other countries, which causes imports to lag behind exports

Question 42

Per the FFIEC, in a stress test the basis risk is dealing with

Answer 42

changes in the relationship between key market interest rates

Question 43

Per the FFIEC, in a stress test the yield curve risk is dealing with

Answer 43

changes in the shape and slope of the yield curve

Question 44

Per the FFIEC, in a stress test the instantaneous rate shock is dealing with

Answer 44

instantaneous and significant changes in the levels of interest rates

Question 45

Per the FFIEC, in a stress test the prolonged rate shock is dealing with

Answer 45

substantial changes in interest rates over time

Question 46

Examples of financial instruments that are derivatives

Answer 46

- interest rate futures - agreement to buy a piece of equipment in six months at a price determined today - a contract to purchase a commodity in six months at a price determined today

Question 47

Platinum Co. has a receivable due in 30 days for 30,000 euros. The treasurer is concerned that the value of the euro relative to the dollar will drop before the payment is received. To reduce risk

Answer 47

enter into a forward contract to sell 30,000 euros in 30 days

Question 48

Consider a world consisting of only two countries, Canada and Italy. Inflation in Canada in one year was 5%, and in Italy 10%. The Canadian Dollar will

Answer 48

appreciate by 5%

Question 49

The dominant reason why countries devalue their currencies is to

Answer 49

improve the balance of trade

Question 50

If the central bank of a country raises interest rates sharply, the country's currency will most likely

Answer 50

increase in relative value

Question 51

A U.S firm sold $3 million in finished goods to a firm in Thailand for delivery in six months with the contract to be invoiced in dollars. In the ensuing period, the value of the bhat declined by 80%, which meant that Thai firm could not afford to purchase the dollars necessary to fulfill the contract. This is an example of

Answer 51

economic exposure

Question 52

In relation to the role of capital in mitigating financial risk, it has been strongly suggested that in the new regulatory environment, regulators treat capital:

Answer 52

as a shock absorber and allow firms to draw down capital during periods of market stress that would be expected to be replenished when market conditions improve.

Question 53

One United States dollar is being quoted at 120 Japanese yen on the spot market and at 123 Japanese yen on the 90-day forward market, hence the annual effect in the forward market is the

Answer 53

USD at a premium of 10%. The difference between the spot market and 90-day forward market price of a dollar in terms of yen, is 3 yen. Over a 360-day year, this 90-day difference of 3 yen translates into 12 yen, which is 10% of the spot market quote of 120 yen. The forward market quote is higher than that in the spot market, hence it is expected that the dollar will appreciate, and the U.S. dollar is at a premium of 10%.

Question 54

According to IRS Tax code, methods allowed to control transfer pricing manipulation include

Answer 54

- comparable uncontrolled price - resale price - cost-plus approach

Question 55

When exchange rates change, the values of a foreign subsidiary's assets and liabilities change when looked at from the perspective of the parent firm. Thus, there must be some method for a multinational company to consolidate the subsidiary's activities that logically deals with changes in exchange rates. This best describes:

Answer 55

translation exposure

Question 56

Put option is

Answer 56

the right (but not the obligation) to sell a specific security at fixed conditions of price and time. Typically purchased if price is expected to decrease over the option period.

Question 57

Call option is

Answer 57

the right (but not the obligation) to buy a specific security at fixed conditions of price and time. Typically purchased if price is expected to rise over the option period.

Question 58

The recommended derivative instrument for a company with several LT floating rate bonds outstanding, stable cash flow, and the desire to hedge interest rate risk is a

Answer 58

swap agreement

Question 59

Immunizing a portfolio from interest rate risk by matching the duration of assets to the duration of liabilities might be ineffective and/or inappropriate because

Answer 59

duration matching is effective in immunizing portfolios from parallel shifts in the yield curve

Question 60

When two companies are both members of a Multinational Corporation (MNC) and the purchasing subsidiary wants to buy a component part of the selling subsidiary, the acceptable range for transfer pricing is $300-600. The purchasing sub has a home tax rate of 50% and the selling sub has a home tax rate of 20%. The optimal transfer price will affect whom and be what amount?

Answer 60

Selling sub and MNC will max earnings by setting the transfer price at $600 per unit

Question 61

If an institution is developing a capital position that is designed to cover risk beyond what is considered necessary for its best estimate reserves, the institution would be creating a

Answer 61

risk margin

Question 62

Hedging approach to financing is when

Answer 62

each asset is offset with a financing instrument of the same approximate maturity or duration

Question 63

A company manufactures goods in Esland for sale to consumers in Woostland. Currently, the economy of Esland is booming and imports are rising rapidly. Woostland is experiencing an economic recession, and its imports are declining. How will the Esland currency, $E, react with respect to the Woostland currency, $W?

Answer 63

The $E will decline with respect to the $W

Question 64

The U.S. inflation rate is expected to be 5% per annum while the Italian lira is expected to depreciate against the U.S. dollar by 10% during the same period. During the next year, an Italian firm importing from its U.S. parent can expect its lira cost for these imports to:

Answer 64

Increase by about 15% 100 x 1.05 = 105.0 105 x 1.10 = 115.5 (115.5 - 100) / 100 = 15.5%

Question 65

If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client an investment in

Answer 65

precious metals

Question 66

One of the key reasons one might use an option rather than an interest rate swap to mitigate interest rate risk would be because

Answer 66

a swap binds the user to the rate when it is set, whereas an option gives the buyer the right to walk away anytime during the transaction period if it would be less expensive to do so

Question 67

An American importer expects to pay a British supplier 500,000 British pounds in three months. The best hedge for the importer to fix the price in dollars is to

Answer 67

buy British pound call options

Question 68

Factors contributing to the decline in demand for the dollar during 2002-2004

Answer 68

- large US current account deficit - relatively high inflation rates in the US compared to major trading partners - Relatively high growth rates in US compared to Europe and Japan

Question 69

Debt-servicing problems of less developed countries that primarily sell raw materials to the United States would be eased by

Answer 69

an expanding US economy with stable money supply growth because it would maintain a steady demand for their raw materials and the money from the sale would aid in servicing their debt

Question 70

When a foreign competitor's currency weakens compared to the USD

Answer 70

the foreign company will have an advantage in the US market