Topic 10: An Introduction to Risk Management and Derivatives Flashcards Preview

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Flashcards in Topic 10: An Introduction to Risk Management and Derivatives Deck (60)
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1
Q

Risk

A

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

2
Q

Categories of risk

A

Operational Risk

Financial Risk

3
Q

Operational Risk

A

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

4
Q

There are many varied forms of operational risk

A
  • Technology
  • Property and equipment
  • Personnel
  • Competitors
  • Natural disasters
  • Government policy
  • Suppliers and outsourcing
5
Q

Financial Risk

A

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

6
Q

Types of Financial Risk

A
  • interest rate risk
  • foreign exchange risk
  • liquidity risk
  • credit risk
  • capital risk.
7
Q

Capital Risk

A

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

8
Q

Interest rate risk

A

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

9
Q

Foreign exchange risk

A
  • 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).

10
Q

Liquidity risk

A

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.

11
Q

Credit risk

A
  • 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.

12
Q

Capital risk

A
  • 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.

13
Q

Model for Risk Management Process

A

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.

14
Q

Model for Risk Management Process

1) Identify operational and financial risk exposures.

A

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

15
Q

Model for Risk Management Process

2) Analyse the impact of the risk exposures.

A

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

16
Q

Model for Risk Management Process

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

A

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

17
Q

Model for Risk Management Process

4)Select appropriate risk management strategies and products

A

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

18
Q

Model for Risk Management Process

5) Establish related risk and product controls.

A

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

19
Q

Model for Risk Management Process

6) Implement the risk management strategy.

A

Written authority to proceed needs to be obtained.

20
Q

Model for Risk Management Process

7) Monitor, report, review and audit.

A

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.
21
Q

Futures Contracts

A
  • 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
22
Q

Futures Contracts margain

A

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

23
Q

Futures Contracts marked to market

A
  • 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.
24
Q

marked to market

A

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

25
Q

Initial Margain

A

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

26
Q

Clearing House

A

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

27
Q

Forward Contracts

A
  • 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).
28
Q

Two types of forward contracts are

A

Forward Rate Agreements, and

Forward Foreign Exchange Contracts

29
Q

Forward Rate Agreements (FRA):

A
  • 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.
30
Q

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

A

2Mv5M (date).

31
Q

FRA Agreed Rate

A

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

32
Q

FRA settlement date

A

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

33
Q

FRA contact period

A

the term of the interest rate protection built into FRA

34
Q

Forward Foreign Exchange Contracts (FFE):

A
  • 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.
35
Q

Options Contracts

A

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

36
Q

exercise price or the strike price

A

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

37
Q

An option buyer will not exercise the right to sell if

A

the market price is higher than the strike price.

38
Q

an option buyer will not exercise the right to buy

A

if the market price is lower than the strike price

39
Q

There are two types of options

A

Call options

Put options

40
Q

Call options

A

right but not an obligation to buy

41
Q

Put options

A

right but not an obligation to sell

42
Q

There are two options contract types:

A

European-type options

American-type options

43
Q

European-type options

A

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

44
Q

American-type options

A

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

45
Q

Option premium

A

the price we pay to purchase an option

46
Q

In the money

A

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

47
Q

At the money

A

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

48
Q

Out of the money

A

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

49
Q

Swap Contracts

A
  • 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
50
Q

Two of the main types of swaps are:

A

Interest rate swaps

Cross-currency swaps

51
Q

Types of swaps include

A

intermediated swaps

direct swaps

52
Q

Interest Rate Swap

A

The exchange of interest payments associated with a notional principal amount

53
Q

Intermediated Swaps

A

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

54
Q

These are reasons for considering entering into an interest rate swap

A
  • 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).
55
Q

The main type of interest rate swap

A

Fixed for floating interest rate swap (vanilla swap)

56
Q

Vanilla Swap

A

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

57
Q

Basis Swap

A

A swap of series of two different reference rate interest payments

58
Q

swap rate

A

fixed interest rate specified in a swap contract

59
Q

reference rate

A

variable rate published

60
Q

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:

A
  • 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.