Risk Management, Derivatives and Treasury
What the domain tests
This domain tests identification and hedging of currency, interest-rate, commodity and liquidity risk using forwards, futures, options, swaps and FRAs, plus treasury controls. Expect hedging outcomes and whether to hedge.
Core rules and concepts
- Transaction exposure affects known foreign-currency cash flows; translation exposure affects reported statements; economic exposure affects long-run competitiveness.
- A forward contract locks an exchange rate; futures are standardised, exchange-traded and require margin; options give a right, not an obligation, for a premium; swaps exchange interest or currency flows; FRAs fix a future interest rate.
- Hedging reduces uncertainty but has an opportunity cost. A forward can be worse than the spot outcome if rates move favourably; an option preserves upside but costs premium.
- Treasury policy should prohibit speculation, set limits, segregate dealing and settlement, monitor counterparties and mark positions to market.
- An interest-rate cap sets a maximum rate; a floor sets a minimum; a collar combines both.
Worked example
A Nigerian importer must pay $1m in three months. Spot is N1,500/$; the three-month forward is N1,550/$. A forward purchase locks the naira cost at N1.55bn. If the spot rate in three months is N1,600/$, the forward saves N50m; if it is N1,480/$, the forward costs N70m more than spot. The hedge removes uncertainty, not the possibility of a better unhedged outcome.
Traps that cost marks
Do not confuse transaction and translation exposure; treat hedging as guaranteed profit; ignore option premium, margin calls, basis risk and counterparty risk; or use derivatives to speculate without authority.