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TP TMI: Financial Risk Management

TP TMI · Work through your exam, one topic at a time.

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Financial Risk Management

What the domain tests

Financial risk management tests identification, measurement, and control of market and counterparty risk: FX, interest rate, commodity, and credit exposure arising from treasury activity. Expect calculations of exposure and hedge outcomes, plus conceptual questions on hedge accounting, derivative controls, and policy limits.

Core rules and concepts

  • Exposure types. Transaction exposure comes from firm commitments and receivables; translation exposure from consolidating foreign subsidiaries; economic exposure from future competitiveness.
  • Netting and natural offsets. Aggregate exposures by currency and maturity before hedging. A natural hedge reduces the need for derivatives but must be documented.
  • Instruments. Forwards lock a rate; futures are standardized and margined; options give a right, not an obligation; swaps exchange interest or currency flows.
  • Hedge accounting. Under IFRS 9, a hedge must be designated and documented, and effectiveness assessed. A cash flow hedge recycles gains and losses from OCI; a fair value hedge affects profit or loss.
  • VaR limits. VaR states a loss threshold at a confidence level and horizon; it says nothing about losses beyond that threshold. Parametric VaR assumes distributions; historical VaR relies on past data.
  • Counterparty risk. Measure mark-to-market plus potential future exposure, set credit limits, and use ISDA documentation and collateral support annexes.

Worked example

A company has a EUR 1,000,000 receivable in 90 days. Spot is 1.1000 USD/EUR and the 90-day forward is 1.0950. Hedging with a forward locks USD 1,095,000. If spot at maturity is 1.0600, the unhedged receipt would be USD 1,060,000 and the hedge adds USD 35,000. If spot is 1.1300, the unhedged receipt would be USD 1,130,000 and the hedge costs USD 35,000. The forward removes both downside and upside; forward points reflect the interest rate differential.

Traps that cost marks

Treating a hedge as speculation; forgetting forward points; designating a hedge after the fact; ignoring basis risk; overhedging a forecast exposure; and measuring exposure gross when netting is permitted.