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

24 sample cards from the Financial Risk Management deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

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