Learning outcomes: Evaluate some advantages and disadvantages of hedging risk exposures. Explain how a company can determine whether to hedge specific risk factors, including the role of the board of directors and the process of mapping risks. Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency and interest rate risk. Assess the impact of risk management instruments.
Questions:
503.1. You are the Chief Risk Officer (CRO) at a non-financial company and the board of directors has asked you to make a recommendation with respect to hedging one of the firm's key exposures. The board wants you to make a recommendation of either "in favor" or "against" the implementation of a hedge against the exposure. Your staff prepared the following arguments, three in favor and three against:
Three Arguments AGAINST hedging an exposure at a non-financial firm
a. None of the arguments are valid
b. Each set of arguments contains one mistake (or fallacy) and two valid arguments
c. Each set of arguments contains two mistakes (or fallacies) and one valid argument
d. All of the arguments are valid in both sets
503.2. Crouhy refers to the difference between hedging activities related to firm's operations and hedging related to the balance sheet. When it comes to hedges, as risk-reducing positions, which of the following best summarizes his advice to managers?
a. If markets are perfect and the capital asset pricing model (CAPM) assumptions are true, then hedging and risk reduction are theoretically useless in all cases, including both operations and financial positions
b. Even if markets are imperfect and CAPM assumptions are false, hedging and risk reduction in theory cannot add value
c. Firms should risk-manage (e.g., hedge) their operations and, if markets are imperfect, maybe should hedge their assets and liabilities (so long as they disclose their hedging policy)
d. Firms should always hedge their balance sheets, even if markets are perfect, but they probably should not hedge their operations (and they should avoid disclosure in order to protect confidential information that might be revealed by, for example, forward transactions).
503.3. In order to put risk management into practice, Crouhy outlines high-level steps in the following order:
a. When developing the firm's risk appetite, it is rarely feasible to define an objective in terms of a single, simple formula; rather, the objective should be broken down into clear rules that can be implemented in line with major policy choices such as risk constituents (e.g., shareholders or debtors), time horizon, and accounting versus economic profits
b. When mapping the firm's risks, it is important to differentiate between risks that can be insured against, risks that can be hedged, and risks that are noninsurable and nonhedgeable. This classification is important because the next step is to look for instruments that might help to minimize the risk exposure of the firm.
c. When implementing a strategy, because FAS 133 and IFRS 9 allow for hedge accounting for any derivative instrument regardless of the economic relationship between the derivative and the hedged item, firm's should prefer mark-to-mark (MtM) derivatives over-the-counter (OTC) derivatives
d. When implementing a strategy, a key tactical decision is whether to employ static or dynamic hedges. A static strategy is relatively easy to implement and monitor. Dynamic strategies involve an ongoing series of trades that are used to calibrate the combined exposure and the derivative position; this dynamic strategy calls for much greater managerial effort in implementing and monitoring the positions, and may incur higher transaction costs.
Answers here:
Questions:
503.1. You are the Chief Risk Officer (CRO) at a non-financial company and the board of directors has asked you to make a recommendation with respect to hedging one of the firm's key exposures. The board wants you to make a recommendation of either "in favor" or "against" the implementation of a hedge against the exposure. Your staff prepared the following arguments, three in favor and three against:
Three Arguments AGAINST hedging an exposure at a non-financial firm
- Our investors own diversified portfolios such that in theory our firm's specific risks are effectively costless to them
- If markets are perfect, hedging is a theoretically a zero-sum game
- Practical (non-theoretical) objections include that risk management requires specialized skills; and can incur high compliance costs
- Financial distress incurs a high fixed costs, which is a salient market imperfection
- Risk management gives management better economic control over the firm's natural economic performance
- Hedging has the potential to reduce the firm's cost of capital, reduce its cash flow volatility, and enhance its ability to grow
a. None of the arguments are valid
b. Each set of arguments contains one mistake (or fallacy) and two valid arguments
c. Each set of arguments contains two mistakes (or fallacies) and one valid argument
d. All of the arguments are valid in both sets
503.2. Crouhy refers to the difference between hedging activities related to firm's operations and hedging related to the balance sheet. When it comes to hedges, as risk-reducing positions, which of the following best summarizes his advice to managers?
a. If markets are perfect and the capital asset pricing model (CAPM) assumptions are true, then hedging and risk reduction are theoretically useless in all cases, including both operations and financial positions
b. Even if markets are imperfect and CAPM assumptions are false, hedging and risk reduction in theory cannot add value
c. Firms should risk-manage (e.g., hedge) their operations and, if markets are imperfect, maybe should hedge their assets and liabilities (so long as they disclose their hedging policy)
d. Firms should always hedge their balance sheets, even if markets are perfect, but they probably should not hedge their operations (and they should avoid disclosure in order to protect confidential information that might be revealed by, for example, forward transactions).
503.3. In order to put risk management into practice, Crouhy outlines high-level steps in the following order:
- Risk appetite: Determine the firm's risk appetite which should include the firm's risk and return objectives
- Mapping: After the objectives have been set, map the relevant risks and estimate their current and future magnitudes
- Instrument selection: After mapping the risks, identify instruments that can be used to risk-manage the exposures (Some of the instruments can be devised internally; i.e., natural hedges)
- Strategy: Construct and implement a strategy
- Evaluation: Periodically evaluate the performance of the risk management system
a. When developing the firm's risk appetite, it is rarely feasible to define an objective in terms of a single, simple formula; rather, the objective should be broken down into clear rules that can be implemented in line with major policy choices such as risk constituents (e.g., shareholders or debtors), time horizon, and accounting versus economic profits
b. When mapping the firm's risks, it is important to differentiate between risks that can be insured against, risks that can be hedged, and risks that are noninsurable and nonhedgeable. This classification is important because the next step is to look for instruments that might help to minimize the risk exposure of the firm.
c. When implementing a strategy, because FAS 133 and IFRS 9 allow for hedge accounting for any derivative instrument regardless of the economic relationship between the derivative and the hedged item, firm's should prefer mark-to-mark (MtM) derivatives over-the-counter (OTC) derivatives
d. When implementing a strategy, a key tactical decision is whether to employ static or dynamic hedges. A static strategy is relatively easy to implement and monitor. Dynamic strategies involve an ongoing series of trades that are used to calibrate the combined exposure and the derivative position; this dynamic strategy calls for much greater managerial effort in implementing and monitoring the positions, and may incur higher transaction costs.
Answers here:
Last edited by a moderator:
