Topic 16: Financial Risk Management Part I (Sem 2)

Question 1

Sources of financial risk for firms

Answer 1

Price increases (Inflation)
Interest rate volatility
Exchange rate volatility
Commodity price volatility

CHECK GRAPHS ON NOTES

Question 2

Hedging

Answer 2

Process that mitigates or reduces a firm’s exposure to price or rate fluctuations. In the US hedging is known as immunisation.

Question 3

Derivative security

Answer 3

A financial asset that represents a claim to another financial asset.

Question 4

The Risk Profile

Answer 4

A plot showing how the value of a company is affected by changes in prices or rates:

The slope of the risk profile indicates the exposure to the risk i.e:

Upward slope = Positive relation ship
Downward slope = negative relationship

Question 5

Transaction Exposure

Answer 5

Short-run financial risk arising from the need to buy or sell at uncertain prices in the near-term

Question 6

Economic Exposure

Answer 6

Long-term financial risk arising from permanent changes in prices or other economic fundamentals.

Question 7

Forward Contracts

Answer 7

A legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed on today.

This fixes the future transaction price and so eliminates financial risk on that contract.

Note a forward contract will always leave one party at a disadvantage: i.e:

Unhedged position (No future contract): If price rises the buyer loses but gains if the price falls.

With forward contract: The buyer gains if the price rises but loses if the price falls.

Foward contracts prevent financial risk however they introduce credit risk.

Question 8

The payoff profile

Answer 8

A plot showing the gains and losses that will occur on a forward contract as the result of unexpected price changes.

NOTE: CHECK EXAMPLES IN NOTES

Question 9

Credit risk

Answer 9

The possibility that the counterparty will not honour the obligation.

Question 10

Futures Contract

Answer 10

A forward contract with the feature that gains and losses are realised (i.e. paid) each day rather than only on the settlement date.

Note: This reduces credit risk.

NOTE: CHECK EXAMPLES IN NOTES

Question 11

Cross Hedge

Answer 11

Hedging an asset with contracts written on a closely related, but not identical, asset.

NOTE: CHECK EXAMPLES IN NOTES