Chapter Six: Financial Risk Management

This set of vocabulary flashcards covers financial risk management concepts, various types of market and financial risks, theories of exchange and interest rate determination, and types of foreign exchange exposure.

Financial Risk Management

The process of identifying risks, analyzing them and making investment decisions based on either accepting or mitigating the risk.

Financial Risk

A quantitative or qualitative risk arising through countless financial transactions such as sales, purchases, investments, loans, and other business activities.

Market Risk

Risk of investments declining in the value of economic developments or other events that affect the entire market.

Equity Risk

The risk of loss due to a drop in the market price of shares.

Interest Rate Risk

The risk of losing money or capital losses due to changes in the prevailing bank interest rate, often resulting in a decline in bond values (also known as Price Risk).

Foreign Exchange Risk

The risk applied to foreign investments between currency or from one country to another country.

Liquidity Risk

Risk occurring when investors are unable to sell an investment at a fair price, such as houses or land.

Credit Risk

Risk occurring when a borrower is unable to pay the interest or the principal loan on the maturity date.

Reinvestment Risk

The loss from reinvesting principal or income at a lower interest rate, resulting in a lower return than before.

Inflation Risk

The loss of purchasing power because the value of investments does not keep up with inflation.

Foreign Investment Risk

The risk of loss associated with buying shares in emerging markets across various countries.

Counter or Sovereign Risk

The risk that repayments by foreign borrowers may be interrupted because of interference from foreign government entities.

Insolvency Risk

The risk faced by financial institutions for not having enough capital to offset the decline in the value of its assets relative to its liabilities.

Foreign Exchange (FOREX) Rate

The exchange rate of a particular currency with another, which fluctuates depending on the demand and supply of the currencies.

Purchasing Power Parity

A theory propounded by Professor Gustav Cassel stating that the rate of exchange between two countries equates their relative purchasing powers.

Balance of Payment Approach

A model postulating that a foreign exchange rate in equilibrium will remain so if it maintains a stable account balance; trade deficits cause devaluation while surpluses cause strengthening.

Monetary Approach

A theory proposing that FOREX rates are determined by the demand and supply of money; increased money supply relative to partners causes currency depreciation.

Asset Approach

A theory suggesting that exchange rates today are determined largely by expectations of the future performance of that currency.

Expectation Theory

A theory suggesting that forward interest rates are representative of expected future interest rates.

Liquidity Theory

A recommendation that investors choose long-term maturities only if provided with additional yield to compensate for the lack of liquidity.

Preferred Habitat Hypothesis

A proposal that investors prefer specific maturity horizons due to appropriate premiums depending on the policies of market participants.

Market Segmentation Theory

Advice that different investors prefer different investment horizons due to the nature of their business, preventing maturity date changes to exploit temporary opportunities.

Transaction Exposure

A type of FOREX risk arising from organizational transactions such as purchases, contractual payments (royalties/licenses), or sales to customers in other countries.

Translation Exposure

Fluctuations in assets, liabilities, or profits when they are translated from an operating currency into a reporting currency.

Economic Exposure

Risk due to changes in macroeconomic conditions like exchange rates, government regulation, or political stability that affect investments in a foreign country.