Association of Corporate Treasurers (ACT) Qualifications Financial Risk Management Syllabus

Compare FX forwards and FX options as hedging instruments.

A forward locks in a rate with no upfront premium but obliges performance, giving certainty but no upside participation. An option gives the right but not the obligation to transact, costing an upfront premium but protecting the downside while preserving favourable upside. Forwards suit certain exposures; options suit uncertain/contingent exposures.

What is a currency option, and what distinguishes a call from a put?

A currency option gives the buyer the right, not the obligation, to exchange currencies at a set strike by/at expiry, for a premium. A call is the right to buy the underlying currency; a put is the right to sell it. Buyers have limited downside (the premium); writers have unlimited risk and receive the premium.

State Interest Rate Parity (covered) and what it determines.

Covered interest rate parity determines the forward FX rate from spot and the two interest rates: $$F = S \times \frac{1 + r_{q}}{1 + r_{b}}$$ where $r_{q}$ is the quoted (terms) currency rate and $r_{b}$ the base currency rate. The currency with the higher interest rate trades at a forward discount.

State Purchasing Power Parity (PPP) and its relevance to FX.

PPP holds that exchange rates adjust so identical goods cost the same across countries; expected FX change reflects the inflation differential: $$\frac{E(S_{1})}{S_{0}} = \frac{1 + i_{q}}{1 + i_{b}}$$ where $i$ are the two countries' inflation rates. It underpins long-run economic exposure and forecasts of real exchange-rate moves.

What does the International Fisher Effect state?

The expected change in the spot exchange rate equals the interest-rate differential between two currencies; the currency with the higher nominal interest rate is expected to depreciate by approximately that differential, because higher nominal rates reflect higher expected inflation.

How is an FX forward point / forward rate calculated relative to spot?

Forward = spot adjusted for the interest-rate differential. Approximately, forward points $\approx S \times (r_{q}-r_{b}) \times \frac{d}{B}$ where $d$ is days and $B$ the day-count basis. A higher-yielding quoted currency trades at a forward discount (premium points), reflecting covered interest parity, not a forecast of spot.

What is a natural hedge for FX risk? Give examples.

A natural hedge offsets currency exposure through the firm's own operations rather than financial instruments — e.g. matching foreign-currency revenues with costs/borrowing in the same currency, invoicing in the home currency, or sourcing inputs in the sales currency. It reduces net exposure cheaply and is usually exhausted before using derivatives.

What is the difference between a static hedging policy and a layered/rolling hedging programme?

A static hedge fixes a single hedge for an exposure once. A layered (rolling/ratio) programme hedges a declining percentage of exposures further out (e.g. 100% of 0–3 months, 75% 3–6 months, falling over time), smoothing the average hedged rate, reducing timing risk and avoiding hedging at a single point in the cycle.

What are the main sources of interest rate risk for a corporate treasury?

Repricing/cash-flow risk on floating-rate debt and investments; fair-value risk on fixed-rate instruments; basis risk between different reference rates; yield-curve (non-parallel shift) risk; and optionality risk (prepayment, caps/floors). The core exposure is to changes in funding cost and the value of interest-bearing assets/liabilities.

Distinguish cash-flow interest rate risk from fair-value interest rate risk.

Cash-flow risk: future interest cash flows on floating-rate instruments change as rates move (the cash flow varies, the value stays near par). Fair-value risk: the market value of fixed-rate instruments changes inversely with rates (cash flow is fixed, the value varies). Hedging one often creates the other.

What is the gap (repricing) analysis approach to measuring interest rate risk?

Gap analysis buckets rate-sensitive assets and liabilities by repricing date; the repricing gap in each bucket (RSA − RSL) shows net exposure. A positive gap benefits from rising rates; a negative gap from falling rates. It is simple but static and ignores the size/timing of rate moves within buckets.

Define duration and modified duration.

Macaulay duration is the weighted-average time to receive a bond's cash flows (in years). Modified duration measures price sensitivity to yield: $$\text{ModDur} = \frac{\text{Macaulay Duration}}{1 + y/n}$$ and the price change is approximately $\Delta P \approx -\text{ModDur} \times P \times \Delta y$.

