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Questions and Answers
What is the primary reason for an entity to decide to reduce financial risk?
What is the primary reason for an entity to decide to reduce financial risk?
When would an entity consider transferring financial risk contractually?
When would an entity consider transferring financial risk contractually?
What approach should an entity take towards risks with high significance and frequency?
What approach should an entity take towards risks with high significance and frequency?
In which scenario would an entity opt for financial risk avoidance?
In which scenario would an entity opt for financial risk avoidance?
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What type of risk reduction would be most suitable when an entity faces risks with high magnitude but low frequency?
What type of risk reduction would be most suitable when an entity faces risks with high magnitude but low frequency?
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What are the four steps involved in Financial Risk Management?
What are the four steps involved in Financial Risk Management?
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Which factor determines how much financial risk an entity can bear?
Which factor determines how much financial risk an entity can bear?
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What is the major concern for a multi-national company regarding financial risk?
What is the major concern for a multi-national company regarding financial risk?
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Which institute would consider interest rate risk and credit risk as major concerns?
Which institute would consider interest rate risk and credit risk as major concerns?
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What does Financial Risk Analysis involve?
What does Financial Risk Analysis involve?
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Why is financial risk analysis considered a crucial function for organizations today?
Why is financial risk analysis considered a crucial function for organizations today?
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What is the purpose of extending credit according to the text?
What is the purpose of extending credit according to the text?
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Why is it important to involve staff from all levels in the risk identification process?
Why is it important to involve staff from all levels in the risk identification process?
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What is the next stage after risk assessment according to the text?
What is the next stage after risk assessment according to the text?
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What does the text suggest should be done to prioritize the management of identified risks?
What does the text suggest should be done to prioritize the management of identified risks?
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Which factor is essential for assessing risks according to the text?
Which factor is essential for assessing risks according to the text?
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What should be put in place for ongoing monitoring and reporting of risks as per the text?
What should be put in place for ongoing monitoring and reporting of risks as per the text?
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What is the main concept associated with the Central Limit Theorem in the context of Value at Risk (VaR) calculation?
What is the main concept associated with the Central Limit Theorem in the context of Value at Risk (VaR) calculation?
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How is the 1-day 95% VaR calculated using the Historical method?
How is the 1-day 95% VaR calculated using the Historical method?
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In terms of financial risk treatment, what does Financial Risk Retention signify?
In terms of financial risk treatment, what does Financial Risk Retention signify?
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Which step in calculating VaR involves identifying the least worst return within a specific percentile range?
Which step in calculating VaR involves identifying the least worst return within a specific percentile range?
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What does the Central Limit Theorem suggest about random variable averages and their distribution?
What does the Central Limit Theorem suggest about random variable averages and their distribution?
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What can an entity do to manage interest rate risk through Matching?
What can an entity do to manage interest rate risk through Matching?
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Which technique can be used as a natural hedge for currency appreciation or depreciation in Foreign Currency Exchange Rate Risk Management?
Which technique can be used as a natural hedge for currency appreciation or depreciation in Foreign Currency Exchange Rate Risk Management?
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In Interest Rate Risk Management, what does 'Smoothing' involve?
In Interest Rate Risk Management, what does 'Smoothing' involve?
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What strategy can an exporter use to avoid worrying about currency fluctuations?
What strategy can an exporter use to avoid worrying about currency fluctuations?
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Which tool can be utilized in managing Interest Rate Risk besides Matching and Smoothing?
Which tool can be utilized in managing Interest Rate Risk besides Matching and Smoothing?
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If an exporting company expects the currency to depreciate soon, what strategy can it adopt?
If an exporting company expects the currency to depreciate soon, what strategy can it adopt?
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How does the Central Limit Theorem relate to Value at Risk (VaR) calculation?
How does the Central Limit Theorem relate to Value at Risk (VaR) calculation?
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What is the main purpose of Financial Risk Retention as a risk treatment method?
What is the main purpose of Financial Risk Retention as a risk treatment method?
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What does the 1-day 95% Value at Risk (VaR) correspond to in the context of using 100 days of data?
What does the 1-day 95% Value at Risk (VaR) correspond to in the context of using 100 days of data?
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What is the primary criterion for an entity to decide to reduce financial risk?
What is the primary criterion for an entity to decide to reduce financial risk?
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Which method is used to calculate Value at Risk (VaR) according to the text?
Which method is used to calculate Value at Risk (VaR) according to the text?
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What method would a company use to reduce financial risk if the magnitude of risk is high but the frequency is low?
What method would a company use to reduce financial risk if the magnitude of risk is high but the frequency is low?
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When should an entity decide to avoid certain financial risks according to the text?
When should an entity decide to avoid certain financial risks according to the text?
