Financial Risk Management Basics

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Questions and Answers

What is the primary reason for an entity to decide to reduce financial risk?

Identifying a high frequency of risk (correct)

Transferring the risk contractually

Avoiding the risk completely

Dealing with high magnitude risks

When would an entity consider transferring financial risk contractually?

When the magnitude of risk is high (correct)

When the entity wants to avoid all risks

When the magnitude of risk is low

When the frequency of risk is high

What approach should an entity take towards risks with high significance and frequency?

Avoid the risks completely (correct)

Ignore the risks

Reduce the risks by controlling frequency

Transfer the risks contractually

In which scenario would an entity opt for financial risk avoidance?

Identifying high significance and frequency risks Signup and view all the answers

What type of risk reduction would be most suitable when an entity faces risks with high magnitude but low frequency?

Risk transfer Signup and view all the answers

What are the four steps involved in Financial Risk Management?

Identifying Risks, Assessing Risks, Treating Risks, Reporting Risks Signup and view all the answers

Which factor determines how much financial risk an entity can bear?

Risk Tolerance Signup and view all the answers

What is the major concern for a multi-national company regarding financial risk?

Foreign Currency Exchange Risk Signup and view all the answers

Which institute would consider interest rate risk and credit risk as major concerns?

Banking or Lending Institute Signup and view all the answers

What does Financial Risk Analysis involve?

Identifying risk factors and managing them effectively Signup and view all the answers

Why is financial risk analysis considered a crucial function for organizations today?

To effectively manage and mitigate risks Signup and view all the answers

What is the purpose of extending credit according to the text?

To encourage customers to buy Signup and view all the answers

Why is it important to involve staff from all levels in the risk identification process?

To bring a variety of experiences to identify critical risks Signup and view all the answers

What is the next stage after risk assessment according to the text?

Measurement and mitigation Signup and view all the answers

What does the text suggest should be done to prioritize the management of identified risks?

Severity of occurrence Signup and view all the answers

Which factor is essential for assessing risks according to the text?

Frequency of occurrence Signup and view all the answers

What should be put in place for ongoing monitoring and reporting of risks as per the text?

A plan Signup and view all the answers

What is the main concept associated with the Central Limit Theorem in the context of Value at Risk (VaR) calculation?

Convergence of random variable averages to a normal distribution for large samples. Signup and view all the answers

How is the 1-day 95% VaR calculated using the Historical method?

By arranging actual historical returns from worst to best and selecting the 5th worst return. Signup and view all the answers

In terms of financial risk treatment, what does Financial Risk Retention signify?

Deciding to take no action if the risk value is manageable by the entity. Signup and view all the answers

Which step in calculating VaR involves identifying the least worst return within a specific percentile range?

Step 3 - Financial Risk Treatment Signup and view all the answers

What does the Central Limit Theorem suggest about random variable averages and their distribution?

They tend to converge to a normal distribution with larger sample sizes. Signup and view all the answers

What can an entity do to manage interest rate risk through Matching?

Hold assets and liabilities in both fixed and floating interest rates Signup and view all the answers

Which technique can be used as a natural hedge for currency appreciation or depreciation in Foreign Currency Exchange Rate Risk Management?

Matching Signup and view all the answers

In Interest Rate Risk Management, what does 'Smoothing' involve?

Holding assets and liabilities in both fixed and floating interest rates Signup and view all the answers

What strategy can an exporter use to avoid worrying about currency fluctuations?

Invoicing in Local Currency Signup and view all the answers

Which tool can be utilized in managing Interest Rate Risk besides Matching and Smoothing?

Derivatives such as options, forwards, futures, and swaps Signup and view all the answers

If an exporting company expects the currency to depreciate soon, what strategy can it adopt?

Timing foreign currency receipts and payments Signup and view all the answers

How does the Central Limit Theorem relate to Value at Risk (VaR) calculation?

It ensures a normal distribution of random variable averages in large samples Signup and view all the answers

What is the main purpose of Financial Risk Retention as a risk treatment method?

To decide to take no action when risk is within tolerable levels Signup and view all the answers

What does the 1-day 95% Value at Risk (VaR) correspond to in the context of using 100 days of data?

The 5th worst day within the 100 days of data Signup and view all the answers

What is the primary criterion for an entity to decide to reduce financial risk?

High magnitude and high frequency of risk Signup and view all the answers

Which method is used to calculate Value at Risk (VaR) according to the text?

Historical method Signup and view all the answers

What method would a company use to reduce financial risk if the magnitude of risk is high but the frequency is low?

Financial Risk Transfer Signup and view all the answers

When should an entity decide to avoid certain financial risks according to the text?

When the significance and frequency of the risk are high Signup and view all the answers

If a company aims to keep certain risks away due to their high significance and frequency, what approach would it take?

Financial Risk Avoidance Signup and view all the answers

In which scenario would a company opt for Financial Risk Retention according to the text?

When the frequency is low but magnitude is high Signup and view all the answers

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?

Financial Risk Avoidance Signup and view all the answers

What is the suggested method to ensure that a company has the required level of liquidity at the right time?

Liquidity Diversification Signup and view all the answers

How can a company reduce credit risk according to the text?

Utilizing Credit Scoring Models Signup and view all the answers

What technique is suggested for hedging liquidity risk in the text?

