Risk Management Short Answer Type Questions
Question 1.
Explain the process of risk management.
Answer:
The process used to systematically manage pure risk exposures is known as risk management. The risk management process consists of four steps:
(i) Identify risk: There are many potential risks that confront individuals and businesses. The risk management process is concerned primarily with the identification of the relevant exposures to pure risks.
(ii) Evaluating risks: For each source of pure risks that is identified, an evaluation should be performed. In this stage, risk can be categorized as to how often associated loses are likely to occur.
(iii) Select risk management techniques: The results of the analysis in step 2 are used as the basis of making decision regarding ways to handle risks.
(iv) Implement and review decisions: The business or individual must implement the techniques selected.
Question 2.
Explain foreign exchange risk.
Answer:
International business can reduce the international risk exposure to its home market but increases its exposure in following:
(i) Exchange rate movements: Most international business results in the exchange of one currency for another to make payment. Exchange rate fluctuates and due to that, the cash outflow also changes.
(ii) Foreign Economic condition: When multinational companies enter into the foreign markets to sell their product, the demand for these products will depend on the economic conditions in those markets.
(iii) Political risk: When MNC’s establish subsidiaries in foreign countries, they are, exposed to political risk.
It actually represents political actions taken by the host government or the public that affect the MNC’s cash flows.
Question 3.
What are the features of foreign exchange risk management?
Answer:
The foreign exchange risk management consists of spot market, forward and future market. The spot market deals with foreign exchange, delivered within 2 days or less. On the other hand, forward market deals with foreign exchange which is delivered in 3 days or more.
Exchange rate is one of the crucial factor, considered by MNC’s because rate fluctuation directly affect the sales revenue of firm’s exporting goods and services. Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to anticipated changes in the exchange rate.
The salient features of foreign exchange risk management are as follows:
- It consists of spot, forward and future market
- There can be a possible gain or loss because of exchange rate fluctuation.
- It directly affects the sales revenue of MNC’s
- It has more importance because MNC’s operate in multiple currencies.
Question 4.
Why do companies involved in international.trade hqve te hedge their foreign exchange exposure.
Answer:
Companies involved in international trade have to hedge their foreign exchange exposure for various reasons. In deciding whether to hedge foreign exchange exposure, Merck focused on the objective of maximizing long term cash flows and on the potential effect of exchange rate movements on the firms ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholders wealth. The company has a large portion of earning generated overseas. While a disproportionate share of costs is incurred in dollars.
Volatile cash flows can adversely affect the firm’s ability to implement the strategic plan, especially investments in RBD that form the basis for future growth. To succeed in a highly competitive industry, the company needs to make a long term commitment’to a high level of research funding. Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options of income to be converted.
Question 5.
Discuss Hedging of Transaction Exposure.
Answer:
Transaction Exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.
A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.
The various methods of managing transaction exposures are:
- Forward market hedge
- Money market hedge
- Options market hedge
- Exposure netting.
In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.
A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should go for hedging of foreign currency cash inflows or outflows.
Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.