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P1.T1.20.4. Risk appetite and hedging (Chapter 2)

Nicole Seaman

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Learning objectives: Compare different strategies a firm can use to manage its risk exposures and explain situations in which a firm would want to use each strategy. Explain the relationship between risk appetite and a firm’s risk management decisions. Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy. Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency and interest rate risk. Assess the impact of risk management tools and instruments, including risk limits and derivatives.


20.4.1. According to GARP, "a recent trend among corporations is to use a board-approved risk appetite to guide management and (potentially) to inform investors." Which of the following statements is TRUE about the firm's risk appetite?

a. Risk appetite is the total amount of risk a firm can bear without becoming insolvent
b. In practice, the risk appetite should be focused on a single thing: one broad, durable philosophical statement that avoids linkages to the firm's day-to-day risk management operations because these are bound to change
c. Although risk appetite has an upper bound (an upper trigger), it is similar to a one-sided confidence interval: there is no such thing as a lower bound (a lower trigger) on risk appetite given that less risk is better
d. A risk appetite includes the mechanisms (e.g., detailed policy, business-specific risk statements, and a framework for risk limits) that link a top-level statement to the firm’s day-to-day risk management operations

20.4.2. Let's assume a firm's investors are exposed either to systematic or firm-specific (aka, idiosyncratic, non-systematic) risk. Do the firm's equity investors want its managers to hedge risk?

a. Always, if the firm strategy is to retain the risk
b. Never, unless hedging enables managers to meet short-term targets linked to their compensation
c. No, if the investor is diversified and financial markets are perfect and frictionless
d. Yes, if the investor is diversified and the strategy is sufficiently complex to suit the investor

20.4.3. To hedge risk, the firm's toolbox includes derivatives such as swaps, futures, forwards, and options. About the use of derivatives to hedge, each of the following is true EXCEPT which is inaccurate?

a. Derivatives represent a decision to transfer (or mitigate) the risk(s) when the firm neither wants to retain nor avoid the risk
b. Because hedging can only mute the volatility of accrual-based earnings, hedging cannot increase (or even alter) the firm's cash flows and therefore cannot influence agency risks
c. A large conglomerate (ie, a firm with multiple business units operating in different industries/sectors) is more likely to create natural hedges than a small, focused firm
d. Airlines can cross-hedge the cost of jet fuel with futures contracts on (crude or heating) oil, but if the commodity's price drops rapidly, unhedged airlines are likely to outperform their hedged competitors

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