Derivatives like options and swaps Signup and view all the answers

What is the purpose of creating possible scenarios where a company may face liquidity problems as per the text?

Having contingency funding for urgent incidences Signup and view all the answers

How can an entity reduce credit risk by focusing on lending to different industries?

Credit Risk Management Signup and view all the answers

What is suggested to assess the creditworthiness of individual borrowers according to the text?

Credit Scoring Models Signup and view all the answers

What is the purpose of extending credit as mentioned in the text?

To encourage customers to buy from the company Signup and view all the answers

Why is it important to involve staff from all levels in the risk identification process?

To bring a variety of experiences for a cohesive result Signup and view all the answers

What is the next stage after risk assessment according to the text?

Risk Mitigation Signup and view all the answers

How should risks be assessed according to the text?

Both quantitatively and qualitatively Signup and view all the answers

Which department or team should be assigned to follow up collections and recover outstanding credits?

Dedicated department or team Signup and view all the answers

What does effective credit collection or recovery mechanisms help in minimizing?

Financial Risks Signup and view all the answers

What method can an entity use to have a common interest rate for its assets and liabilities?

Smoothing Signup and view all the answers

How can an exporter or importer avoid worrying about currency fluctuations?

Trading in home currency internationally Signup and view all the answers

Which technique can an entity use to hedge risk using options, forwards, futures, and swaps?

Matching Signup and view all the answers

In what way does an entity manage interest rate risk through derivatives?

By using options, forwards, futures, and swaps Signup and view all the answers

What does 'Leading and Lagging' involve in managing foreign currency exchange rate risk?

Balancing the timing of foreign currency receipts and payments Signup and view all the answers

How does an entity create a natural hedge during times of interest rate changes?

By balancing fixed and floating interest rates in assets or liabilities Signup and view all the answers

What is the formula to calculate Gross Margin?

Sales of goods - Cost of goods sold Signup and view all the answers

Which term represents the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)?

EARNING BEFORE INTEREST TAXES DEPRECIATION and AMORTIZATION Signup and view all the answers

What does EBIT stand for in financial management?

EARNING BEFORE INTEREST and TAXES Signup and view all the answers

What is calculated separately in the context of financial results?

Exceptional Income Signup and view all the answers

In what type of companies is the Gross Margin calculation applicable?

Commercial companies Signup and view all the answers

Which term represents the difference between Revenues of sold fixed assets and Net Book Value of sold fixed assets?

CAPITAL GAIN OR LOSSES (ON ASSET DISPOSAL) Signup and view all the answers

What is a fundamental ratio of financial analysis that is essential for average/long term lenders?

Capacity of repayment Signup and view all the answers

Which ratio must be superior to 1 to indicate good liquidity of a balance sheet within one year?

Current ratio Signup and view all the answers

What does the company need to have in order to be considered solvent according to the text?

Sufficient real assets Signup and view all the answers

What does the level of Free Cash Flow compared to turnovers signify according to the text?

Refund of loans assurance for lenders Signup and view all the answers

What element is defined by the fact that assets within one year are superior to liabilities within one year?

Current ratio Signup and view all the answers

What is the main purpose of the Capacity of repayment ratio in financial analysis?

To assess the refund capacity for average/long term lenders Signup and view all the answers

What is the main purpose of Negative Working Capital according to the text?

Releases resources Signup and view all the answers

Which factors contribute to the Working Capital Need (WCN) as mentioned in the text?

Level of inventory, Cost, Volume Signup and view all the answers

What does the formula Net Cash = WC - WCN suggest according to the text?

Net cash is linked to the Working Capital Need Signup and view all the answers

What does the analysis of big financial equilibrium involve?

Comparison of WCN and NC evolutions Signup and view all the answers

How does the company's awareness of the Business Finance Requirement (BFR) affect its financial operations?

It helps in managing operational deadlines efficiently Signup and view all the answers

Which elements contribute to the Net Cash of a company according to the text?

Treasury assets, Marketable securities, Bank overdrafts Signup and view all the answers

What does the Equity ratio represent in a company's financial statements?

Equity / Total of liabilities Signup and view all the answers

When is a company considered 'under capitalized' based on the Equity ratio?

When it is lower than 33% Signup and view all the answers

What is the purpose of the Working Capital (WC) in a company?

To finance part of the current assets Signup and view all the answers

In a functional balance sheet, what does 'Treasury assets' most likely refer to?

Assets that are highly liquid and easily convertible into cash Signup and view all the answers

Why do current assets require stable financing according to the text?

To cover the needs for the investment cycle Signup and view all the answers

What does the term 'Stable resources' primarily refer to in relation to the balance sheet analysis?

Assets that do not change frequently in value Signup and view all the answers

What ratio is used to calculate Economic Profitability?

Return on Capital Employed (ROCE) Signup and view all the answers

Which measure represents the profitability of equity?

Net Income Signup and view all the answers

What does ROE stand for in financial profitability analysis?

Return on Equity Signup and view all the answers

In the context of the leverage effect, what does 'resources uses' refer to?

Savings and investments Signup and view all the answers

What principle is illustrated by the scenario involving Mr. Alpha and Mr. Gamma's transactions?

Leverage effect Signup and view all the answers

What does the leverage effect aim to explain in financial contexts?

The influence of debt on returns for investors Signup and view all the answers

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.