Week 4 Discussion II
What is a financial risk?
Financial risk is defined as the possibility of accrual of losses for an investor in a company that has debts and is unable to generate adequate cashflows to meet its financial obligations. In addition, financial risk is also understood to be the possibility of an entity or government in defaulting its bonds that would result in the loss of investments by bondholders. Investors are able to assess financial risk using ratios to evaluate inherent or associated risk of an investment. The debt-to-capital ratio is an example of a measure used to evaluate the percentage of debt acquired and the overall capital structure of an entity.
High debt usually illustrates high risk given that it translates to decline in ability to fulfill financial obligations in entirety. The capital expenditure ratio is another type of ratio used to evaluates the cashflow accruable from operations by dividing them using the capital expenditures to arrive at the amount of money that the entity has available to ensure continued operations after repayment of debts (Boughton 39).
What is a defaulting on an interest rate swap?
An interest swap is defined as an agreement by entities to their respective interest rate provisions through access to one another’s credit arrangements. Interest rate swaps are usually agreements aimed at taking advantage of low credit costs by accessing other lines of credit owned by another organization. Interest swaps are easily combined with debt issues to alter the nature of liability accruable to a borrower. Interest rate swaps have two inherent risks namely default and rate risk. Default risk is seen to be difficult to hedge. Default results in the party undertaking credit, being unable to finance the funds accrued or sourced using the interest rate swap agreement. This is also seen to be a form of credit exposure (CE), which is defined as an immediate loss accrued to a one party if the counterparty defaults on the credit derivative (Moosa 29).
What is a counterparty risk?
Counterparty risk is defined as risk assumed to both parties based on the presumption that the two sides may not fulfill their contractual obligations. It is also understood to be similar to default risk given that both parties assume a similar level of risk whereby one is counterparty to the other. Credit derivatives are the only financial instruments that have inherent counterparty risks.
How a currency swap can reduce the above risk?
Currency swaps are important financial instruments used by financial institutions, corporations, and investors. They function in a similar manner to interest rate and equity swaps. Currency swaps are complicated in nature given that they involve two parties who exchange principal with each other with an aim to access exposure to specific currencies. Based on such notional exchanges, the cashflows from time to time are traded for an appropriate currency (Arize 44).
This are considered as effective financial instruments because they enable multinational entities to utilize their relationships when expending into new markets by enhanced access to new currency. Hedging in currency swap can be undertaken by developing forward contracts. Currency swaps provide an effective means of hedging risk of a portfolio as well as against exchange rate volatility (Aronson 53).
Arize, Augustine C. Balance of Payments Adjustment: Macro Facets of International Finance Revisited. Westport, Conn: Greenwood Press, 2010. Print.
Aronson, David R. Evidence-based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals. Hoboken, N.J: John Wiley & Sons, 2007. Print.
Boughton, James M. The Monetary Approach to Exchange Rates: What Now Remains? Princeton, N.J: International Finance Section, Dept. of Economics, Princeton University, 2008. Print.
Moosa, Imad A. Structural Time Series Modelling: Applications in Economics and Finance. Hyderabad, India: ICFAI University Press, 2006. Print