Topic 10: An Introduction to Risk Management and Derivatives

Question 1

Risk

Answer 1

is the possibility or probability that something may occur that is unexpected or unanticipated that may cause loss or injury.

Question 2

Categories of risk

Answer 2

Operational Risk

Financial Risk

Question 3

Operational Risk

Answer 3

exposures that may impact on the normal commercial functions of a business

Question 4

There are many varied forms of operational risk

Answer 4

• Technology
• Property and equipment
• Personnel
• Competitors
• Natural disasters
• Government policy
• Suppliers and outsourcing

Question 5

Financial Risk

Answer 5

risks that result in unanticipated changes in projected cash flows or the structure and value of balance sheet assets and liabilities

Question 6

Types of Financial Risk

Answer 6

• interest rate risk
• foreign exchange risk
• liquidity risk
• credit risk
• capital risk.

Question 7

Capital Risk

Answer 7

Risk that a corporation will not have sufficient capitla to expand the business or maintain its debt to equity ration2

Question 8

Interest rate risk

Answer 8

This is the risk of an exposure to adverse movements in current market interest rates

Question 9

Foreign exchange risk

Answer 9

• This is the risk of an adverse movement in the value of one currency relative to another currency.

Eg. You borrow $10,000 in USD and convert it to AUD. Then the USD appreciates (in terms of AUD). So you have to pay more AUD to your lender (both interest and principal).

Question 10

Liquidity risk

Answer 10

For ADIs it is the ability to meet demand of their depositors, and for other businesses it is the ability to meet commitments as and when they fall due.

Question 11

Credit risk

Answer 11

• This is the risk that a debtor (borrower) will not repay principal and interest in terms of contractual obligations that have been made.

Eg. During the GFC many banks found it difficult to recover money owed by individuals on their sub-prime mortgage.

Question 12

Capital risk

Answer 12

• This is the risk that a business will have insufficient capital to expand the activities and maintain the desired gearing ratio.

Eg. During the GFC many investment banks suffered losses in the P&Ls. This lead to lower retained earnings and lower capital. In some cases, the total equity was wiped out and the banks became non-viable.

Question 13

Model for Risk Management Process

Answer 13

1) Identify risk exposures.
2) Analyse the impact
3) Assess the attitude of the organisation to identified risk .
4) Select appropriate risk management strategies
5) Establish controls.
6) Implement strategy.
7) Monitor, report, review and audit.

Question 14

Model for Risk Management Process

1) Identify operational and financial risk exposures.

Answer 14

Need to understand the business, including its operations, personnel, competitors, regulators, legislative requirements, stakeholders, cash flows and the balance-sheet structure.

Question 15

Model for Risk Management Process

2) Analyse the impact of the risk exposures.

Answer 15

involves a business impact analysis, which measures the operational and financial impact of an identified risk exposure.

Question 16

Model for Risk Management Process

3) Assess the attitude of the organisation to each identified risk exposure.

Answer 16

determine the level of risk that it is willing to accept – it will not seek to mitigate or remove all risks.

Question 17

Model for Risk Management Process

4)Select appropriate risk management strategies and products

Answer 17

analyse what risk management options are available, which will involve a cost-benefit analysis.

Question 18

Model for Risk Management Process

5) Establish related risk and product controls.

Answer 18

Ensure that adequate controls have been established, including procedural and system controls

Question 19

Model for Risk Management Process

6) Implement the risk management strategy.

Answer 19

Written authority to proceed needs to be obtained.

Question 20

Model for Risk Management Process

7) Monitor, report, review and audit.

Answer 20

The risk management process is dynamic and ongoing.

• Within the context of a corporation, the board of directors must establish objectives and policies in relation to the identification, measurement and management of risk exposures.
• It is the responsibility of the CEO to ensure that appropriate risk management procedures are implemented throughout the corporation.

Question 21

Futures Contracts

Answer 21

• is an agreement between two parties to buy or sell a specified commodity or financial instrument at a specified date in the future at a price determined today
• Standardized contracts
• traded on a formal exchange
• facilitate the management of risk exposures

Question 22

Futures Contracts margain

Answer 22

Initial margin of between 2% and 10% of the contract value.

Question 23

Futures Contracts marked to market

Answer 23

• The value of the contract is periodically assessed to reflect current market values.
• If there has been an adverse movement then a top up margin will be required to be paid.
• Failure to make the margin will result in the contract being closed out by the Clearing House.

