FRM-1-esat

Module 1 Introduction to financial risk management (FRM)

Financial Risk Management Module 1 Introduction to financial risk management Question 1 In 2009 which organisation posted the biggest quarterly corporate loss in US history and in the same month announced staff bonuses in excess of USD 450 million? a. b. c. d.

Americ American an Inter Internat nation ional al Group Group (AIG (AIG). ). Lehman Brothers. Gene Genera rall Mot Motor ors. s. Merr Merril illl Lync Lynch. h.

Question 2 The Gig, an Australian heavy metal band, has decided to let its fans invest i n the music industry and guaranteed that for every $100 invested in The Gig Music Fund they will get a monthly dividend of $12.00. After six months $20 million has been invested and the depositors have all received $12.00 a month. A spokesman announced that the band needs to raise an additional $5 million to fund a new album and offers music lovers $15 per month for every new $100 invested. You decide a. b. c. d.

s the Gig has a proven track record of paying dividends, you go ahead with the investment. s the new album is a guaranteed success, there is little risk involved. this appear appearss to be a Ponzi Ponzi scheme, scheme, so you reject reject the offer. offer. everyone everyone so far has has made money money and hundreds hundreds of people people have already already done done their research research,, so it is a quality investment. 

Question 3 The board of South Soap Ltd, an Australian soap manufacturer exporting throughout the Pacific, has decided to appoint a treasurer to manage its $100 million per annum foreign exchange exposure. When setting the performance measure, the board rationale was as follows. As we have never n ever had a treasur t reasurer er before, befor e, we will wil l benchmark benchm ark the treasurer tre asurer ’ s performance against our current poli cy of doing d oing noth ing— which whic h we believe bel ieve is i s risk -neutral.

How is the t reasurer most likely likely to respond to this performance measure? measure? a. Mini Minimi mise se the the tre treas asur urer er s risks by taking out full cover. b. Minimise the treasurer s risks by taking out no cover at all. c. Actively Actively manag managee the foreign foreign excha exchange nge exposure exposure.. d. Adopt Adopt a neutra neutrall 50 per cent cent cover cover.. ’ ’

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Question 4 Sea Mines Australia Ltd currently exports the bulk of its bauxite production to a Chinese manufacturer of aluminium products under a fixed AUD pricing arrangement with settlement terms of 180 days after delivery. Given that movements in the AUD and commodity prices have traditionally been highly correlated, what is the primary risk faced by Sea Mines Australia Ltd in respect of these exports? a. b. c. d.

Liquidity risk. Commodity price risk. Interest rate risk. Credit risk.

Question 5 Air Rock, a regional Australian airline, receives 80 per cent of its revenues in AUDs and the remainder in USDs. The airline pilots have been on strike for three months but Air Rock has an obligation to continue to make lease payments on its fleet. What is the primary risk faced by Air Rock Airlines? a. b. c. d.

Liquidity risk. Commodity price risk. Interest rate risk. Credit risk.

Question 6 CPT Imports Pty Ltd pays customs duty in AUDs based on the AUD value of the USD invoice when the goods are imported. What is CPT Imports Pty Ltd ’s exposure? a. b. c. d.

Foreign exchange transaction risk. Foreign exchange translation risk. Foreign exchange competitive risk. Customs duty is paid in AUDs, hence there is no exposure.

Question 7 Which one of the following is not a business or operating risk? a. Human error resulting in a loss. b. System breakdown preventing payments. c. Fraud that an employee cannot repay. d. Counterparty defaults through bankruptcy.

Question 8 A company that fully hedges all known risk exposures is employing which type of risk behaviour? a. b. c. d.

Risk averse. Risk taking. Risk neutral. Risk seeking.

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Question 9 The primary purpose of hedging is to reduce a. b.

tax.

the potential for competitive advantage.

c.

volatility in financial results.

d.

interest rate and foreign exchange costs.

Question 10 Alpha Pty Ltd (Alpha) and Omega Ltd (Omega) are two manufacturers of electronic components. While Alpha is a small family business, Omega is a large multinational firm with operations in several countries. Alpha exports more than 50 per cent of its finished products to one client in New Zealand while Omega exports to several destinations and clients. Omega hedges only abnormally large foreign orders in the belief that it is not highly exposed to any one client or currency. What i s the primary benefit to Alpha of hedging its foreign tr ansactions? a. b.

Financing benefits. Reducing the potential volatility of earnings.

c.

Reducing the potential for competitive disadvantage.

d.

Reducing the cost of doing business.

Question 11 Why would an Australian gold-mining company decide that it will use the USD as its functional currency? a.

Gold is considered a USD- based commodity so shareholders may want a ‘ pure ’ exposure to world gold prices.

b.

This would mean that the company has no foreign excha nge exposure as its f oreign exchange risk came from the sale of gold, which was in USD.

c.

The USD is less volatile than the AUD and therefore reduces the foreign exchange risk to the company.

d.

