Revision
We will cover following topics
Key Takeaways
LO 1.a: Compare different strategies a firm can use to manage its risk exposures and explain situations in which a firm would want to use each strategy.
Firms manage their risk exposures using four main strategies:
1) Risk acceptance,
2) Risk avoidance,
3) Risk mitigation, and
4) Risk transfer.
Risk acceptance involves deciding to accept certain risks because the cost of mitigating or avoiding them is higher than the potential losses. This is common for minor risks or when the firm can manage the consequences effectively. For instance, a firm may accept minor currency fluctuations if international transactions are a small part of its operations.
Risk avoidance entails eliminating activities or positions that expose the firm to risk, such as a tech company avoiding markets with unstable regulations to prevent potential losses.
Risk mitigation aims to reduce the impact of risks through measures like diversification and hedging. Diversification spreads investments across various assets to minimize the overall impact of a negative event, while hedging uses financial instruments to offset potential losses, such as using futures contracts to hedge against commodity price fluctuations.
Risk transfer involves shifting risk to another party, typically through insurance. By purchasing insurance policies, firms transfer the financial burden of potential losses to insurers, effectively managing risks like property damage or liability claims. However, this strategy introduces counterparty risk, relying on the insurer to fulfill their obligations in case of a loss.
LO 1.b: Explain the relationship between risk appetite and a firm’s risk management decisions.
The risk appetite of a firm reflects its readiness to retain risk. It is impacted by inputs from various levels of management, including line managers and senior executives. The firm conducts risk mapping to identify known risks, evaluating their potential impact in terms of scale, timing, and location. Subsequently, senior managers and the board of directors set enterprise-wide risk tolerance thresholds, which require ongoing monitoring and periodic review.
LO 1.c: Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy.
Implementing a hedging strategy offers advantages such as cost reduction, smoother operational performance, improved business forecasting, and the opportunity to secure short-term gains. However, there are drawbacks to consider, including potential distractions from core operations, compliance expenses, the introduction of new risks while mitigating others, and the complexity associated with many hedging techniques. Challenges in risk management often arise from issues like misinterpreting or inaccurately mapping risk exposures, adapting to fluctuations in dynamic market conditions, and breakdowns in internal communication.
LO 1.d: Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency, and interest rate risk.
Hedging operational risks aims to shield revenues and expenses from unexpected uncertainties, such as fluctuating input costs or currency fluctuations affecting domestic performance. Financial risk pertains to balance sheet elements such as assets and liabilities, which may require management through strategies like interest rate hedging. Firms must determine whether to approach hedging of operational and financial risks statically (with a single hedge) or dynamically.
LO 1.e: Assess the impact of risk management tools and instruments, including risk limits and derivatives.
A risk management process should be appropriately tailored by selecting appropriate limits and deciding which risks to retain. Derivative instruments can be utilized for physical risk management, such as forward contracts, futures contracts, swap contracts, call options, put options, exotic options and swaptions. Understanding the advantages and disadvantages of these risk management tools in relation to whether they are exchange-traded or over-the-counter (OTC) is crucial for firms.
Practice Questions
1) A risk analyst is preparing a report for her manager, highlighting the use of exchange-based derivatives for hedging. Which of the following is a correct statement to include in the report?
A. No transaction costs are incurred during the trading of exchange-based derivatives.
B. More flexibility is offered by exchange-based derivatives for customization of trade terms of the hedging instrument.
C. Basis risk is reduced more effectively in a hedging transaction by exchange-based derivatives as compared to OTC derivatives.
D. Counterparty credit risk can be reduced by exchange-based derivatives through margin requirements and netting.
D is correct. Exchange-traded derivatives can reduce the exposure to counterparty credit risk through margin requirements and netting.
A is incorrect. Trading of exchange-traded derivatives is mostly associated with a low transaction cost, but it is not zero.
B is incorrect. Exchange-traded derivatives have standard trade terms with no flexibility to customize the trade terms.
C is incorrect. Since exchange-traded derivatives have standardized trade terms, it is often difficult to find the perfect positions for hedging. This leads to an increase in basis risk, and not in reduction.
