Financial Risk Management Flashcards

A company holds receivables denominated in euros while reporting in U.S. dollars. What type of risk does this exposure primarily represent?

Answer: Transaction (foreign exchange) risk

Foreign-currency receivables expose the firm to transaction risk because exchange-rate movements alter the dollar value of the amount collected.

Which instrument is most commonly used to hedge the risk of rising interest rates on a floating-rate loan?

Answer: Interest rate swap (pay fixed, receive floating)

A pay-fixed/receive-floating swap converts floating-rate exposure into a fixed cost, neutralizing the impact of rising rates.

Value at Risk (VaR) at a 95% confidence level over one day is best described as:

Answer: The maximum loss expected to be exceeded only 5% of the time

A 95% one-day VaR estimates a loss threshold that should be exceeded on only about 5% of trading days.

A key limitation of standard VaR is that it:

Answer: Does not describe the magnitude of losses beyond the VaR threshold

VaR identifies a loss threshold but says nothing about how severe losses can become once that threshold is breached.

Which risk measure addresses the shortcoming of VaR by averaging losses in the tail?

Answer: Conditional VaR (Expected Shortfall)

Conditional VaR, or Expected Shortfall, averages the losses that occur beyond the VaR cutoff.

Diversification reduces which type of risk?

Answer: Unsystematic (specific) risk

Holding many uncorrelated assets averages away firm-specific (unsystematic) risk, but systematic risk remains.

A natural hedge for a U.S. exporter with euro revenues would be to:

Answer: Incur euro-denominated costs or debt

Matching euro costs or liabilities against euro revenues offsets currency exposure without using derivatives.