F3: Financial risks

Answer: A. Interest rate risk is the exposure to changes in the cost of borrowing or return on investments due to interest rate movements. Foreign exchange risk is the exposure to changes in exchange rates affecting the value of overseas transactions or assets. Credit (counterparty) risk is the exposure to a customer or counterparty failing to meet its payment obligations. Business, operational and reputational risk are broader enterprise risk categories not specifically about financial instruments or rates. Systematic and unsystematic risk relate to investment portfolio theory, not directly to the three specific exposures described. Inflation, political and agency risk are relevant financial strategy considerations but do not match the three exposures described in the scenario.

Answer: B. Systematic (market) risk arises from economy-wide factors affecting all companies and cannot be diversified away, so investors require compensation for bearing it, reflected in beta and the CAPM formula. Unsystematic (specific) risk arises from factors unique to an individual company and can be reduced or eliminated by holding a diversified portfolio of shares, so a rational, well-diversified investor does not need to be compensated for it. There is no general rule that unsystematic risk always exceeds systematic risk — this varies by company and cannot be assumed. Systematic risk, being market-wide, cannot be eliminated even in a very large, diversified portfolio, let alone with just two shares. CAPM is built on the assumption that investors hold well-diversified portfolios, not single shares, which is precisely why only systematic risk is priced.

Answer: C. The CAPM formula is Ke = Rf + beta x (Rm - Rf). Substituting the figures: Ke = 4% + 1.2 x (10% - 4%) = 4% + 1.2 x 6% = 4% + 7.2% = 11.2%. 7.2% is only the risk premium component (beta x market premium) and omits adding back the risk-free rate. 10.0% simply restates the market return and ignores the company's specific beta entirely. 12.0% would result from multiplying beta by the market return alone (1.2 x 10%) rather than by the market risk premium (Rm - Rf).

Answer: D. Asset beta strips out the effect of financial gearing and reflects only the systematic risk inherent in the company's underlying business operations, as if it were financed entirely by equity. Equity beta reflects the risk actually borne by shareholders, which includes both this business risk and the additional financial risk created by the company's level of gearing (since debt increases the volatility of returns to equity holders). Asset beta does not reflect financial risk at all — that is precisely what distinguishes it from equity beta. The two betas are only identical when a company has no debt (i.e. it is fully equity-financed); as soon as any gearing exists, equity beta exceeds asset beta. Both asset beta and equity beta measure systematic risk under CAPM; neither measures unsystematic (diversifiable) risk.

Answer: A. The ungearing (asset beta) formula adjusts the equity beta to remove the effect of financial gearing: Ba = Be x [Ve / (Ve + Vd x (1-T))]. Substituting: Ba = 1.50 x [80 / (80 + 20 x 0.75)] = 1.50 x [80/95] = 1.50 x 0.8421 = 1.26 (to 2dp). 1.50 is simply the original equity beta, unadjusted for gearing, and would ignore the presence of debt entirely. 1.20 would result from omitting the (1-T) tax adjustment on the debt term entirely (using 80/(80+20) = 0.80, then 1.50 x 0.80 = 1.20). 1.78 would result from inverting the ratio inside the brackets (using 95/80 instead of 80/95, then 1.50 x 1.1875 = 1.78).

Answer: B. The regearing formula reintroduces the effect of the target company's own capital structure onto the proxy's asset beta: Be = Ba x [(Ve + Vd x (1-T)) / Ve]. Substituting: Be = 1.10 x [(60 + 40 x 0.75)/60] = 1.10 x [(60+30)/60] = 1.10 x [90/60] = 1.10 x 1.5 = 1.65. 1.10 is simply the proxy's asset beta, left ungeared and not adjusted for the target's own financial risk. 1.83 would result from omitting the (1-T) tax adjustment on the debt term entirely (using (60+40)/60 = 1.667, then 1.10 x 1.667 = 1.83). 0.73 would result from inverting the ratio (using 60/90 instead of 90/60, then 1.10 x 0.667 = 0.73).