It matches the functional currency of all its competitors and accordingly is not disadvantaged.

Question 12 Given the concept of the risk r eturn trade-off, why would purchasing a share in a company be considered more risky than buying a government bond? a.

Shares will lose money when interest rates rise and bonds increase in value.

b.

You can n ever lose money if you buy bonds but y ou coul d if you bought company shar es.

c.

Company shares would be expected to have a wider range of possible returns than a bond.

d.

Bonds are risk -free.

Question 13 Which of the following is a main role of the corporate risk manager (e.g. the treasurer)? a. b.

The day -to -day running of the business. Statutory reporting and fi nancial operat ions of the business.

c.

Making recommendations and formulating policies with respect to risk management.

d.

The procurement and management of funds and management of financial risk.

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Question 14 Which of the following benefits flow from risk management/hedging? I. II. III.

a. b. c. d.

Lower volatility in profit results. Extra time for an organisation to arrange its affairs. Companies with hedging outperform competitors who are not hedged. I and II only. I and III only. II and III only. I, II and III.

Question 15 Who is responsible for establishing the risk appetite of an organisation? a. b. c. d.

ASIC.

The organisation’s financiers. The board of directors. The corporate treasurer.

Question 16 Who should approve financial risk management policies? a. b. c. d.

The corporate treasurer. The financial controller. The shareholders at the annual general meeting. The board of directors.

Question 17 Which of the following results from reducing financial volatility? I. II. III.

a. b. c. d.

Higher share price. Higher gearing. Cheaper debt. I only. II only. I and II only. I, II and III.

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Question 18 After the Global Financial Crisis in 2008, Hindsight Industries found that its actual borrowing costs (of 8.00%) were lower than its forecast borrowing costs by over 1.00 per cent per annum. While interest rates rose significantly in 2009, Hindsight ’s treasurer announced that the company ’s actual borrowing costs of 8.00 per cent had again been achieved and that Hindsight Industries once again out performed its competitors and the market in borrowing costs. As the chief executive officer, do you a. b. c. d.

dismiss the treasurer? pay the treasurer a bonus? order an independent review of the company’s borrowing program? order an internal review of the company’s borrowing program?

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Solutions Question 1 Correct Answer: a In March 2009 AIG posted the biggest quarterly loss in US corporate history while virtually simultaneously announcing total bonuses to staff of USD 450 million including USD 165 million to the loss -making derivatives traders (which AIG ’s management stated to the US Congress that it was contractually obliged to do). You can review this topic area in the study materials under the section entitled ‘The global financial environment and its implications ’.

Question 2 Correct Answer: c This is clearly a Ponzi scheme. Ponzi schemes use capital to pay apparent dividends in order to retain funds and attract new ones. Regular, above-market returns are a key warning sign—refer to the section on Bernard Madoff in the study guide. Consistently above -market returns are a sign of danger, not a signal to invest. A key question to ask is—If they are so good at investing, why are they offering it to you? Note that a $12.00 return per month equates to an annual return of $144, which is more than the $100 initial investment. You can review this topic area in the study materials under ‘Case study 1.4: Ponzi schemes—Bernard Madoff ’s USD 65 billion fraud ’.

Question 3 Correct Answer: b The Board obviously lacks expertise in risk management. Doing nothing and remaining completely unhedged is not the same as risk neutrality. But, if this is the Board ’s understanding, then the incoming treasurer can easily meet his/her performance expectations by simply doing nothing. That is, the treasurer can meet the treasury benchmark by simply never hedging and essentially adopting a standard strategy of informing the Board that treasury is ‘actively monitoring carefully ’. We need to look at this performance measure from the perspective of the treasurer, not the organisation or the board. While taking out no cover at all may not be in the best interests of the organisation, it may well be in the best interests of the treasurer. The rationale is that by doing nothing, he will at least meet the benchmark requirement. If the treasurer chooses to hedge, the treasurer will probably incur some hedging expenses for the firm. Even worse, the hedging positions may force the firm to give up potential gains due to market fluctuations. However, if the treasurer does not hedge and there is a loss due to the lack of hedging, the treasurer can argue that the market is to blame rather than himself or herself. You can review this topic area in the study materials under ‘Performance measurement in the context of financial risk management ’.

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Question 4 Correct Answer: d As the pricing arrangement is fixed in AUD , there is no currency or commodity risk. However, there is significant credit risk due to the extended settlement terms of the arrangement. You can review this topic area in the study materials under the section entitled ‘Step 3: Determine the risk factors’.

Question 5 Correct Answer: a Liquidity risk is the correct answer. Without revenue generated by flying the planes, and with lease payments continuing, the airline is suffering financial stress through not having sufficient funds to meet its obligations as and when they fall due. You can review this topic area in the study materials under the section entitled ‘Step 3: Determine the risk factors’.

