Managing Risk

Question 1

What is the definition of risk?

Answer 1

Risk is the probability/likelihood of an event happening where possible outcomes can be identified

Example: Rolling a dice.

Question 2

What is uncertainty?

Answer 2

Uncertainty refers to not being able to identify possible outcomes or assess their likelihood of occurrence.

Question 3

What is company risk?

Answer 3

Company risk is the total risk faced by shareholders or owners, consisting of systematic and non-systematic risk.

Question 4

How is total risk calculated?

Answer 4

Total Risk = Systematic Risk + Non-Systematic Risk.

Question 5

What is systematic risk?

Answer 5

Systematic risk affects all companies to varying extents and is largely due to macro-economic factors.

Question 6

What are some examples of systematic risk factors?

Answer 6

• Inflation
• Taxation policy
• Interest rates
• Exchange rates.

Question 7

What is non-systematic risk?

Answer 7

Non-systematic risk consists of company-specific risk factors.

Question 8

What is the foreign exchange market?

Answer 8

The market where one currency is converted into another, known as the foreign exchange market or FOREX.

Question 9

What is the significance of the foreign exchange market?

Answer 9

It is the most liquid market in the world due to high volume and frequency of trading.

Question 10

Define bid price.

Answer 10

The bid price is the highest price a buyer will pay for a security.

Question 11

Define ask price.

Answer 11

The ask price is the lowest price a seller will accept for a security.

Question 12

What is the spread in trading?

Answer 12

The spread is the difference between the bid price and the ask price.

Question 13

What is the direct quote in foreign exchange?

Answer 13

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.

Question 14

What is the indirect quote in foreign exchange?

Answer 14

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.

Question 15

What are the four types of foreign exchange risks for a company?

Answer 15

• Pre-transaction risk
• Transaction risk
• Translation risk
• Economic exposure.

Question 16

What is pre-transaction risk?

Answer 16

Pre-transaction risk refers to possible exchange rate fluctuations between pricing a transaction and the moment it is agreed.

Question 17

What is transaction risk?

Answer 17

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.

Question 18

What is translation risk?

Answer 18

Translation risk is the risk that assets held abroad will lose value in the home currency due to exchange rate movements.

Question 19

What is economic exposure?

Answer 19

Economic exposure refers to the risk to all future cash flows and overall business value due to exchange rate movements.

Question 20

What are external risk hedging instruments?

Answer 20

• Forward contracts
• Futures contracts
• Option contracts.

Question 21

What is a forward currency contract?

Answer 21

A forward currency contract is an agreement to exchange a specified amount of currency at a specified exchange rate on a future date.

Question 22

What is a forward premium?

Answer 22

A forward premium occurs when the forward rate exceeds the existing spot rate.

Question 23

What is a forward discount?

Answer 23

A forward discount occurs when the forward rate is less than the existing spot rate.

Question 24

What is a futures contract?

Answer 24

A futures contract is similar to a forward contract but is tradable and can be bought and sold daily.

Question 25

What is an option in foreign exchange?

Answer 25

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.

Question 26

What is a Forward Rate Agreement (FRA)?

Answer 26

An FRA is an agreement about the future level of interest rates, allowing the management of interest rate risk exposure.

Question 27

What factors affect interest rates?

Answer 27

* Demand for money * Supply of money * Fiscal deficit and government borrowing * Inflation * Global interest rates.

Question 28

What is a FRA?

Answer 28

An over-the-counter product enabling the management of an interest rate risk exposure ## Footnote FRA stands for Forward Rate Agreement.

Question 29

What is the purpose of a FRA?

Answer 29

To lock-in interest rates for borrowing or lending at a specified future date.

Question 30

What does a company do if it expects interest rates to rise?

Answer 30

Enter into a FRA to secure a fixed interest rate.

Question 31

What happens if the spot interest rate exceeds the FRA rate?

Answer 31

The company receives compensation from the FRA counterparty.

Question 32

If the spot rate in six months is 8.5% and the FRA rate is 7%, what is the compensation amount?

Answer 32

£90,000.

Question 33

What is the notional amount in a FRA?

Answer 33

The amount of loan on which interest is calculated.

Question 34

What is the difference between the buyer and seller of a FRA?

Answer 34

Buyer borrows the notional sum (long position), seller lends the notional sum (short position).

Question 35

What is the Reference Rate in a FRA?

Answer 35

The floating rate used in the FRA contract (e.g., SONIA, EURIBOR).

Question 36

What is the FRA Rate?

Answer 36

The fixed interest rate the buyer of FRA pays or the price of the FRA.

Question 37

What is the settlement date in a FRA?

Answer 37

The date on which the forward loan becomes effective and the FRA is cash settled.

Question 38

What occurs if the market rate is less than the FRA rate on the settlement date?

Answer 38

The buyer pays the seller the difference.

Question 39

What does a 3×6 FRA mean?

Answer 39

A 3-month loan beginning in 3 months.

Question 40

What happens during settlement of a FRA if the market rate is greater than the FRA rate?

Answer 40

The seller pays the buyer the difference.

Question 41

Calculate the saving for a long position with a FRA rate of 6% if the market rate is 8%.

Answer 41

£5,000.

Question 42

What is the formula to calculate the present value of FRA payment?

Answer 42

FRA Payment = Savings / (1 + (Market Rate)(Days/360)).

Question 43

What is a disadvantage of FRAs?

Answer 43

Lack of liquidity and subject to default risk.

Question 44

What does the term 'long position' refer to in a FRA?

Answer 44

The party borrowing money under the FRA.

Question 45

What does the term 'short position' refer to in a FRA?

Answer 45

The party lending money under the FRA.

Question 46

Fill in the blank: The FRA market is characterized as _______.

Answer 46

[liquid and available with banks/dealers across major currencies].

Question 47

What is the typical benchmark for FRAs that have been replaced?

Answer 47

SONIA (Sterling Overnight Index Average).

Question 48

What is the main benefit of entering into a FRA?

Answer 48

Certainty over effective interest costs of borrowing in the future.