What is PV01 / DV01 (the basis point value)?

PV01 (DV01) is the change in the present value/price of an instrument or portfolio for a one-basis-point ($0.01\%$) move in interest rates: $$\text{PV01} \approx \text{ModDur} \times P \times 0.0001.$$ Treasurers use it to size hedges so the hedge's PV01 offsets the exposure's PV01.

What is an interest rate swap and how does it transform exposure?

An interest rate swap exchanges streams of interest on a notional principal — typically fixed-for-floating. A borrower with floating-rate debt can pay fixed/receive floating to lock its cost; one with fixed debt can pay floating/receive fixed to benefit from falling rates. No principal is exchanged; only net interest is settled.

What is a forward rate agreement (FRA)?

An FRA is an OTC contract fixing an interest rate on a notional deposit/loan for a future period. At settlement, the difference between the agreed rate and the reference rate is exchanged (discounted), hedging a single future interest period. It is cash-settled and does not involve actual lending.

Compare interest rate caps, floors and collars.

A cap is a series of options paying out when the reference rate exceeds the strike, limiting a borrower's maximum rate (premium paid). A floor sets a minimum rate, protecting a lender/investor. A collar combines buying a cap and selling a floor (or vice versa), reducing or zeroing the net premium but capping both downside and upside.

What is basis risk in interest rate hedging?

Basis risk is the risk that the rate on the hedge and the rate on the exposure do not move perfectly together — e.g. hedging a loan priced off one benchmark with an instrument referencing another, or a tenor/timing mismatch. It leaves residual risk even when a hedge is in place.

Why were IBORs (e.g. LIBOR) reformed, and what replaced them?

LIBOR was based on banks' estimated borrowing costs in a thin market, making it vulnerable to manipulation and unrepresentative. It has been replaced by transaction-based, near risk-free overnight rates (RFRs): SONIA (GBP), SOFR (USD), €STR (EUR), SARON (CHF) and TONA (JPY).

How do the new risk-free rates (RFRs) differ structurally from LIBOR?

RFRs are overnight, near risk-free, backward-looking rates with no credit/term premium, whereas LIBOR was a forward-looking term rate including bank credit risk. Term interest is therefore computed by compounding the RFR in arrears over the period, and a credit-adjustment spread is added when transitioning legacy contracts.

What is a credit adjustment spread (CAS) in benchmark reform?

A fixed spread added to an RFR to account for the fact that LIBOR included bank credit and term premium that the RFR does not. For fallbacks it was set using the historical median basis (typically a 5-year median) between LIBOR and the compounded RFR, so that transitioning contracts are economically broadly neutral.

What factors should an interest rate risk policy specify?

The target fixed/floating debt ratio (and tolerance band), hedging horizon, approved instruments, benchmark indices, authority/limits, treatment of basis and refinancing risk, and accounting (hedge accounting) objectives. It links hedging to the firm's risk appetite and the interest-rate sensitivity of its business.

What is the strategic argument for a target fixed-to-floating debt mix?

Fixed-rate debt gives cash-flow certainty but loses value/benefit if rates fall; floating debt tracks the market and can match revenues that move with rates/inflation, but exposes the firm to rising-rate cash-flow risk. The optimal mix matches the interest-rate sensitivity of the firm's cash flows and its risk appetite, balancing certainty against cost.

What characterises commodity price risk and how is it commonly hedged?

Commodity price risk is exposure to volatile prices of inputs/outputs (energy, metals, agriculture). It is hedged with commodity futures, forwards, swaps and options, or naturally via supply contracts and pricing. Key complications are basis risk (grade/location/timing differences) and that producers and consumers face opposite directional exposures.

What is basis risk in commodity hedging specifically?

The risk that the hedging instrument (often a standardised exchange-traded future) does not perfectly track the actual commodity exposure due to differences in grade/quality, delivery location, or timing/tenor. The 'basis' is the difference between the spot price of the physical commodity and the futures price used to hedge.

