FM: Risk management
13 free practice questions on risk management, Section G of the ACCA Financial Management (FM) question bank. Topics include Interest rate parity, Money market hedge, Types of currency risk, Interest rate risk, Purchasing power parity, Internal hedging of currency risk. Each question carries its syllabus reference and a worked explanation. Practise them in the quiz with instant feedback, or read every question with its answer further down this page.
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All 13 risk management questions
The same questions the quiz above draws on, in syllabus order, each with its answer and worked explanation. 11 are multiple choice and 2 are numerical, where you work the answer out before choosing it.
A UK company has sold goods to a US customer, with payment of $500,000 due in three months. The risk that the sterling value of this receipt will fall before payment is an example of:
- Translation risk
- Transaction risk
- Economic risk
- Interest rate risk
Show answer and explanation
Answer: B. Transaction risk is the risk that the home-currency value of a specific, committed foreign-currency cash flow — here a $500,000 receipt — changes between the transaction date and the settlement date because of exchange rate movements. Translation risk (option A) arises on consolidating the financial statements of foreign subsidiaries, economic risk (option C) is the longer-term effect of exchange rates on competitiveness, and option D concerns interest rates rather than currency.
A company has a large floating-rate (variable-rate) loan. What is the main risk it faces?
- That its share price will fall sharply on the stock market
- That inflation will reduce its sales
- That a rise in market interest rates will increase its interest payments
- That its customers will pay late
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Answer: C. With floating-rate debt, the interest charge moves with market rates, so the principal risk is that a rise in interest rates increases the company's interest payments, reducing its profits and cash flow. This interest rate risk can be managed using forward rate agreements, interest rate futures, options or swaps. Options A, B and D describe other risks that are not the direct consequence of holding floating-rate debt.
The spot exchange rate is $1.2000/£1. Annual inflation is expected to be 5% in the US and 2% in the UK. Using purchasing power parity, what is the expected spot rate in one year?
- $1.1657/£1
- $1.2000/£1
- $1.2300/£1
- $1.2353/£1
Show answer and explanation
Answer: D. Purchasing power parity gives the expected future spot rate as spot × (1 + foreign inflation) ÷ (1 + home inflation), with the dollar as the foreign currency: $1.2000 × (1.05 ÷ 1.02) = $1.2000 × 1.02941 = $1.2353/£1. The higher US inflation causes the dollar to weaken, so the pound buys more dollars. Option A applies the ratio the wrong way round, option B ignores inflation, and option C simply adds the 3% inflation differential instead of using the proper ratio.
The spot exchange rate is $1.2500/£1. The annual interest rate is 4% in the US and 1% in the UK. Using interest rate parity, what is the one-year forward rate?
- $1.2871/£1
- $1.2500/£1
- $1.2134/£1
- $1.2875/£1
Show answer and explanation
Answer: A. Interest rate parity gives the forward rate as spot × (1 + foreign interest rate) ÷ (1 + home interest rate), with the dollar as the foreign currency: $1.2500 × (1.04 ÷ 1.01) = $1.2500 × 1.029703 = $1.2871/£1. The currency with the higher interest rate (the dollar) trades at a forward discount. Option B ignores the interest differential, option C applies the ratio inversely, and option D simply adds 3%. Forward rates are set by interest rate parity, not by purchasing power parity.
According to interest rate parity, a currency with a relatively high interest rate will tend to:
- Trade at a forward premium against a lower-interest currency
- Trade at a forward discount against a lower-interest currency
- Have a forward rate exactly equal to its spot rate
- Be unaffected in the forward market
Show answer and explanation
Answer: B. Interest rate parity means any interest rate advantage is offset in the forward market: the currency with the higher interest rate trades at a forward discount (it is expected to weaken), so an investor cannot earn a risk-free gain by borrowing in the low-rate currency and investing in the high-rate one. Option A reverses this relationship, and options C and D contradict the way forward rates are set by the interest differential.
Which of the following is an internal method of managing foreign currency risk?
- Matching foreign currency receipts against foreign currency payments in the same currency
- Buying a currency option from a bank
- Entering into a forward exchange contract
- Using a currency futures contract bought from an exchange
Show answer and explanation
Answer: A. Internal hedging techniques manage currency risk without external instruments. They include matching (offsetting foreign receipts against payments in the same currency), netting between group companies, leading and lagging the timing of payments, and choosing the currency of invoicing. Options B, C and D are all external hedging methods involving a bank or an exchange. Internal methods are generally cheaper because they avoid transaction costs and premiums.
What does a forward exchange contract allow a company to do?