2) A startup firm EcoWave Dynamics provides solutions related to climate change to its clients. It is expecting to receive a new round of funding which will lead to changes in the capital structure of the firm. Upon receiving the funding, the management team of EcoWave Dynamics wants to shift focus to riskier projects. With regards to risk capacity and risk appetite, which of the following statements is true for EcoWave Dynamics?
A. The company’s risk capacity will increase and its risk appetite will decrease.
B. The company’s risk capacity will decrease and its risk appetite will increase.
C. Both the company’s risk capacity and risk appetite will increase.
D. Both the company’s risk capacity and risk appetite will remain the same.
C is correct. Since the company will receive a round of funding, the company’s capital will increase, which will increase its risk capacity. Since the company will shift its focus to riskier projects, it will also increase the amount of risk the company is willing to accept, leading to an increase in its risk appetite.
A is incorrect. The risk appetite will increase as well.
B is incorrect. The company’s risk capacity will increase as well.
D is incorrect. Both the company’s risk capacity and risk appetite will increase.
3) The risk manager of a consulting firm is assessing the possible hedging strategies followed by various stakeholder groups of a publicly traded electronics company. Which of the following statements is correct?
A. Hedging strategies will be generally preferred by the debt investors to stabilize the revenue stream.
B. The firm will not be rewarded by the equity investors for using hedging to reduce its tax exposure over a multi-year period.
C. Firm’s equity investors would prefer to hold a well-diversified portfolio if the firm hedges its risks specific to the electronics industry.
D. Foreign exchange risk is not required to be hedged by either equity or debt investors.
A is correct. Unlike equity investors, debt investors gain little from fluctuations in revenue streams. Therefore, debt investors would want to hedge the exposure and stabilize the revenue.
B is incorrect. Using hedging to reduce the tax exposure will lead to an increase in after-tax earnings. So, equity investors would reward the firm for using hedging to reduce its tax exposure.
C is incorrect. If the portfolio of equity investors is already well-diversified, then hedging is not required to further reduce the firm specific (idiosyncratic) risk.
D is incorrect. Since the electronics company does not have foreign exchange exposure as its core competency, it would be reasonable to hedge this exposure.
4) A risk analyst who is evaluating the advantages and disadvantages of hedging risk exposures. Which of the following statements does not reflect an advantage of hedging?
A. Hedging can allow the management to control its financial performance in an order to meet the requirements of the board of directors.
B. Hedging performed through derivative instruments can be cheaper than purchasing an insurance policy.
C. Hedging may lead to operational improvements within a firm.
D. Hedging can increase a firm’s earnings and cash flows in the long-term.
D is correct. Many market participants hold the belief that hedging is a zero-sum game, asserting that it does not lead to a long-term increase in a firm’s earnings or cash flows. They argue that hedging merely shifts earnings and cash flows between different periods rather than generating new value. According to this perspective, the benefits of hedging are neutralized over time as the gains in one period are offset by the losses in another, resulting in no net positive impact on the firm’s overall financial health. This view suggests that while hedging can provide short-term stability and predictability, it does not contribute to the long-term growth or profitability of a company.
A is incorrect. It is anadvantage of hedging that it can allow the management to control its financial performance in an order to meet the requirements of the board of directors.
B is incorrect. It is an advantage of hedging that hedging performed through derivative instruments can be cheaper than purchasing an insurance policy.
C is incorrect. Hedging has as advantage that it may lead to operational improvements within a firm.
5) A risk manager at a bank is assessing the characteristics of exchange-traded instruments and over-the-counter (OTC) instruments. Which of the following statements correctly describes the features of exchange-traded instruments?
A. Exchange-traded instruments are traded privately between a bank and a firm.
B. Exchange-traded instruments contain credit risk.
C. Exchange-traded instruments are standardized and cover only certain underlying assets.
D. Exchange-traded instruments can be customized based on the requirements of the customers.
C is correct. Exchange-traded instruments are limited to specific underlying assets and are highly standardized, such as in terms of maturities and strike prices, to enhance market liquidity.
A is incorrect. Exchange-traded instruments are traded over exchanges such as Chicago Mercantile Exchange (CME). Instead, bilateral OTC instruments are traded provately between a bank and a firm.
B is incorrect. Since exchange-traded instruments have the exchange as the counterparty, there is very minimal credit risk.
D is incorrect. Exchange-traded instruments are highly standardized and cannot be customized.