Answer: C. As gearing increases, the financial risk borne by equity holders rises (since fixed interest obligations increase the volatility of returns available to shareholders), which increases the equity beta via the regearing (Hamada) relationship, and — under CAPM — a higher beta directly increases the required cost of equity. It is not correct that more debt always reduces overall risk; rather, gearing shifts and typically increases the risk borne specifically by equity holders, even while overall firm risk (asset beta) is unchanged. A falling beta with an unchanged cost of equity does not reflect the direction of the regearing relationship, which shows beta rising with gearing. Gearing changes are a core driver of changes to equity beta and cost of equity under this framework, so claiming no effect under any circumstances is incorrect.

Answer: D. A company with variable-rate borrowing is exposed to the risk that interest rates rise, increasing the cash interest it must pay in future periods — this is the interest rate exposure described. A company with fixed-rate borrowing instead has the reverse exposure: if rates fall, it is 'locked in' to paying more than the new market rate, representing an opportunity cost rather than an increase in actual cash cost. Foreign exchange transaction risk relates to exposure arising from cross-currency transactions, which is not mentioned in the scenario (no currency is referenced). Credit risk relates to a counterparty's ability to pay amounts owed to the company, which is unrelated to the company's own borrowing costs.

Answer: A. An FRA is an over-the-counter agreement that fixes the interest rate applicable to a notional amount over a specified future period (e.g. a '3v9' FRA covers a 6-month period beginning in 3 months), without any actual exchange of principal — it is cash-settled based on the difference between the agreed rate and the actual reference rate on the settlement date. A currency forward contract fixes an exchange rate, not an interest rate, and is irrelevant to this borrowing-rate hedging need. An interest rate swap typically exchanges fixed and floating interest payments over the life of an existing loan or exposure, rather than fixing a rate for a single specific future period on a loan not yet drawn. A share option is an equity derivative unrelated to interest rate risk management.

Answer: B. Because the FRA fixed a borrowing rate of 5.00% but the actual market rate turned out to be higher at 6.00%, the bank compensates the company for the extra cost it will now incur on its actual loan: settlement = (6.00% - 5.00%) x $5,000,000 x (6/12) = 1% x $5,000,000 x 0.5 = $25,000, payable from the bank to the company (ignoring discounting, as is standard for a simplified settlement calculation at this level). $50,000 would result from omitting the 6/12 time adjustment for the length of the underlying period. $300,000 incorrectly uses the full reference rate (6%) rather than the 1% rate differential in the calculation. $5,000 would result from using 0.1% instead of the correct 1% rate differential.

Answer: C. Basis risk arises because exchange-traded futures are standardised (fixed contract sizes, standard maturity dates) and their price does not always move in perfect lockstep with the specific interest rate the treasurer is trying to hedge, so the gain or loss on the futures position may not exactly offset the change in the underlying borrowing cost — a risk not present with a tailored, over-the-counter FRA matched exactly to the exposure. Counterparty default risk is generally lower, not absent, with exchange-traded futures because of the clearing house guarantee, whereas FRAs, being over-the-counter, typically carry more direct counterparty risk. Using an interest rate futures contract does not create foreign exchange risk, since this instrument relates purely to domestic interest rates, not currencies. Interest rate futures are cash-settled and do not involve physical delivery of a loan principal; they are closed out or cash-settled based on price movements.

Answer: D. The value of one tick on an interest rate futures contract is found by multiplying the contract's notional size by the tick size (expressed as a decimal, since one tick of 0.01 in price terms represents 0.0001 as a rate/decimal) and by the fraction of a year the contract covers: $1,000,000 x 0.0001 x (3/12) = $1,000,000 x 0.0001 x 0.25 = $25. $100 would result from omitting the 3/12 time adjustment for the 3-month contract period. $8.33 would result from using a 1-month period (1/12) instead of the correct 3-month contract period (3/12): $1,000,000 x 0.0001 x (1/12) = $8.33. $1,000 would result from using a tick size of 0.001 (one decimal place out) rather than the correct 0.0001.

Answer: A. The number of contracts needed is calculated as the loan amount divided by the contract size, adjusted for any difference between the length of the loan period being hedged and the standard futures contract period: (12,000,000 / 1,000,000) x (3/3) = 12 x 1 = 12 contracts. Since both the loan and the futures contract cover the same 3-month period here, no further adjustment is needed beyond scaling for the notional amount. 36 would result from incorrectly multiplying by 3 (period in months) rather than using the correct period ratio of 3/3 = 1. 4 would result from dividing the loan amount by 3,000,000, an incorrect misreading of the contract size. 1 simply ignores the amount to be hedged relative to the size of a single contract.

Answer: B. An interest rate cap is an option that sets a maximum interest rate; if market rates rise above the cap, the option pays out to compensate the borrower, but if rates fall, the company simply lets the option lapse and benefits from paying the lower prevailing market rate — this asymmetric protection (downside protection with upside potential retained) is the key advantage of options over instruments like futures or FRAs, which fix a rate in both directions and remove the ability to benefit if rates move favourably. A cap does not guarantee one single fixed rate outcome; the whole point is that the company can still pay less than the cap if rates fall, which a purely fixed hedge would not permit. Being an option, a cap does not create any obligation for the company to actually borrow at the cap rate — it retains the choice of whether to exercise the benefit. A cap protects a borrower against rising rates; the instrument that protects against falling rates (typically bought by investors/lenders, or sold by a borrower as part of a collar) is a floor, not a cap.

Answer: C. Combining a bought cap with a sold floor creates a collar: the premium received from selling the floor helps offset (fully or partially) the premium paid for the cap, reducing the net cost of the hedge. In exchange, the company gives up some of the benefit of falling rates, because if rates fall below the floor level, the company (as seller of the floor) must compensate the floor holder, effectively setting a minimum rate the company will pay, in addition to the maximum set by the cap. This is not a currency swap, which is an entirely different instrument used to manage foreign exchange and/or cross-currency interest rate exposure, not applicable here since no currency risk is described. The payoff profile of a cap-plus-sold-floor collar is fundamentally different from buying two caps, since the sold floor creates an obligation on the downside that a second cap would not. Selling a floor is not economically identical to an FRA; an FRA fixes a single rate in both directions with no option premium, unlike the asymmetric payoff of options in a collar.

Answer: D. An interest rate swap allows a company to exchange one type of interest payment obligation for another (here, variable for fixed) based on an agreed notional principal, without needing to actually repay or refinance the underlying loan — only the interest cash flows are swapped with the counterparty. A rights issue raises new equity capital and is an entirely different type of transaction, not a derivative used to manage an existing loan's interest rate profile. A money market hedge is a technique specifically used to hedge foreign currency transaction exposure using borrowing and depositing in different currencies, not to change the interest rate basis of an existing domestic loan. A scrip dividend is a method of paying a dividend in new shares rather than cash and has no connection to interest rate risk management.

Answer: A. The total potential gain from a comparative advantage swap is the difference between the fixed rate differential and the floating rate differential between the two companies. Company A has a comparative advantage in fixed-rate borrowing (its fixed rate is 1.5% lower than B's), while the difference in floating rates is only 0.5%. The total gain available to share is 1.5% - 0.5% = 1.0% per annum. 1.5% is simply the fixed-rate differential alone, without netting off the floating-rate differential that each company could access directly without a swap. 0.5% is simply the floating-rate differential alone. 2.0% would result from adding the two differentials together instead of subtracting one from the other.

Answer: B. Translation exposure arises purely from the accounting process of converting the financial statements of a foreign subsidiary into the parent's reporting currency; it changes reported figures (and can affect gearing ratios or covenant compliance) but does not itself represent an actual cash inflow or outflow. Transaction exposure specifically relates to a contracted cash flow in a foreign currency (e.g. an invoice to be paid or received), which is a real cash-based exposure, unlike the scenario described. Economic exposure is a broader, longer-term concept concerning how exchange rate movements affect a company's future competitiveness and cash flows, rather than the mechanical restatement of historical financial statements on consolidation. Credit exposure relates to counterparty default risk and is unrelated to currency translation.

Answer: C. Since the forward rate is quoted as $1.2500 per £1, converting the USD receivable into GBP requires dividing the dollar amount by the rate: $500,000 / 1.2500 = £400,000. £625,000 incorrectly multiplies instead of divides ($500,000 x 1.25). £500,000 simply restates the dollar figure as if the exchange rate were 1:1, ignoring the actual quoted rate entirely. £390,625 would result from converting at the spot rate ($1.2800/£) instead of the agreed forward rate: $500,000 / 1.2800 = £390,625 — the whole point of the forward hedge is to lock in the forward rate instead.

