CTP Financial Risk Management 4 — Questions and Answers
Question 1: A U.S. company has a EUR-denominated subsidiary. To hedge the translation exposure of the subsidiary's equity, it should:
- Borrow in USD and convert proceeds to EUR to fund the subsidiary
- Borrow in EUR to create a EUR liability that offsets the EUR-denominated equity (Correct answer)
- Buy EUR call options equal to the subsidiary's book value
- Use a pay-USD, receive-EUR cross-currency swap
Correct answer: Borrow in EUR to create a EUR liability that offsets the EUR-denominated equity
Issuing EUR-denominated debt creates a natural hedge: translation losses on the subsidiary's equity are offset by translation gains on the EUR liability.
Question 2: The 'Greeks' in options pricing include Delta, Gamma, Theta, and Vega. A long call option position will experience time value decay as expiration approaches, which is reflected by:
- A positive Theta
- A negative Theta (Correct answer)
- A high positive Delta
- A low Gamma
Correct answer: A negative Theta
Theta represents time decay; a long option position has negative Theta because option value erodes as time passes, all else equal.
Question 3: Enterprise Risk Management (ERM) differs from traditional siloed risk management primarily because ERM:
- Focuses exclusively on financial risks
- Considers all risks holistically across the organization and their interdependencies (Correct answer)
- Is required under Sarbanes-Oxley for all public companies
- Eliminates the need for individual business unit risk assessments
Correct answer: Considers all risks holistically across the organization and their interdependencies
ERM integrates all risk categories—financial, operational, strategic, and reputational—into a unified framework that considers how risks interact across the enterprise.
Question 4: A commodity producer uses a collar strategy to hedge price risk. Which combination of instruments constitutes a zero-cost collar?
- Buy a put and buy a call at the same strike
- Buy a put and sell a call, with premiums that offset each other (Correct answer)
- Sell a put and sell a call at different strikes
- Buy a futures contract and sell a put option
Correct answer: Buy a put and sell a call, with premiums that offset each other
A zero-cost collar involves buying a protective put and selling a call at a higher strike; the call premium received offsets the put premium paid.
Question 5: Under the COSO ERM framework, 'risk appetite' is best defined as:
- The maximum loss a company can sustain before insolvency
- The amount of risk an organization is willing to accept in pursuit of its objectives (Correct answer)
- The residual risk remaining after controls are applied
- The probability-weighted expected loss from all risk categories
Correct answer: The amount of risk an organization is willing to accept in pursuit of its objectives
Risk appetite is the broad-based amount of risk a company accepts in pursuit of value, set by the board and guiding strategic decision-making.
Question 6: Stress testing differs from VaR analysis because stress testing:
- Is always more accurate than VaR
- Examines the impact of severe but plausible scenarios rather than relying on historical distributions (Correct answer)
- Only considers market risk, not credit or liquidity risk
- Requires fewer data inputs and assumptions
Correct answer: Examines the impact of severe but plausible scenarios rather than relying on historical distributions
Stress testing evaluates portfolio impact under specific extreme scenarios (e.g., 2008 financial crisis) and does not rely on historical return distributions as VaR does.
Question 7: A company's natural hedge is most effective when:
- Revenues and costs in the same foreign currency are roughly equal in size (Correct answer)
- The company invoices all customers in its domestic currency
- The company uses financial derivatives to offset all currency exposure
- The foreign currency is pegged to the domestic currency
Correct answer: Revenues and costs in the same foreign currency are roughly equal in size
A natural hedge occurs when foreign currency revenues and costs offset each other, reducing net currency exposure without requiring financial instruments.
CTP Financial Risk Management 4
A U.S. company has a EUR-denominated subsidiary.
To hedge the translation exposure of the subsidiary's equity, it should: