Kingpin804

All of the following are types of financial risk EXCEPT:

A) credit risk.

B) accounting risk.

C) liquidity risk.

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Accounting risk does not directly involve other parties outside the firm. Therefore, it is not a source of financial risk.

Kingpin804

Which of the following is a source of financial risk?

A) Operations.

B) Taxes.

C) Commodity prices.

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This is true by definition. The sources of financial risk are: liquidity risk, credit risk, commodity prices, equity prices, exchange rates, interest rates.

Kingpin804

Suppose that in a currency swap, counterparty A makes a payment to counterparty B who, unbeknownst to A, defaults on the payment that is due at the same time to A. This is called:

A) accounting risk.

B) liquidity risk.

C) settlement risk.

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This is a classic example of settlement risk.

Kingpin804

A property that is usually necessary for a risk source to be considered financial is that it involves:

A) money only.

B) a transaction with a party outside the firm.

C) money and interest rates only.

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Financial risks are usually associated with transactions with other parties.

Kingpin804

All of the following are sources of non-financial risk EXCEPT:

A) settlement risk.

B) credit risk.

C) legal risk.

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Credit risk is a type of financial risk.

Kingpin804

The LDC Bank specializes in foreign exchange transactions and lending to emerging market countries. They have provided a loan to the country of Tinia so that Tinia can install a water irrigation system in the interior of the country. The LDC Bank is very careful with their lending practices, calculating the probability of a country’s default through the use of simulation. They have also entered into a currency swap that allows them to receive Mexican pesos in exchange for paying U.S. dollars. Which of the following risk is NOT explicitly mentioned in these series of transactions by the LDC Bank?

A) Herstatt risk.

B) Model risk.

C) Regulatory risk.

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Regulatory risk is due to the fact that different securities in a firm’s portfolio are subject to regulation by different regulatory bodies. Although the LDC Bank is sure to have exposure to regulatory risk, it is not explicitly described in these transactions. Model risk refers to the risk that models may fail due to poor inputs or construction. The bank’s use of simulation to predict country default is subject to model risk. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in the LDC Bank’s currency swap.

Kingpin804

When describing the risk exposures that an analyst should examine as part of an enterprise risk management system, what terms describe the risks pertaining to the factors that directly affect firm or portfolio values and the risks associated with external capital markets?

Firm/Portfolio Value

External Capital Market

A) [td=1,1,136]Market risk Factor risk [/td]

B) [td=1,1,136]Systematic risk Financial risk [/td]

C) [td=1,1,136]Market risk Financial risk [/td]

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Financial and non-financial risk factors are general terms. Financial risk factors are those associated with external capital markets and the transactions within external markets. Non-financial risk factors capture other types of risk. Financial risk factors include market risk, liquidity risk, credit risk, and sovereign risk. Market risk pertains to the factors that affect firm or portfolio values (e.g. interest rates, exchange rates, equity prices, commodity prices, etc.). Non-financial risk factors include settlement (Herstatt) risk, operations risk, model risk, sovereign risk, regulatory risk, and other miscellaneous risk factors. Note that sovereign risk has both financial and non-financial risk components.

Kingpin804

BigBank engages in foreign exchange transactions. They have just provided a forward contract to a major multinational corporation that allows the corporation to sell Swiss francs in 90 days. They have also entered into a currency swap that allows them to receive Japanese yen in exchange for paying U.S. dollars. Furthermore, they are in the process of selling a large position in Canadian dollars in the spot market. Which of the following risks is NOT explicitly mentioned in these series of transactions by BigBank?

A) Operations risk.

B) Herstatt risk.

C) Liquidity risk.

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Operations risk is the potential for failures in the firm’s operating systems due to personnel, technological, mechanical, or other problems. Although BigBank is sure to have exposure to operations risk, it is not explicitly described in these transactions. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in BigBank’s currency swap. Liquidity risk refers to the potential for sustaining losses due to the inability to sell or buy a position quickly. BigBank’s sale of the Canadian dollars is subject to liquidity risk.

Kingpin804

If the one-day value at risk of a portfolio is $50,000 at a 95 percent probability level, this means that we should expect that in one day out of:

A) 20 days, the portfolio will decline by $50,000 or more.

B) 20 days, the portfolio will decline by $50,000 or less.

C) 95 days, the portfolio will lose $50,000.

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This means that 5 out of 100 (or one out of 20) days, the value of the portfolio will experience a loss of $50,000 or more.

Kingpin804

The minimum amount of money that one could expect to lose with a given probability over a specific period of time is the definition of:

A) value at risk (VAR).

B) delta.

C) the hedge ratio.

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This is an often-used definition of VAR.