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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. American International Group (AIG).
b. Lehman Brothers.
c. General Motors.
d. Merrill Lynch.
Question 2
The Gig, an Australian heavy metal band, has decided to let its fans invest in 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. s the Gig has a proven track record of paying dividends, you go ahead with the investment.
b. s the new album is a guaranteed success, there is little risk involved.
c. this appears to be a Ponzi scheme, so you reject the offer.
d. everyone so far has made money and hundreds of people have already done their 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 had a treasurer before, we will benchmark the treasurers performance against our current
policy of doing nothingwhich we believe is risk-neutral.
How is the treasurer most likely to respond to this performance measure?
a. Minimise the treasurers risks by taking out full cover.
b. Minimise the treasurers risks by taking out no cover at all.
c. Actively manage the foreign exchange exposure.
d. Adopt a neutral 50 per cent cover.

Module 1 Introduction to financial risk management (FRM)


Page 1 2014 (Edition 14)
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. Liquidity risk.
b. Commodity price risk.
c. Interest rate risk.
d. 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. Liquidity risk.
b. Commodity price risk.
c. Interest rate risk.
d. 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 Ltds exposure?
a. Foreign exchange transaction risk.
b. Foreign exchange translation risk.
c. Foreign exchange competitive risk.
d. 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. Risk averse.
b. Risk taking.
c. Risk neutral.
d. Risk seeking.
Module 1 Introduction to financial risk management (FRM)
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Question 9
The primary purpose of hedging is to reduce
a. tax.
b. 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 is the primary benefit to Alpha of hedging its foreign transactions?
a. Financing benefits.
b. 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 exchange exposure as its foreign 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 return 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 never lose money if you buy bonds but you could if you bought company shares.
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. The day-to-day running of the business.
b. Statutory reporting and financial operations 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. Lower volatility in profit results.
II. Extra time for an organisation to arrange its affairs.
III. Companies with hedging outperform competitors who are not hedged.
a. I and II only.
b. I and III only.
c. II and III only.
d. I, II and III.
Question 15
Who is responsible for establishing the risk appetite of an organisation?
a. ASIC.
b. The organisations financiers.
c. The board of directors.
d. The corporate treasurer.
Question 16
Who should approve financial risk management policies?
a. The corporate treasurer.
b. The financial controller.
c. The shareholders at the annual general meeting.
d. The board of directors.
Question 17
Which of the following results from reducing financial volatility?
I. Higher share price.
II. Higher gearing.
III. Cheaper debt.
a. I only.
b. II only.
c. I and II only.
d. 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, Hindsights treasurer announced that the companys 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. dismiss the treasurer?
b. pay the treasurer a bonus?
c. order an independent review of the companys borrowing program?
d. order an internal review of the companys 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 AIGs 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 signrefer 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 isIf 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 schemesBernard Madoffs
USD65billion 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 Boards 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
thebest 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
thestatement 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,
theterms can be defined as follows.
I Risk averse is when full hedging is undertaken (i.e. hedges away all economic risk exposures).
I Risk neutral is when there is a focus on expected returns, not risks.
I Risk taking and risk seeking are similar and infer that the organisation is seeking to take on additional
risks in order to increase returns.
Module 1 Introduction to financial risk management (FRM)
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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 oneif 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
tomaturity.
You can review this topic area in the study materials under the section entitled Step 4: Appraise risks (The risk-
return trade-off).
Module 1 Introduction to financial risk management (FRM)
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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 organisations 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)
inthe following ways:
Higher share price Lower volatility in profit and/or the balance sheet should lead to a more stable
shareprice, and many shareholders are willing to pay a premium for a more stable
share price.
Higher gearing 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).
Module 1 Introduction to financial risk management (FRM)
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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 risksan 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.
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).
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