Answer: D. A money market hedge for a future foreign currency payment works by depositing enough foreign currency today (earning interest) to exactly cover the future payment. The USD amount needed today is $816,000 / 1.02 = $800,000 (this is the amount that will grow to $816,000 after 6 months' interest at 2%). This $800,000 is then obtained today by converting GBP at the spot rate: $800,000 / 1.28 = £625,000, which is the amount the company must borrow (in GBP) today. £800,000 is the intermediate USD deposit figure and has not yet been converted into GBP. £637,500 would result from converting the full future payment at the spot rate without first discounting for the 6 months' USD deposit interest: $816,000 / 1.28 = £637,500. £816,000 simply restates the future USD payment figure without any conversion or discounting applied.

Answer: A. A currency option gives the holder the right, but not the obligation, to exchange currency at a fixed rate, in exchange for an upfront premium; if the market moves favourably, the holder simply lets the option lapse and deals at the better spot rate, retaining the upside, while still being protected against adverse movements — this asymmetric payoff is the defining advantage over a futures contract, which fixes the rate in both directions (no premium, but also no ability to benefit from favourable movements). It is exchange-traded currency futures, not options, that typically involve margin rather than an upfront option premium, and futures do not provide the same asymmetric upside as an option — this is precisely what differentiates the two instruments. A money market hedge can, in fact, also be used for anticipated transactions where the timing and amount are reasonably certain, so this is not a correct limitation. A currency swap is typically used for longer-term, ongoing exposures (such as hedging a foreign currency loan across its full life), not exclusively single, one-off short-term transactions.

Answer: B. A currency swap is specifically designed to exchange a series of cash flows (interest payments and, where agreed, the principal amounts) in one currency for equivalent cash flows in another currency over an extended period, making it the appropriate instrument for converting the full remaining exposure of a long-term USD loan into sterling without needing to repay and refinance the original loan. A single forward contract only fixes the rate for one transaction on one future date, so a whole series of forwards (one for each payment date) would be needed to replicate what a single currency swap achieves in one agreement. An interest rate cap manages the level of interest rates within a single currency and does not address the cross-currency conversion of cash flows at all. A scrip dividend is entirely unrelated, being a method of paying dividends in shares rather than cash.

Answer: C. Interest rate parity states that the forward exchange rate should adjust to offset the interest rate differential between the two currencies, so that no risk-free arbitrage profit is available. Since the US interest rate (5%) is higher than the UK rate (3%), the dollar is expected to depreciate against sterling in the forward market — meaning more dollars are needed to buy one pound forward. Forward rate = 1.5000 x (1.05/1.03) = 1.5000 x 1.019417 = 1.5291 (to 4dp). 1.4714 incorrectly inverts the interest rate ratio (1.5000 x 1.03/1.05), which would apply if the currencies' relative rates were reversed. 1.5750 would result from simply adding the 5% rate onto the spot rate rather than applying the correct parity ratio. 1.5000 assumes no change at all, ignoring the interest rate differential entirely.

Answer: D. Purchasing power parity predicts that a currency in a higher-inflation country will depreciate relative to a currency in a lower-inflation country, so as to preserve equivalent purchasing power. Since US inflation (4%) exceeds UK inflation (2%), the dollar is expected to weaken relative to sterling, meaning more dollars will be needed to buy one pound: expected spot rate = 1.4000 x (1.04/1.02) = 1.4000 x 1.019608 = 1.4275 (to 4dp). 1.3729 incorrectly inverts the inflation ratio (1.4000 x 1.02/1.04), which would apply if the relative inflation rates were reversed. 1.4560 would result from simply adding the 4% inflation rate directly onto the spot rate rather than applying the correct parity ratio. 1.4000 assumes no change at all, ignoring the inflation differential entirely.

