2C - Financial Risk Management. Questions from review

Which of the following is a characteristic of a "black swan" event?

"Black swan" is a metaphor for a surprise/random event that has a significant impact on a firm; it is hard to predict and is a rare event that is beyond the realm of normal expectations in history, science, finance, and technology. Black swan events may need to be reported to the Securities and Exchange Commission (SEC), but it would depend on the circumstances of the event; there is no mandatory requirement.

Assuming that exchange rates are allowed to fluctuate freely, which one of the following factors would likely cause a nation's currency to appreciate on the foreign exchange market?

- A slower rate of growth in income relative to other countries, which causes imports to lag behind exports. Exchange rates are affected by changes in consumer tastes for products produced in various countries, relative changes in income in various countries, differing inflation rates, and differences in real interest rates. If the demand for a nation's currency increases, the currency will appreciate, and if the supply of the nation's currency decreases, it will appreciate. A slower growth rate in a country compared to that of another country would cause a decline in the country's imports. Since one key source of supply of domestic currency is that made available to purchase foreign currency needed for imports, we would now be supplying less of our currency, and this would cause the domestic currency to appreciate vis-a-vis the foreign currency.

Which one of the following is not a hedging derivative?

- An economic hedge is not a derivative hedge. A fair value hedge reflects fair value of an asset or liability. A cash flow hedge reflects cash flows of forecasted transactions. A foreign currency hedge mitigates exposure to fluctuations in the value of foreign currencies.

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

- An expanding United States economy with stable money supply growth would maintain a steady demand for raw materials of less developed countries. The moneys earned from the sale of raw materials will aid in servicing the debt of less developed nations.

Which of the following primarily determines interest rates for individuals?

- Creditworthiness for individuals is determined by the credit they receive when they borrow money for mortgages, automobile loans, and on credit cards. Their reliability in repaying these loans determines an individual's creditworthiness, which in turn determines the rate of interest on these loans. A more creditworthy individual is likely to receive a lower interest rate than a less creditworthy individual. Annual percentage rate and annual rate of return are interest rate measures. They do not determine interest rates. Liquidity is the ability to repay existing obligations.

An importing partnership has experienced a dramatic surge in its exporting business and is looking for ways to minimize its risks from foreign currency fluctuations. The partnership's imports and exports to European Union countries are at similar levels. Which of the following methods most effectively minimizes risk?

- Hold payables and receivables due in the same currency and amount. Foreign currency risk is the uncertainty of the value of net income resulting from the variability of the market value of foreign-currency-denominated assets and liabilities due to fluctuating exchange rates. A firm participating in financial markets can mitigate some of the risk by having an effective risk management process in place. One of the most effective methods to minimize the risk of foreign currency fluctuations is to hold payables and receivables in the same currency and amount; any fluctuations will offset each other.

What is the least likely reason that interest rates would differ?

- Interest rates tending to be lower for long-term loans

Which of the following types of risk can be reduced by diversification?

- Labor strikes Company risk is risk that is specifically associated with a particular firm due to its mix of products, new products, competition, patents, lawsuits, etc. Since different industries and countries experience different risks of labor strikes, diversification between industries and countries can reduce company risk. The other answer choices are incorrect because interest rate rises, recession, and inflation affect all industries and countries in today's interrelated world economies. These risks apply regardless of the extent that a company diversifies it operations.

Which of the following is not an exchange rate determinant?

- Lack of government controls Governments can influence and even control exchange rates by buying and selling their securities abroad and changing interest rates in their own country. Exchange rate determinants include changes in demand and/or supply of the currency, changes in consumer tastes, relative income changes, relative price changes, relative interest rates, relative inflation rates, and government controls.

If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?

- Precious metals An inflation hedge is an investment with intrinsic value, not tied to financial assets. Financial assets are fixed amounts expressed in a nominal currency value that will decline in real value when inflation occurs. Gold and farmland have intrinsic value and tend to hold that value when inflation reduces the value of currencies because the precious metal valuation adjusts to the new currency. Treasury bonds and corporate bonds are incorrect since such bonds are generally paid in nominal dollars, not indexed to inflation, so would not hedge against inflation. Common stock is incorrect because, even though common stock tends to increase during a period of inflation, the increase is often not sufficient to offset the decline in currency value due to the inflation. The inflation effect on a company's common stock would depend on the structure of financial assets and liabilities it holds during the inflationary period.

A company has several long-term floating-rate bonds outstanding. The company's cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?

- Swap agreement

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?

- The $E will decline with respect to the $W. The demand for Esland products decreases as imports to Woostland decrease. The decline of interest in purchasing Esland products decreases the demand for that country's currency. As the demand for Esland currency decreases, the price of Esland currency will depreciate, or decline.

