FA Risk Management and Assessment 1 — Questions and Answers
Question 1: What is credit risk in financial management?
- The risk of interest rate changes reducing asset value
- The risk that a borrower or counterparty will fail to meet its obligations (Correct answer)
- The risk of currency exchange rate fluctuations
- The risk of operational system failures
Correct answer: The risk that a borrower or counterparty will fail to meet its obligations
Credit risk is the potential for loss when a borrower defaults on a loan or a counterparty fails to fulfill a contractual financial obligation.
Question 2: Which risk management strategy involves transferring risk to a third party such as an insurance company?
- Risk Avoidance
- Risk Retention
- Risk Transfer (Correct answer)
- Risk Mitigation
Correct answer: Risk Transfer
Risk transfer shifts the financial burden of a risk to another party (e.g., insurance, derivatives), reducing the company's direct exposure.
Question 3: What is Value at Risk (VaR)?
- The maximum possible loss on any investment
- The estimated maximum loss over a given period at a specified confidence level (Correct answer)
- The average return on a portfolio over a year
- The volatility of an asset's daily returns
Correct answer: The estimated maximum loss over a given period at a specified confidence level
VaR quantifies the maximum expected loss over a time horizon at a given confidence level (e.g., 95% or 99%), used widely in financial risk measurement.
Question 4: Interest rate risk primarily affects which type of financial instruments?
- Equity shares only
- Fixed-income securities like bonds (Correct answer)
- Foreign currency holdings only
- Raw material commodities
Correct answer: Fixed-income securities like bonds
Fixed-income instruments are most sensitive to interest rate changes because their fixed coupon payments become more or less attractive as rates move.
Question 5: What is liquidity risk?
- The risk of a counterparty defaulting on a contract
- The risk of being unable to sell an asset quickly without a significant price discount (Correct answer)
- The risk of unexpected inflation eroding purchasing power
- The risk of fraud or employee misconduct
Correct answer: The risk of being unable to sell an asset quickly without a significant price discount
Liquidity risk arises when an asset cannot be quickly converted to cash without substantially reducing its value, or when a company cannot meet short-term obligations.
Question 6: A company hedges its foreign currency exposure primarily to:
- Speculate on exchange rate movements for profit
- Eliminate or reduce the impact of adverse currency fluctuations on cash flows (Correct answer)
- Increase leverage in international markets
- Comply with SEC reporting requirements
Correct answer: Eliminate or reduce the impact of adverse currency fluctuations on cash flows
Currency hedging uses instruments like forwards or options to lock in exchange rates and protect against unfavorable movements in foreign currency values.
FA Risk Management and Assessment 1
What is credit risk in financial management?