Question

8. Describe a business practice that would help a company manage each of the following financial risks: (a) liquidity risk; (b) interest rate risk; c) credit risk.

Answer 1

(a) liquidity risk - Determine liquidity level that is sufficient to meet the schedule of cash outflow. This can be accomplished by a.) study the pattern of payment obligations ( amount/duration) b.) add certain cushion to address possible volatility c.) have liquid assets, i.e. investment, in place to match the liability pattern d.) study the pattern of cash inflows e.) arrange a standby facility in case of emergency such as a credit line with a banK

b) interest rate risk - Hedge interest rate risk by method known as immunization. Here, the idea is to match the duration of your liabilities to your assets. That way, if your assets change in value, your liabilities will change in value at the same rate. The easiest way to do this would be to write (sell) zero-coupon bonds with a face value matching your assets and a maturity equal to your duration

c) Credit risk - Keeping daily settlement such as Variation margin settlement and asking for AAA rated collateral from the counterparties