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If a company aims to keep certain risks away due to their high significance and frequency, what approach would it take?
If a company aims to keep certain risks away due to their high significance and frequency, what approach would it take?
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In which scenario would a company opt for Financial Risk Retention according to the text?
In which scenario would a company opt for Financial Risk Retention according to the text?
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If a financial institution decides not to provide a loan to a known defaulter to avoid financial loss, what risk management technique is it practicing?
If a financial institution decides not to provide a loan to a known defaulter to avoid financial loss, what risk management technique is it practicing?
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What is the suggested method to ensure that a company has the required level of liquidity at the right time?
What is the suggested method to ensure that a company has the required level of liquidity at the right time?
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How can a company reduce credit risk according to the text?
How can a company reduce credit risk according to the text?
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What technique is suggested for hedging liquidity risk in the text?
What technique is suggested for hedging liquidity risk in the text?
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What is the purpose of creating possible scenarios where a company may face liquidity problems as per the text?
What is the purpose of creating possible scenarios where a company may face liquidity problems as per the text?
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How can an entity reduce credit risk by focusing on lending to different industries?
How can an entity reduce credit risk by focusing on lending to different industries?
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What is suggested to assess the creditworthiness of individual borrowers according to the text?
What is suggested to assess the creditworthiness of individual borrowers according to the text?
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What is the purpose of extending credit as mentioned in the text?
What is the purpose of extending credit as mentioned in the text?
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Why is it important to involve staff from all levels in the risk identification process?
Why is it important to involve staff from all levels in the risk identification process?
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What is the next stage after risk assessment according to the text?
What is the next stage after risk assessment according to the text?
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How should risks be assessed according to the text?
How should risks be assessed according to the text?
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Which department or team should be assigned to follow up collections and recover outstanding credits?
Which department or team should be assigned to follow up collections and recover outstanding credits?
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What does effective credit collection or recovery mechanisms help in minimizing?
What does effective credit collection or recovery mechanisms help in minimizing?
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What method can an entity use to have a common interest rate for its assets and liabilities?
What method can an entity use to have a common interest rate for its assets and liabilities?
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How can an exporter or importer avoid worrying about currency fluctuations?
How can an exporter or importer avoid worrying about currency fluctuations?
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Which technique can an entity use to hedge risk using options, forwards, futures, and swaps?
Which technique can an entity use to hedge risk using options, forwards, futures, and swaps?
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In what way does an entity manage interest rate risk through derivatives?
In what way does an entity manage interest rate risk through derivatives?
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What does 'Leading and Lagging' involve in managing foreign currency exchange rate risk?
What does 'Leading and Lagging' involve in managing foreign currency exchange rate risk?
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How does an entity create a natural hedge during times of interest rate changes?
How does an entity create a natural hedge during times of interest rate changes?
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What is the formula to calculate Gross Margin?
What is the formula to calculate Gross Margin?
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Which term represents the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)?
Which term represents the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)?
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What does EBIT stand for in financial management?
What does EBIT stand for in financial management?
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What is calculated separately in the context of financial results?
What is calculated separately in the context of financial results?
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In what type of companies is the Gross Margin calculation applicable?
In what type of companies is the Gross Margin calculation applicable?
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Which term represents the difference between Revenues of sold fixed assets and Net Book Value of sold fixed assets?
Which term represents the difference between Revenues of sold fixed assets and Net Book Value of sold fixed assets?
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What is a fundamental ratio of financial analysis that is essential for average/long term lenders?
What is a fundamental ratio of financial analysis that is essential for average/long term lenders?
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Which ratio must be superior to 1 to indicate good liquidity of a balance sheet within one year?
Which ratio must be superior to 1 to indicate good liquidity of a balance sheet within one year?
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What does the company need to have in order to be considered solvent according to the text?
What does the company need to have in order to be considered solvent according to the text?
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What does the level of Free Cash Flow compared to turnovers signify according to the text?
What does the level of Free Cash Flow compared to turnovers signify according to the text?
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What element is defined by the fact that assets within one year are superior to liabilities within one year?
What element is defined by the fact that assets within one year are superior to liabilities within one year?
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What is the main purpose of the Capacity of repayment ratio in financial analysis?
What is the main purpose of the Capacity of repayment ratio in financial analysis?
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What is the main purpose of Negative Working Capital according to the text?
What is the main purpose of Negative Working Capital according to the text?
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Which factors contribute to the Working Capital Need (WCN) as mentioned in the text?
Which factors contribute to the Working Capital Need (WCN) as mentioned in the text?
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What does the formula Net Cash = WC - WCN suggest according to the text?
What does the formula Net Cash = WC - WCN suggest according to the text?
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What does the analysis of big financial equilibrium involve?
What does the analysis of big financial equilibrium involve?
