CPFM Financial Risk Management 3 — Questions and Answers
Question 1: Credit risk is best defined as the risk that:
- A counterparty fails to meet its contractual obligations (Correct answer)
- Interest rates will rise
- A currency will devalue
- Markets become illiquid
Correct answer: A counterparty fails to meet its contractual obligations
Credit risk is the potential loss arising when a borrower or counterparty defaults on its obligations.
Question 2: Which of the following best describes liquidity risk?
- The risk of being unable to sell an asset or meet obligations without significant loss (Correct answer)
- The risk of a credit downgrade
- The risk of interest rate changes
- The risk of currency conversion
Correct answer: The risk of being unable to sell an asset or meet obligations without significant loss
Liquidity risk arises when an entity cannot convert assets to cash or fund obligations without accepting a sizable price concession.
Question 3: A bond's duration measures its sensitivity to changes in:
- Interest rates (Correct answer)
- Exchange rates
- Commodity prices
- Equity volatility
Correct answer: Interest rates
Duration estimates the percentage change in a bond's price for a given change in interest rates.
Question 4: Stress testing differs from VaR primarily because it:
- Examines impact of extreme, often hypothetical scenarios (Correct answer)
- Uses only normal market conditions
- Requires no assumptions
- Ignores tail events
Correct answer: Examines impact of extreme, often hypothetical scenarios
Stress testing evaluates portfolio impact under severe but plausible scenarios that statistical models may underweight.
Question 5: The risk that a firm cannot roll over its short-term debt as it matures is called:
- Refinancing (funding) risk (Correct answer)
- Basis risk
- Translation risk
- Settlement risk
Correct answer: Refinancing (funding) risk
Refinancing or funding risk is the danger of being unable to replace maturing debt on acceptable terms.
Question 6: Which technique transfers risk to a third party in exchange for a premium?
- Insurance (Correct answer)
- Diversification
- Hedging with internal reserves
- Risk avoidance
Correct answer: Insurance
Insurance transfers specified risks to an insurer in return for premium payments.
Question 7: Basis risk in a hedge arises when:
- The hedging instrument and the underlying exposure do not move perfectly together (Correct answer)
- The hedge fully eliminates all risk
- The counterparty defaults
- Interest rates remain unchanged
Correct answer: The hedging instrument and the underlying exposure do not move perfectly together
Basis risk is the residual risk that the price of the hedge and the hedged item diverge.
CPFM Financial Risk Management 3
Credit risk is best defined as the risk that: