Question

2. a) Explain, with examples, the terms liquidity risk and operating risk.

b) Demonstrate, using examples, how derivative securities can be used to manage market risk and exchange rate risk.

Answer 1

Liquidity risk and Operating risk

Liquidity risk can be in two ways. Asset liquidity and funding liquidity. Asset liquidity is the ability of the company to convert its assets into cash as and when needed without any loss. Funding liquidity is the ability to raise fund for sudden requirements. Thus liquidity risk is the risk of the company's inability to meet its liabilities and other obligations as and when arise. Example : Payment of interest on loans, payment to creditors.

Operating risk arises from company's business activities. It is the possible failure in the ordinary business operations. Example : Fraudulent practices by staff, lawsuits etc

Derivative securities to manage Market risk and Exchange Rate Risk

Derivative ia a financial instrument which is derived fro an underlying asset. The price of Derivative is based on the underlying assets. Market risk is the sensitivity of portfolio to price changes in the market like inflation, interest rate etc. Exchange rate risk is caused by changes in the exchange rate between two countries.

Both of these risks can be hedged by using Financial Derivatives. Few examples are as follows:

1. Forward and Future contract : The contracts are agreements between two parties to buy or sell an underlying asset for a fixed price on a specific date in future. The latter is standardised contract compared to the former. Since the price is fixed in advance, the risk due to changes in exchange rate will not arise.
2. Option contracts : These are agreements between two parties where the holder has the right (but not the obligation) to purchase or sell the asset for a fixed price on a specific period of time in future. Since the prices are fixed, the market risks can be hedged.
3. Swap contracts : It is a contract to exchange a series of cash flows in one currency with a series of cash flows in another currency. The obligations are exchanged here. This instrument also is used in hedging.