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

Risk

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

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Categories of risk

Operational Risk
Financial Risk

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Operational Risk

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

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There are many varied forms of operational risk

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

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Financial Risk

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

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Types of Financial Risk

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

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Capital Risk

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

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Interest rate risk

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

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Foreign exchange risk

- 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).

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Liquidity risk

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.

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Credit risk

- 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.

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Capital risk

- 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.

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Model for Risk Management Process

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.

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Model for Risk Management Process
1) Identify operational and financial risk exposures.

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

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Model for Risk Management Process
2) Analyse the impact of the risk exposures.

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

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Model for Risk Management Process
3) Assess the attitude of the organisation to each identified risk exposure.

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

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Model for Risk Management Process
4)Select appropriate risk management strategies and products

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

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Model for Risk Management Process
5) Establish related risk and product controls.

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

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Model for Risk Management Process
6) Implement the risk management strategy.

Written authority to proceed needs to be obtained.

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Model for Risk Management Process
7) Monitor, report, review and audit.

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.

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Futures Contracts

- 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

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Futures Contracts margain

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

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Futures Contracts marked to market

- 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.

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marked to market

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

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Initial Margain

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

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Clearing House

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

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Forward Contracts

- 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).

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Two types of forward contracts are

Forward Rate Agreements, and
Forward Foreign Exchange Contracts

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Forward Rate Agreements (FRA):

- 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.

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

2Mv5M (date).