Consider a world consisting of only two countries, Canada and Italy. Inflation in Canada in one year was 5%, and in Italy 10%. Which one of the following statements about the Canadian exchange rate (rounded) during that year will be true?

- The Canadian dollar will appreciate by 5%. The factors which affect exchange rates are changes in tastes (demand for each other's goods), changes in relative income, changes in relative prices (determined by respective inflation rates), speculation, and changes in real interest rates. In this case, there is a change in relative prices, as the two countries have differing inflation rates. If inflation is higher in Italy, Canadian goods will become relatively cheaper and Italian demand for Canadian goods will rise. This increases demand for the Canadian dollar and supply of the Italian lira, causing the Canadian dollar to appreciate and the Italian lira to depreciate. The difference in inflation rates is 5% (Italy's 10% minus Canada's 5%), so the Canadian dollar appreciates by 5%.

What is the effect when a foreign competitor's currency becomes weaker compared to the U.S. dollar?

- The foreign company will have an advantage in the U.S. market. As a foreign competitor's home currency becomes weaker compared to the U.S. dollar, the competitor's product becomes less expensive for American consumers, providing the firm with an advantage since more of a particular product will be purchased as it becomes relatively cheaper for the consumer.

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

- 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.

In an interest situation, such as an interest-bearing note, the effective annual interest rate will be the same as the nominal or stated rate if the compounding is done ________ and the effective interest rate will be highest when done ________.

- annually; continuously

The Federal Financial Institutions Examination Council (FFIEC) has suggested that regulated institutions should engage in scenario planning and undertake stress tests to determine the impact of a series of possible changes in market interest rates. If the institution did a test for basis risk, they would be dealing with:

- changes in the relationship between key market interest rates. The FFIEC has suggested that institutions undertake stress tests for a variety of types of interest rate risks. Testing for basis risk would involve testing for the impact of the changes in relationships between key market interest rates. Other tests would include tests for instantaneous rate shocks that deal with instantaneous and significant changes in the level of interest rates; prolonged rate shocks that deal with substantial changes in rates over a longer period of time; and yield curve risk that deals with the impact of a changing shape of the yield curve. Regulators understand that not all financial institutions will be required to develop the full range of scenarios; however, tests of interest rate shocks of significant magnitude should be run by all institutions, regardless of the institution's size or complexity.

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:

- economic exposure Economic exposure represents any impact of exchange rate fluctuations on a firm's future cash flow. In this instance, the firm had attempted to protect itself from transactions exposure by invoicing the goods in dollars, but the foreign crisis make it impossible for foreign firms to afford to buy the dollars necessary to fulfill the contract. The firm could have protected itself somewhat from this exposure if some of their expenses had been denominated in bhat.

Hedging activity is a strategy to:

- insulate firms from exposure to price, interest rate, or foreign exchange fluctuations. A hedge is similar to insurance in that it mitigates the risk for many types of financial enterprises. These are counter intuitive financial strategies that insulate firms from exposure to price, interest rate, or foreign exchange fluctuations. Hedging can allow firms to lock in a price, interest rate, or foreign exchange rate in the current period for a transaction to occur in a future period. It does not measure risk, prioritize risk, or transfer risk to other elements on the supply chain.

Small companies have additional risk with which larger organizations generally do not have to be concerned. These additional risks would include all of the following except that small firms:

- often have difficulty dealing with increasing interest rates. All of the answer choices could potentially provide risk for a small company; however, interest rate risk affects both small and large organizations.

Commercial banks and other financial intermediaries provide a variety of services to their retail customers in a very competitive market. Most institutions provide mortgage loans that allow the customer to refinance the loan at any time without a prepayment penalty. The type of interest-rate risk these institutions would be incurring is:

- option risk Option risk occurs when a firm gives the customer the right (but not the obligation) to change the stream from assets, liabilities, or off-balance sheet items. 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. Re-pricing risk occurs when a firm deliberately mismatches in an upsloping yield curve environment by holding assets with a longer duration than that of the liabilities used to fund them. An example of basis risk would be found in the situation where a bank's interest margins are generally spontaneously enhanced in a period of rising interest rates as loan rates tend to adjust upward more rapidly than the rates on deposits. However, at some point, as interest rate increases peak and rates begin to decline, this process reverses itself and there would be increasing pressure on interest rate margins. Yield curve risk arises when the underlying shape of the yield curve changes (e.g., steepens, flattens, becomes inverted). These changes tend to accentuate any asset-liability mismatches the firm has.