Question 24

marked to market

Answer 24

The periodic repricing of an existing contract to reflect current market valuations

Question 25

Initial Margain

Answer 25

A deposit lodged with a clearing house to cover adverse price movements in a futures contract

Question 26

Clearing House

Answer 26

Records transactions conducted on an exchange and facilitates value settlement and transfer

Question 27

Forward Contracts

Answer 27

- over-the-counter risk management products - designed to enable the management of a specified risk.designed to enable the management of a specified risk. - More flexible (not standardised).

Question 28

Two types of forward contracts are

Answer 28

Forward Rate Agreements, and | Forward Foreign Exchange Contracts

Question 29

Forward Rate Agreements (FRA):

Answer 29

- Over-the counter product that is used to manage interest rate risk exposures. - FRA is a contractual agreement between two parties to lock in an agreed interest rate.

Question 30

a FRA to start in two months for a period of three months would be expressed as

Answer 30

2Mv5M (date).

Question 31

FRA Agreed Rate

Answer 31

The fixed interest rate stipulated in the FRA at the start of the contract

Question 32

FRA settlement date

Answer 32

The date when the FRA agreed rate is compared to the reference rate to calculate compensation amount

Question 33

FRA contact period

Answer 33

the term of the interest rate protection built into FRA

Question 34

Forward Foreign Exchange Contracts (FFE):

Answer 34

- Over-the counter product that is used to manage foreign exchange risk exposures - agreement between two parties to lock in an agreed future exchange rate for a specified currency.

Question 35

Options Contracts

Answer 35

gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified price on or before a specified date

Question 36

exercise price or the strike price

Answer 36

the price specified in an option contract at which the option buyer can buy or sellf

Question 37

An option buyer will not exercise the right to sell if

Answer 37

the market price is higher than the strike price.

Question 38

an option buyer will not exercise the right to buy

Answer 38

if the market price is lower than the strike price

Question 39

There are two types of options

Answer 39

Call options | Put options

Question 40

Call options

Answer 40

right but not an obligation to buy

Question 41

Put options

Answer 41

right but not an obligation to sell

Question 42

There are two options contract types:

Answer 42

European-type options | American-type options

Question 43

European-type options

Answer 43

give the option buyer the right to exercise the option only on the contract expiration date.

Question 44

American-type options

Answer 44

give the option buyer the right to exercise the option at any time up to the contract expiration date.

Question 45

Option premium

Answer 45

the price we pay to purchase an option

Question 46

In the money

Answer 46

when the call or put option has value (worth exercising)

Question 47

At the money

Answer 47

when the call or put options strike price is the same as the market price

Question 48

Out of the money

Answer 48

when the call or put option has no value (not worth exercising).

Question 49

Swap Contracts

Answer 49

- Is an over-the-counter financial product that allow parties to enter into a contractual agreement to exchange cash flows - Facilitate management of interest rate and foreign exchange risk exposures

Question 50

Two of the main types of swaps are:

Answer 50

Interest rate swaps | Cross-currency swaps

Question 51

Types of swaps include

Answer 51

intermediated swaps | direct swaps

Question 52

Interest Rate Swap

Answer 52

The exchange of interest payments associated with a notional principal amount

Question 53

Intermediated Swaps

Answer 53

is entered into with a financial institution, usually a bank.

Question 54

These are reasons for considering entering into an interest rate swap

Answer 54

- subject to a variable interest rate – risk is that interest rates might rise. - subject to a fixed interest rate – risk is that interest rates might fall. - The borrower may have a fixed income stream – risk is that with a variable interest rate loan, a rise in interest rates could reduce profitability (matching principle).

Question 55

The main type of interest rate swap

Answer 55

Fixed for floating interest rate swap (vanilla swap)

Question 56

Vanilla Swap

Answer 56

A swap of series of fixed interest rate payments for variable interest rate payments

Question 57

Basis Swap

Answer 57

A swap of series of two different reference rate interest payments

Question 58

swap rate

Answer 58

fixed interest rate specified in a swap contract

Question 59

reference rate

Answer 59

variable rate published

Question 60

At each interest rate reset date the company will pay a fixed rate to the bank and the bank will pay a variable rate to the company, therefore:

Answer 60

- If the variable reference rate is higher than the fixed swap rate, the bank will make a cash payment to the company for the difference between the two rates. - If the fixed swap rate is higher than the variable reference rate, the company will make a cash payment to the bank for the difference between the two rates.