- Choose whether or not to exercise the contract at maturity, like an option
- Fix today the exchange rate at which a currency amount will be bought or sold on a future date
- Borrow foreign currency at a guaranteed interest rate
- Avoid having to settle the contract at all if rates move unfavourably
Show answer and explanation
Answer: B. A forward exchange contract is a binding agreement to buy or sell a set amount of currency at a fixed rate on a specified future date, removing uncertainty about the exchange rate. Unlike an option (option A), it must be honoured — the company cannot walk away if the rate moves in its favour. It concerns exchange rates rather than borrowing (option C), and it is a firm commitment that must be settled (option D). It is one of the most common and straightforward hedging tools.
A UK company must pay a US supplier $1,000,000 in three months. How would it set up a money market hedge?
- Borrow dollars now and hold them for three months
- Do nothing and pay at the future spot rate
- Buy a currency option to sell sterling for dollars at a guaranteed rate
- Deposit dollars now — buying them at today's spot rate, funded by sterling — so the deposit grows with interest to $1,000,000 in three months
Show answer and explanation
Answer: D. For a future foreign-currency payment, a money market hedge involves holding the foreign currency now so it grows, with interest, to the amount needed at the payment date. The company finds the present value of the $1,000,000 at the US deposit rate, buys those dollars now at the spot rate (funding the purchase with sterling, borrowed if necessary) and deposits them. Option A creates rather than hedges a dollar liability, option B leaves the exposure open, and option C is a different, option-based hedge.
A UK company expects to receive $1,000,000 from a customer in three months. Using a money market hedge, the company would:
- Borrow dollars now (the present value of the receipt), convert them to sterling at the spot rate and place the sterling on deposit
- Deposit dollars now and wait for the receipt to arrive
- Buy dollars forward today for delivery in three months at a fixed rate
- Do nothing, because the receipt is in a major currency
Show answer and explanation
Answer: A. For a future foreign-currency receipt, the money market hedge fixes the value by borrowing the foreign currency now. The company borrows the present value of the $1,000,000 (so the loan plus interest equals the receipt), converts it to sterling immediately at the spot rate, and deposits the sterling. When the customer pays, the receipt repays the dollar loan, so the sterling value is locked in today. Option B suits a payment, option C is a forward hedge, and option D leaves the exposure unmanaged.
Which statement about currency options is correct?
- They oblige the holder to exercise the contract regardless of the exchange rate
- They are exactly the same thing as forward contracts in every respect
- They give the holder the right, but not the obligation, to exchange currency at a set rate, in return for a premium
- They can never be used to hedge currency risk
Show answer and explanation
Answer: C. A currency option gives the holder the right, but not the obligation, to buy or sell currency at a set exercise rate on or before a future date, in exchange for an up-front premium. This lets the holder benefit from favourable movements while being protected against adverse ones — its key advantage over a binding forward contract. Option A describes a forward, option B wrongly equates the two, and option D is false. (The FM syllabus requires no numerical currency option calculations.)
What is a forward rate agreement (FRA) used for?
- To fix an exchange rate for a future currency transaction
- To fix the interest rate on a notional loan or deposit for a future period, hedging interest rate risk
- To convert debt finance into equity finance
- To guarantee the level of a company's future share price
Show answer and explanation
Answer: B. A forward rate agreement fixes the interest rate on a notional principal for a specified future period. If the actual market rate differs, a compensating payment passes between the parties, so the company effectively locks in its borrowing or deposit rate and hedges interest rate risk. Option A describes a currency forward, while options C and D describe entirely different arrangements. An FRA is settled by difference and does not involve an actual loan being advanced.
An interest rate swap typically allows a company to:
- Exchange one currency for another at a fixed rate
- Convert the company's existing equity capital into debt finance
- Guarantee that interest rates will never rise
- Exchange a stream of floating-rate interest payments for fixed-rate payments (or vice versa) with a counterparty
Show answer and explanation
Answer: D. An interest rate swap is an agreement between two parties to exchange interest payment streams on a notional principal — most commonly swapping floating-rate obligations for fixed-rate ones (or vice versa) — allowing each party to obtain the interest profile it prefers or to hedge interest rate risk. Option A describes a currency swap, option B is unrelated, and option C overstates the effect, since a swap fixes rather than caps rates. (The syllabus requires no numerical swap calculations.)
Which statement about interest rate options is correct?
- They oblige the buyer to borrow at the agreed rate whatever happens
- They are available only to banks and other large financial institutions
- They give the holder the right, but not the obligation, to deal at a set interest rate, protecting against adverse moves while allowing benefit from favourable ones
- They remove the need to pay any interest at all
Show answer and explanation
Answer: C. An interest rate option, such as a cap, gives the holder the right, but not the obligation, to borrow or lend at a set interest rate, in return for a premium. This protects against adverse interest rate movements while still allowing the holder to benefit if rates move favourably — the same asymmetry as a currency option. Option A describes a binding instrument such as a future or an FRA, option B is untrue, and option D is nonsensical. (The FM syllabus requires no numerical interest rate option calculations.)
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