Answer: A. The Fisher equation links nominal and real rates of return via expected inflation: (1 + nominal rate) = (1 + real rate) x (1 + inflation rate) = 1.03 x 1.05 = 1.0815, so the nominal rate is 8.15%. 8.00% is the simple sum of the real rate and inflation rate (3% + 5%), which ignores the compounding (cross) term between the two rates and is only an approximation, not the precise Fisher result. 1.94% would result from dividing the inflation factor by the real-return factor instead of multiplying them (1.05/1.03 - 1 = 1.94%). 5.00% simply restates the inflation rate on its own, ignoring the real rate of return entirely.

Answer: A. Sound financial risk management follows a considered, policy-driven approach: assessing the exposure, the cost of available hedging instruments, and the company's risk appetite and capacity to absorb adverse movements, rather than either blanket hedging or speculating on rate movements. Hedging is a risk management tool, not a return-generating speculation, so it should not be based on someone's view of where rates will go. Always hedging 100% regardless of cost ignores that hedging itself has a cost (premiums, spreads, administrative burden) and may not be proportionate to the size or materiality of the exposure. Never hedging, on the basis that it removes upside potential, ignores that the purpose of hedging is to reduce the volatility of outcomes and protect against adverse scenarios, not to maximise the potential for a lucky favourable outcome. Basing hedging decisions on one individual's personal forecasting confidence introduces speculation and key-person risk into what should be a governed, policy-based treasury decision.

Answer: B. Economic exposure captures the broader, longer-term impact of exchange rate movements on a company's competitive position, pricing power, and future cash flows — even where no individual contract or accounting entry is directly affected, a sustained adverse currency movement can erode market share and profitability over time, as described here. Transaction exposure is narrower, relating to identifiable, individual contracted cash flows in a foreign currency due on specific dates, which is not what is described in this long-term competitiveness scenario. Translation exposure relates purely to the accounting restatement of a foreign subsidiary's results and net assets into the parent's reporting currency, which is unrelated to a competitive/market-share effect on an exporter's own-currency sales. Credit risk concerns a counterparty's ability to pay what it owes, which has no connection to the competitive dynamics described here.

Answer: C. Netting is an internal treasury technique where intercompany balances in different currencies are offset against each other, so that only the net amount is actually settled (either bilaterally between two entities, or multilaterally across the whole group), reducing the volume and value of cross-border currency transactions, along with the associated transaction costs and exposure — all without needing any external hedging instrument or bank counterparty. A currency swap is an external, bank-counterparty derivative used to exchange cash flows between two parties over time, a fundamentally different (and external) technique from internal group netting. An interest rate collar is an interest rate risk management instrument built from options, unrelated to intercompany currency settlement. A money market hedge is a specific external hedging technique using borrowing and depositing across currencies, distinct from the purely internal netting process described.

Answer: D. Lagging involves deliberately delaying a foreign currency payment (or leading involves accelerating a receipt or payment) in anticipation of a favourable exchange rate movement. Unlike a genuine hedge, this is a speculative technique based on a view of future currency movements: if the view turns out to be wrong, the company could end up paying more in home currency terms, and delaying payment can also strain the relationship with the supplier or counterparty. A forward contract is a hedging instrument, not a speculative delay technique, and does not have a general rule that it 'always' produces a worse outcome — its purpose is to remove uncertainty, not to guarantee a particular direction of outcome. Multilateral netting is an internal group technique unrelated to leading/lagging and is not restricted only to certain use cases in the way described. A currency option does require a premium, but this describes an entirely different instrument from the delayed-payment technique in the question, so it does not correctly identify what is being described.

Answer: A. Value at Risk estimates the maximum expected loss on a portfolio over a given time horizon, at a given confidence level, under normal market conditions. Using the parametric approach: VaR = Portfolio value x Z-score x standard deviation = $10,000,000 x 1.65 x 0.015 = $247,500. This means the company can be 95% confident that its portfolio will not lose more than $247,500 in a single day under normal market conditions. $150,000 would result from omitting the Z-score entirely (simply $10,000,000 x 0.015). $16,500,000 incorrectly multiplies the portfolio value by the Z-score alone, ignoring the standard deviation. $1,650,000 would result from using a standard deviation of 0.165 (misplacing a decimal point) instead of the correct 0.015 (1.5%).