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How does the company's awareness of the Business Finance Requirement (BFR) affect its financial operations?
How does the company's awareness of the Business Finance Requirement (BFR) affect its financial operations?
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Which elements contribute to the Net Cash of a company according to the text?
Which elements contribute to the Net Cash of a company according to the text?
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What does the Equity ratio represent in a company's financial statements?
What does the Equity ratio represent in a company's financial statements?
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When is a company considered 'under capitalized' based on the Equity ratio?
When is a company considered 'under capitalized' based on the Equity ratio?
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What is the purpose of the Working Capital (WC) in a company?
What is the purpose of the Working Capital (WC) in a company?
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In a functional balance sheet, what does 'Treasury assets' most likely refer to?
In a functional balance sheet, what does 'Treasury assets' most likely refer to?
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Why do current assets require stable financing according to the text?
Why do current assets require stable financing according to the text?
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What does the term 'Stable resources' primarily refer to in relation to the balance sheet analysis?
What does the term 'Stable resources' primarily refer to in relation to the balance sheet analysis?
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What ratio is used to calculate Economic Profitability?
What ratio is used to calculate Economic Profitability?
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Which measure represents the profitability of equity?
Which measure represents the profitability of equity?
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What does ROE stand for in financial profitability analysis?
What does ROE stand for in financial profitability analysis?
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In the context of the leverage effect, what does 'resources uses' refer to?
In the context of the leverage effect, what does 'resources uses' refer to?
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What principle is illustrated by the scenario involving Mr. Alpha and Mr. Gamma's transactions?
What principle is illustrated by the scenario involving Mr. Alpha and Mr. Gamma's transactions?
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What does the leverage effect aim to explain in financial contexts?
What does the leverage effect aim to explain in financial contexts?
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Study Notes
Financial Risk Management
- Financial risk cannot be eliminated, but it can be managed and reduced
- Accepting a certain amount of risk is necessary to be in business and make profits
- Factors affecting risk tolerance: company objectives, risk tolerance, and ability to absorb losses
- Financial Risk Management is a comprehensive process with four steps: identifying risks, assessing risks, treating risks, and reporting risks
Risk Identification
- Depends on the nature of the business
- Examples of risk factors: interest rate risk, credit risk, foreign currency exchange rate risk, liquidity risk
- Involves identifying risk factors and controlling them to decide how to manage them effectively
Risk Assessment
- Done from both a quantitative and qualitative perspective
- Factors considered: frequency and severity of occurrence
- Prioritizes the management of risks in relation to those factors
Risk Treatment
- Dependent on the significance of risk to the company and frequency of its occurrence
- Methods: financial risk retention, financial risk reduction, financial risk transfer, and financial risk avoidance
Financial Risk Retention
- If the value of risk is within the tolerable level of the entity, it would decide to do nothing about it
Financial Risk Reduction
- If the significance is low, but the frequency is high, the entity would decide to reduce the risk by controlling the frequency
Financial Risk Transfer
- If the frequency is low, but the magnitude is high, the entity would try to transfer the risk contractually to another party
Financial Risk Avoidance
- Risks that should be effectively kept away from the entity as their significance and frequency are high
- Example: not extending credit to a defaulter
Liquidity Risk Management
- Liquidity diversification: assets and liabilities mature at different durations and proper matching will ensure the company has the required level of liquidity at the right time
- Scenario analysis and contingent plans: creating possible scenarios where the company would face liquidity problems and having contingency funding for urgent incidents
- Liquidity at risk: forecasting liquidity problems for a foreseeable future with a probability of occurrence and holding sufficient liquid funds to finance them
- Derivatives: hedging liquidity risk using a technique such as options, forwards, or swaps
Credit Risk Management
- Credit diversification: reducing credit risk by diversifying the counterparties without concentrating on a few and by reducing the exposure level to each borrower
- Credit scoring models: identifying factors that affect the creditworthiness of a borrower and scoring them to assess each borrower individually
- Effective credit collection or recovery mechanisms: using a dedicated department or team to follow up on collections and work specifically to recover outstanding credits
Interest Rate Risk Management
- Matching: matching assets and liabilities to have a common interest rate
- Smoothing: holding assets or liabilities in both fixed and floating interest rates in a balanced manner
- Derivatives: hedging interest rate risk using options, forwards, futures, or swaps
Foreign Currency Exchange Rate Risk Management
- Invoicing in local currency: trading in home currency internationally
- Matching: using a technique of hedging by timing foreign currency receipts and payments in the same period
- Leading and lagging: adjusting the timing of foreign currency receipts and payments to mitigate currency fluctuations
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Description
Learn about the basics of financial risk management, including factors that determine how much financial risk an entity can bear. Explore concepts like company objectives and risk tolerance in managing financial risks.