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 what would be called:

- risk margin. Risk margin is generally defined as the level of reserves established in addition to the best estimate level of reserves. These additional reserves tend to create a cushion to cover unexpected fluctuations and/or errors in estimations. Required capital is designed to cover the risk of fluctuation under normal situations. Risk margin covers modeling uncertainty, parameter risk (a quantity numerically characteristic of the entire model), and structural uncertainty, as well as providing a buffer for unanticipated events.

Currently, the U.S. tax code requires that transfer prices for multinational corporations are "arm's-length transactions." Methods that are prescribed by the IRS for setting arm's-length prices for tangible goods include all of the following:

- the comparable uncontrolled price. This method is based on the philosophy that what is a reasonable price for one customer is reasonable for another customer. - the resale price. This method assumes that the price at which the items can be resold by the distribution affiliate less an amount to cover overhead head costs and a reasonable profit is a realistic transfer price. - the cost-plus approach. This method entails adding an appropriate profit to the costs of the manufacturing affiliate in order to achieve a reasonable transfer price.

When economists are concerned about the liquidity preference function they are interested in:

- the relationship of the demand for money and the rate of interest.

A U.S.-based company decides to invest capital in an emerging market operation that has a lower expected return rate compared to the expected return for an alternative domestic operation. Which of the following statements correctly supports this decision?

A U.S.-based company would consider investing its capital in an emerging market operation that has a lower expected return rate compared to the expected return for an alternative domestic operation if management expects the U.S. dollar to decline in value, relative to the local foreign currency. Local (i.e., foreign) sales would be expected to increase due to reduced foreign competition, and exports denominated in local currency will appear cheaper to importers, thus leading to increased foreign demand for their products.

Miller Manufacturing and Mining is facing potential translation exposure and believes that it would be desirable to use a money market hedge to reduce their risk to currency fluctuation. They have a 1.2 billion yen receivable that will come due one year from today. Current interest rates in the United States and Japan are 8% and 5% respectively. The current spot exchange rate is 120 yen = $1. If the money market hedge is structured correctly the firm would:

A money market hedge involves borrowing an amount equal to the discounted value of the receivable (1.2B yen ÷ 1.05 = 1.143 billion yen). The proceeds of the loan would be converted to dollars at the current spot rate (1.143B yen ÷ 120 = $9,524,810), and the proceeds would then be invested in the United States. When the receivable is paid, the firm will use the proceeds to pay off the loan balance in Japan and collect the proceeds of the U.S. investment ($9,524,810 × 1.08 = $10,285,714). This would be the guaranteed proceeds from the Japanese sale that were created by using a money market hedge.

Which of the following is not part of the control cycle approach to risk management?

Developing the hedges necessary to mitigate interest rate risk Key elements of the control cycle approach to risk management include the following: Modeling the expected results using a set of initial assumptions Doing a profit test to determine if the product provides a contribution margin Measuring the actual results Determining, both in quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results Determining what actions need to be taken with respect to the product, including possible adjustments to reserves Using the findings to strengthen the model and update the assumptions as needed with feedback from the process

Which of the following factors would not be relevant when determining the risk premium on a specific security?

Earnings per share is a computation/ratio and would not be relevant when determining the risk premium on a specific security. Equity risk premium is the excess return that investing in the stock market provides over a risk-free rate, such as the return from government treasury bonds. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium will vary depending on the level of risk in a particular portfolio (including liquidity and seniority) and will also change over time (i.e., length of maturity) as market risk fluctuates. Liquidity refers to the ease (or lack thereof) of converting the security into cash without affecting the security's price. Seniority, in terms of a security, refers to the order of repayment in the event of bankruptcy or liquidation. As a rule, high-risk investments are compensated with a higher premium.

Suppose a firm borrows $100,000 for one year at 9% with interest being paid on a discount basis. The effective rate on the loan would be:

Effective rate of interest = Interest paid / Usable funds = (9% x $100,000) / ($100,000 - (9% x $100,000)) = $9,000 / $91,000 = .0989 or 9.9%

Enterprise risk management includes all of the following except:

Enterprise risk management includes items such as business risk, operations risk, supply-chain risk, product liability risk, and political and economic risk. Diversification risk is not a component of enterprise risk management.

Which of the following is not an exchange rate determinant?

Exchange rates are determined by the interaction of supply and demand for the various foreign currencies in foreign exchange markets. If the demand for a nation's currency increases, the currency increases in value in terms of the other currencies. If the supply of the nation's currency increases, the price of the currency will depreciate or decline in value in terms of other currencies. Flexible exchange rates are not a determinant. They are an adjustment that eliminates balance of payment surpluses or deficits. Exchange rates are determined by changes in consumer taste, relative interest rates, and relative income changes.