Question 6 Correct Answer: a Paying customs duty is a transaction and will affect the statement of comprehensive income (as opposed to the statement of financial position). Payment in AUDs does not change the fact that, as the exchange rate fluctuates, the amount of Australian dollars required will also fluctuate. You can review this topic area in the study materials under the section entitled ‘Step 3: Determine the risk factors’.

Question 7 Correct Answer: d Counterparty defaulting through bankruptcy is credit risk; all other options relate to items that are business or operating risks. You can review this topic area in the study materials under the section entitled ‘Step 3: Determine the risk factors’.

Question 8 Correct Answer: a A risk averse board chooses to hedge away all economic risk exposures. For the purposes of this segment, the terms can be defined as follows. 

‘Risk averse’ is when full hedging is undertaken (i.e. hedges away all economic risk exposures).



‘Risk neutral’ is when there is a focus on expected returns, not risks.



‘Risk taking’ and ‘risk seeking ’ are similar and infer that the organisation is seeking to take on additional

risks in order to increase returns. 2014 (Edition 14 )

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You can review this topic area in the study materials under the section entitled ‘Step 3: Determine the risk factors’.

Question 9 Correct Answer: c The primary purpose is to reduce volatility in financial results. You can review this topic area in the study materials under ‘Step 4: Appraise risks ’.

Question 10 Correct Answer: b Alpha is not directly comparable to Omega in size even though they are in the same industry. Alpha needs to hedge its foreign exchange exposure. Being a small company that probably faces tight margins, a small currency movement could lead to significant loss. Hence, answer B is the most appropriate. You can review this topic area in the study materials under the section entitled ‘Step 4: Appraise risks ’.

Question 11 Correct Answer: a A pure exposure to gold is when a company is completely exposed to movements in the gold price. By removing the impact of foreign exchange movements on the gold price, the Australian gold -mining company can maintain this pure exposure. B is incorrect as the foreign currency is now Australian dollars. This will only reduce, not totally remove, foreign exchange exposure, as the company will still have many expenses in AUD, which will create an exposure. C is incorrect, as the AUD/USD price is a relative one—if the AUD strengthens against the USD, the USD is weakening against the AUD. D is incorrect unless every gold company uses the USD as its functional currency. You can review this topic area in the study materials under the section entitled ‘Step 1: Set the core criteria (Establish functional currency) ’.

Question 12 Correct Answer: c The wider the range of possible outcomes that an investment has, the riskier the investment is considered to be. Option A is incorrect as bonds lose money when rates rise and shares could move either way. Option B is also incorrect as you can lose money if you sell bonds before maturity. Option D is only correct if the bond is held to maturity. You can review this topic area in the study materials under the section entitled ‘Step 4: Appraise risks (The risk return trade -off)’. 2014 (Edition 14 )

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Question 13 Correct Answer: d Statutory reporting is usually the job of the CFO, while the role of the corporate risk manager/treasurer is the procurement and management of funds and management of risk. The role of the CFO is the strategic overview of financial policies. No doubt a treasurer would assist here, but the question is asking for the main role, which is more operational (i.e. liquidity and funding management). You can review this topic area in the study materials under the section entitled ‘The framework for financial risk management (Managing financial risk) ’.

Question 14 Correct Answer: a Hedging may enable companies to outperform their competitors, but it does not ensure it. You can review this topic area in the study materials under the section entitled ‘The framework for financial risk management (Identifying financial risk and opportunity in an organisation) ’.

Question 15 Correct Answer: c The board of directors sets the organisation ’s risk profile, along with other policy matters. You can review this topic area in the study materials under the section entitled ‘Step 4: Appraise risks (Benchmarks according to function) ’.

Question 16 Correct Answer: d The board of directors is required to take responsibility for the approval of the financial risk management policy that acts as the mandate and delegation of authority for management to hedge. You can review this topic area in the study materials under the section entitled ‘Step 4: Appraise risks (Benchmarks according to function) ’.

Question 17 Correct Answer: d The benefits of lower risk are provided by those who finance the business (i.e. shareholders and financiers) in the following ways: Higher share price

Lower volatility in profit and/or the balance sheet should lead to a more stable share price, and many shareholders are willing to pay a premium for a more stable share price.

Higher g earing

Lower financial volatility provides less risk to financiers and will therefore enable the company to support higher debt levels. This will also enable the company to make more investments through having greater access to debt (Lewent & Kearney 1990).

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Cheaper debt

Less risk to financiers should also translate to a lower cost of debt (although this may be negated if the gearing level is increased too much).

You can review this topic area in the study materials under the section entitled ‘The framework for financial risk management’ (Identifying financial risk and opportunity in an organisation).

Question 18 Correct Answer: c This situation is paralleled by the extremely impressive results achieved in the AWA case. High returns normally mean high risks—an independent audit should identify how these better than market results were achieved. You can review this topic area in the study materials under the reading dealing with the AWA case study.

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