Define counterparty credit risk and the related settlement risk.

Counterparty credit risk is the risk that a derivative or trading counterparty defaults before fulfilling its obligations, causing replacement-cost loss. Settlement (Herstatt) risk is the specific risk that one party delivers (e.g. one leg of an FX trade) but the other fails before delivering its side, typically across time zones.

How is counterparty credit exposure on derivatives measured (current and potential)?

Current exposure = the present mark-to-market value if positive (replacement cost). Potential future exposure (PFE) estimates how large the exposure could become over the life of the trade given market moves. Total credit exposure combines current exposure plus an add-on for PFE; netting and collateral reduce it.

How do netting and collateral (CSA) reduce counterparty credit risk?

Close-out netting under an ISDA Master Agreement nets all positive and negative mark-to-market positions with a counterparty into a single net amount on default. A Credit Support Annex (CSA) requires posting collateral (margin) against net exposure, reducing the uncollateralised amount and hence the loss given default.

What tools manage customer (trade receivables) and supplier credit risk?

For customers: credit assessment/scoring and limits, trade credit insurance, letters of credit, factoring/invoice discounting, retention of title, and tighter terms. For suppliers: assessing supplier financial health, dual sourcing, prepayment protection, and supply-chain finance. The aim is to limit loss from non-payment or supplier failure disrupting supply.

What are the components of expected credit loss?

$$EL = PD \times LGD \times EAD$$ where PD is the probability of default, LGD is loss given default (1 − recovery rate), and EAD is the exposure at default. Expected loss is provisioned/priced; unexpected loss (volatility around it) is covered by capital/buffers.

What is country and political risk, and how can it be mitigated?

Country/political risk is the risk that sovereign actions or instability — expropriation, capital/exchange controls, currency inconvertibility, sanctions, war, or sovereign default — cause loss or block cash flows. Mitigants include political risk insurance (e.g. ECAs/MIGA), local-currency financing, structuring through stable jurisdictions, diversification, and limiting exposure to high-risk countries.

Distinguish transfer risk from sovereign (default) risk.

Sovereign risk is the risk that a government defaults on its own obligations. Transfer (convertibility) risk is the risk that a government imposes exchange controls preventing local entities from converting local currency or transferring funds abroad to service obligations — even if the entity itself is solvent and willing to pay.

How is a forward derivative priced relative to spot in general terms?

By no-arbitrage cost-of-carry: the forward equals the spot price grossed up by the financing cost and adjusted for any income/yield from holding the asset. For a financial asset, $$F = S \times e^{(r-q)T}$$ (or $F = S(1+r)^{T}$ discretely), where $r$ is the funding rate and $q$ the yield/convenience income.

What are the components of an option's premium?

Premium = intrinsic value + time value. Intrinsic value is the in-the-money amount (zero if out-of-the-money). Time value reflects the chance the option moves further into the money before expiry, driven by volatility, time to expiry and interest rates. Key sensitivities are the 'Greeks': delta, gamma, vega, theta, rho.

Briefly define the option Greeks delta, gamma, vega and theta.

Delta: rate of change of option value with the underlying price. Gamma: rate of change of delta (curvature). Vega: sensitivity to implied volatility. Theta: sensitivity to the passage of time (time decay). They quantify how an option's value responds to each market variable for hedging.

What three hedge relationships are permitted under IFRS 9?

1) Fair value hedge — hedging exposure to changes in fair value of a recognised asset/liability or firm commitment; 2) Cash flow hedge — hedging variability in future cash flows (e.g. forecast transactions, floating-rate debt); 3) Net investment hedge — hedging FX exposure of a net investment in a foreign operation.

Under IFRS 9, how is the accounting different for a fair value hedge versus a cash flow hedge?

Fair value hedge: both the hedging instrument and the hedged item's gain/loss (on the hedged risk) go through profit or loss, largely offsetting. Cash flow hedge: the effective portion of the hedging instrument's gain/loss is deferred in other comprehensive income (a cash flow hedge reserve) and recycled to P&L when the hedged item affects earnings; ineffectiveness goes straight to P&L.

