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Unformatted text preview: 16-1CHAPTER 16: FINANCIAL RISK MANAGEMENTEND OF CHAPTER QUESTIONS AND PROBLEMS1. Hedging is a strategy designed to reduce risk. Risk management encompasses hedging, but goes beyond.It consists of identifying the appropriate level of risk that a firm should have, determining the level of riskthat a firm currently has, and adjusting the actual level of risk to the desired level of risk. Obviously insome situations, this will involve increasing the firms risk. Risk management is also an ongoing processin which monitoring a firms risk and making appropriate adjustments continually keep the firm at itsdesired level of risk.2.Increases in the volatility of interest rates, exchange rates, commodity prices and stock prices is onereason why derivatives have become increasingly used. Another reason is that technologicalimprovements have made it more feasible to use derivatives, which tend to rely heavily on accurate andtimely information and the ability to do complex calculations. A third important reason is not specificallymentioned in this chapter but should be remembered from elsewhere in the book: derivatives tend to havelower transaction costs than other ways of managing risk.3. A dealer is engaged in numerous derivatives transactions and has the potential for taking on enormousmarket and credit risk. The objective of a dealer is to earn a profit off of the spread between its buyingand selling prices and not to speculate on the direction of the market. It is extremely important that adealer carefully manage its market and credit risk, especially the former. Consequently a dealer usuallyhedges most of its transactions. A dealer must be engaged in continuous monitoring of its position andmust be careful to manage other risks that might be present in its system. An end user typically engagesin a derivatives transaction to hedge a specific risk or spot transaction. It is not normally engaged in sucha large number of derivatives transactions, nor does it take such exposure that it must monitor its riskquite as often or as carefully. However, the potential for misuse of derivatives by end users is certainlythere and a level of risk management appropriate to the extent of its exposure is warranted.4.Market risk is associated with movements in interest rates, exchange rates, commodity prices and stockprices. Credit risk is the risk associated with having a counterparty fail to pay off. Market risk and creditrisk are typically managed separately and require different techniques. Market risk is managed by lookingat deltas, gammas, vegas, VAR, etc. Credit risk is typically managed by monitoring the extent of activitywith a given party and by using credit enhancements like collateral and marking-to-market. Market riskand credit risk can be related, such as when your counterparty to a swap is in financial trouble but you oweit more than it owes you, in which case you have no credit risk....
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- Fall '08