Financial risk management is a component of enterprise risk management (ERM). ERM encompasses the methods and procedures used by an organization to control risks and grasp opportunities to help a firm achieve their identified objectives. Included under the heading of financial risks would be such items as:

Financial risk management is one component of the concept of enterprise risk management of the firm, which would include risks such as the following: Business risk (uncertainty associated with the ability to forecast EBIT due to factors such as sales variability and operating leverage) Operations risk (risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events) Supply-chain risk (potential disruptions to continued manufacturing production and thereby commercial financial exposure) Product liability risk (responsibility of the firm or vendor of goods to compensate for injury caused by defective merchandise that it has provided for sale) Political and economic risk (risk that a government buyer or a country prevents a transaction from being completed, or fails to meets its payment obligations; and/or the risk associated with the overall health of the economy)

Which of the following is not an interest rate risk?

Hedging is not a risk but rather a way to mitigate risk. Examples of interest rate risks include the following: Yield curve risk (arises from variations in interest rate moves along the yield curve) Repricing risk (created by firms deliberately mismatching a portfolio by holding longer-duration assets when compared to liabilities in an attempt to enhance earnings) Options risk (arises from legal rights to engage in a future transaction at a predetermined price) Basis risk (Since loan rates tend to adjust upward more rapidly than deposit rates, there is a tendency for interest margins to increase spontaneously when rates are rising; however, as rates stabilize, the improvement may disappear as deposit rates catch up, and then interest margins would fall when rates began to decline.)

A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?

If a firm borrows $250,000 but is required to maintain $50,000 as a minimum compensating balance, then the firm only has use of $200,000, but is paying 6% interest on the entire $250,000. To determine the effective interest rate, the interest in dollars ($250,000 × 6%, or $15,000) should be divided by the amount of the loan available to the borrower, the effective loan amount, which is only $200,000. However, there are two issues that further complicate this problem. This company ordinarily maintains a $25,000 balance in its checking account. Therefore, the company will only be out $25,000 ($50,000 - $25,000). This means the effective loan amount is $225,000 ($250,000 - $25,000), not $250,000. Also, the company earns checking account interest which partially offsets the loan interest. The applicable amount on which to determine interest is only the part that pertains to this borrowing, the additional $25,000. The interest on this is $500 (2% × $25,000). The effective interest dollar amount for this borrowing is $14,500 ($15,000 - $500). The effective interest rate is now calculated as: $14,500 ÷ $225,000 = .0644, or 6.44% effective interest rate

Mitigating financial risk at the firm level includes all of the following

Mitigating financial risk at the firm level includes an ability to track risk in the unregulated sector (not the regulated financial sector, which is already tracked), as well as incorporating a risk margin for extreme or outlier events; creating provisions for independent signoff of liability; and creating specific requirements for financial condition reporting.

Key elements of financial risk management include all of the following except:

Political and economic risk is a component of enterprise risk management. Enterprise risks reflect conditions on a macroeconomic level, rather than a microeconomic one. Financial risk management includes interest rate risk, liquidity risk, foreign currency risk, default risk, systemic risk, counterparty risk, and credit risk.

Actuaries use all of the following in the control cycle except:

Predicting future market conditions is not included in the control cycle. The control cycle used by actuaries includes modeling expected results using a set of initial assumptions; doing a profit test to determine if the product provides a positive contribution margin; measuring actual results; determining, in both quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results; determining what actions need to be taken with respect to the product, including adjusting the reserves that might need to be held; and using the findings to strengthen the model and update the assumptions as necessary with a feedback into the profit test.

forecasting technique used by firms to predict exchange rate movement

Technical forecasting, fundamental forecasting, and market-based forecasting are all quantitative forecasting techniques. Technical forecasting involves the use of historical exchange rate data to predict future values. Fundamental forecasting is based on the presumed relationship between exchange rates and economic variables. Market-based forecasting starts from the premise that financial markets provide an unbiased estimate of future events and uses either the spot rate or the forward rate.

The risk management process involves which of the following steps related to both internal and external controls?

The risk management process includes both internal and external controls and involves the following: - 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

In terms of mitigating financial risk from a regulatory perspective, there is a strong need for increased cooperation between national jurisdictions. Which of the following would not increase that cooperation?

There is a strong need for increased cooperation between national jurisdictions that would develop an agreed-upon risk management policy for key marketwide risk indicators; manage and monitor risk indicators within that policy; publicly report macro-risk (not micro-risk) indicators; and facilitate risk identification and communication with appropriate decision makers, at both national and international levels.