CPA Notes 114

Topics: United States dollar, Forward contract, Derivative Pages: 14 (7452 words) Published: October 19, 2014

Module 1 – Introduction to financial risk management
1. What are the major categories of risk? Please provide examples. (Topic heading: Main categories of risk controls SG 1.32)
Seven categories of risk are outlined. These are summarised in the table below: Type of risk




The risk of not being able to pay back what you owe due
to the inability to convert assets into cash quickly,
without materially moving the price.

Holding long-term property investments
that cannot be converted into cash
quickly to pay obligations as they fall


The risk of funding support not being met by investors or

An existing financier (e.g. bank)
withdraws its funding commitment as a
result of poor performance by the entity.

Interest rate

The risk of a change in interest rates impacting
borrowing costs, interest income and/or asset/debt

Central bank increases the cash rate
and your company has a floating rate
loan pegged to the cash rate.


The risk of the foreign exchange rate fluctuating,
impacting the currency conversion of revenues,
expenses, assets and/or liabilities. Includes transaction,
translation, competitive/economic and accounting

If the AUD falls, an Australian importer
of clothing from the US pays more AUD
for the same amount of clothing.


The risk of the change in price of a commodity, whether
used as an input or generated as an output.

The price of iron ore falls as a result of a
lack of confidence in general economic
conditions, reducing revenues for an
iron ore producer.


The risk of another party to a contract not meeting its
obligations (i.e. defaulting).

A debtors declares bankruptcy, resulting
in an uncollected receivable.


The risk of human or computer error/fraud impacting the
financial results of the business.

A contract note for a currency deal is not
entered into the system, causing a
settlement delay or unmonitored

2. How do I calculate the information in Table 1.8 and Table 1.9 for Case Study 1.3 – Bright Gold Corporation? (Topic heading: Step 5: Manage risks (Treasury operations) SG 1.44-1.45)
Prior to discussing the calculations in Tables 1.8 and 1.9 some background information is provided. Collars
A 'collar' provides a floor price and a cap price, thereby limiting the exposure of the organisation. To hedge the risk of a falling price, you pay a premium to guarantee a lower limit (i.e. floor). This cost can be offset by the receipt of a premium to give up the benefit of rising price movements in excess of the upper limit (i.e. cap). It is possible to structure a zero cost collar (also referred to as a nil premium collar), where the premium paid equals the premium received. However, the premiums of the cap/floor do not necessarily have to equal each other. The net outcome can be negative or positive and is dependent on the positioning of the floor and cap. Table 1.8

Note that the information in Table 1.8 is provided/assumed.
Over the three years, the total cost to guarantee a floor (at AUD 1000) equals the total premium received from giving up the benefit of price rises above the cap (at AUD 1600). That is, the gold put premiums total AUD 113 (i.e. AUD 40 + AUD 39 + AUD 34), and these are exactly offset by the gold call premiums, which total AUD 113 (i.e. AUD 15 + AUD 40 + AUD 58). This is referred to as a zero-cost, or nil premium, collar. Table 1.9

It is possible to calculate the 'movement required for margin to fall below target' (e.g. FX = 7 cents). We know that the target margin is 15%, the current FX rate is 0.8000, the production costs are AUD 800 and the selling price is USD 800. So, we need to solve for the FX rate ('y') that still achieves the 15% target margin. 15% = [(USD 800 / 'y') / AUD 800 ] - 1

1.15 = (USD 800 /...
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