What are the IFRS 9 qualifying criteria for hedge accounting?

There must be (1) an eligible hedging instrument and hedged item, (2) formal designation and documentation at inception of the relationship, risk objective and strategy, and (3) the hedge must meet effectiveness requirements: an economic relationship between item and instrument, credit risk not dominating value changes, and an appropriate hedge ratio consistent with risk management.

How did IFRS 9 change hedge effectiveness testing compared with IAS 39?

IFRS 9 removed the strict retrospective 80–125% 'bright-line' quantitative test. It requires a qualitative/forward-looking demonstration of an economic relationship, that credit risk does not dominate, and an appropriate hedge ratio. This better aligns hedge accounting with actual risk management activities, though ineffectiveness is still measured and recognised.

What is a net investment hedge and what does it offset?

A net investment hedge under IFRS 9 hedges the FX translation exposure on a net investment in a foreign operation. Gains/losses on the hedging instrument (e.g. foreign-currency borrowing or forwards) for the effective portion are recognised in OCI alongside the foreign-currency translation reserve, and recycled to P&L on disposal of the foreign operation.

What are the main post-crisis OTC derivatives regulations (EMIR / Dodd-Frank)?

Following the G20 Pittsburgh reforms, standardised OTC derivatives must be (1) centrally cleared through CCPs, (2) reported to trade repositories, (3) subject to margin requirements for non-cleared trades, and where applicable (4) traded on regulated platforms. In the EU this is EMIR; in the US, Dodd-Frank Title VII.

What is central clearing and what protections does a CCP provide?

Central clearing interposes a central counterparty (CCP) between the two trade parties via novation, so the CCP becomes buyer to every seller and seller to every buyer. It mutualises and manages counterparty risk through initial and variation margin, a default fund, multilateral netting and a default waterfall, reducing systemic contagion.

Distinguish initial margin from variation margin.

Initial margin is collateral posted up front to cover potential future exposure (worst-case move over the close-out period) and is held to protect against a counterparty default. Variation margin is exchanged regularly (often daily) to settle the current mark-to-market change in value, so the net position is kept close to zero.

What is the clearing obligation/threshold concept for non-financial corporates under EMIR?

Non-financial counterparties (NFCs) must clear standardised OTC derivatives only if their gross notional in speculative positions exceeds the clearing thresholds (NFC+). Derivatives objectively reducing commercial/treasury risks (hedging) are excluded from the threshold calculation, so genuine corporate hedgers often avoid mandatory clearing but still face reporting and risk-mitigation rules.

What does mark-to-market (MTM) mean and why is it important in treasury?

Mark-to-market is valuing a position at its current fair (market) value rather than cost. It is essential for measuring current credit exposure, collateral/margin calls, hedge effectiveness, and reporting gains/losses. A positive MTM on a derivative represents an asset and a credit exposure to the counterparty.

What is a Credit Valuation Adjustment (CVA)?

CVA is the adjustment to the risk-free fair value of a derivative to reflect the expected loss from the counterparty's possible default — effectively the market value of counterparty credit risk. Conceptually $$\text{CVA} \approx \sum_{t} \text{EE}_{t}\times \text{PD}_{t}\times \text{LGD}$$, the discounted expected exposure times default probability times loss given default.

Distinguish CVA, DVA and FVA.

CVA (Credit Valuation Adjustment): reduces value for the counterparty's default risk. DVA (Debit Valuation Adjustment): the mirror — adjusts for the firm's own default risk (a benefit). FVA (Funding Valuation Adjustment): the cost/benefit of funding the uncollateralised portion of a derivative. Together they form part of the 'XVA' suite of valuation adjustments.

How does collateralisation (a CSA) affect CVA?

A two-way CSA with frequent variation-margin exchange keeps net exposure close to zero, sharply reducing expected exposure and therefore CVA. Residual CVA remains from gap risk over the margin period of risk (the time between the last margin call and close-out) and from any uncollateralised thresholds or minimum transfer amounts.