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# Risk is an inherent part of business, and managing its potential conse

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Senior Manager
Joined: 28 Jul 2016
Posts: 250
Location: India
Concentration: Finance, Human Resources
GPA: 3.97
Risk is an inherent part of business, and managing its potential conse  [#permalink]

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30 Sep 2018, 10:31
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Question 1
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based on 211 sessions

74% (03:33) correct 26% (03:44) wrong

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Question 2
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based on 235 sessions

58% (01:11) correct 42% (01:26) wrong

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Risk is an inherent part of business, and managing its potential consequences means anticipating those events that could generate adverse and costly outcomes for an organization, while taking actions to advert and/or diminish the effects of such events. Futures contracts, forward contracts, swaps, inverse floaters and options are a group of financial instruments called derivatives that are available to hedge against financial risk. These securities are an agreement to buy or sell an asset whose value is set by the market price or interest rate of some other security. Derivatives are useful in corporate risk management, yet because they are complex, highly leveraged and complicated they can lead to significant losses if not properly exercised.

Inappropriate uses of derivatives have led to highly publicized failures. For instance, Britain’s Barings Bank, which financed America’s 1803 Louisiana Purchase, collapsed in 1995 when one of its derivatives traders lost \$1.4 billion. For nearly 20 years, California’s Orange County successfully managed an investment fund that generated outstanding returns as long as interest rates declined; but when interest rates increased, the purchase of very risky derivative products resulted in the fund losing about \$2 billion. Still when properly implemented, such as hedging rather than speculating to increase profits, derivatives have significant benefits, which is why a high percentage of American companies use derivatives regularly.

A particular derivative known as futures is useful for managing and reducing a variety of risks related to interest rate, stock price and exchange rate fluctuations. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines. The futures markets allow a firm to be protected against changes that occur between when a decision is made and when a transaction is completed. A firm’s risk aversion and its ability to assume the risk in consideration influence its decision to hedge, and the futures markets allow a firm flexibility in the timing of its financial transactions.

Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

According to information contained in the passage, which of following is accurately supported?

a. Derivatives are too complex to be soundly used.
b. Derivatives are one of the best financial tools available for managing the risks associated with interest rate, stock price and exchange rate variability.
c. Derivatives are beneficial to circumvent potential risks a company may face.
d. A firm needs to have flexibility in the timing of its financial transactions.
e. In spite of their pitfalls, derivatives are necessary to help a company speculate against risks

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Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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30 Sep 2018, 18:44

+1 kudos to the posts containing answer explanations of all questions

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Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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30 Sep 2018, 22:30
1
Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

IMO B. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines.
Manager
Joined: 21 Jul 2012
Posts: 90
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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30 Sep 2018, 22:32
According to information contained in the passage, which of following is accurately supported?

a. Derivatives are too complex to be soundly used.
b. Derivatives are one of the best financial tools available for managing the risks associated with interest rate, stock price and exchange rate variability.
c. Derivatives are beneficial to circumvent potential risks a company may face.
d. A firm needs to have flexibility in the timing of its financial transactions.
e. In spite of their pitfalls, derivatives are necessary to help a company speculate against risks

IMO C.Derivatives are useful in corporate risk management, yet because they are complex, highly leveraged and complicated they can lead to significant losses if not properly exercised.
Para 2, Line 8 "Still when properly implemented, such as hedging rather than speculating to increase profits, derivatives have significant benefits".
The above 2 lines elaborates the answer.
Manager
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GMAT 1: 660 Q49 V31
GPA: 2.84
WE: Other (Energy and Utilities)
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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01 Oct 2018, 01:10
prashant6923 wrote:
Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

IMO B. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines.

Hey,

How come C is not the option?

No matter what logic i apply i end up with C as the answer?

what am i missing?

Would really appreciate an explanation!
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Senior Manager
Joined: 28 Jul 2016
Posts: 250
Location: India
Concentration: Finance, Human Resources
GPA: 3.97
Risk is an inherent part of business, and managing its potential conse  [#permalink]

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01 Oct 2018, 04:32
2
Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

Question 1

The answer comes from the third paragraph. The second sentence of the paragraph says that long hedges are useful to guard against price increase, and that short hedges are useful to guard against price declines. Since the questions claims that the currency rate of its trading partners is expected to increase and that raw materials from its supplier is expected to decrease, then it would be prudent to purchase a long hedge to protect itself against potential interest rate increases and to sell a short hedge to protect itself against the potential increases in the cost of raw materials.
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Senior Manager
Joined: 28 Jul 2016
Posts: 250
Location: India
Concentration: Finance, Human Resources
GPA: 3.97
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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01 Oct 2018, 04:35
honneeey wrote:
prashant6923 wrote:
Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

IMO B. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines.

Hey,

How come C is not the option?

No matter what logic i apply i end up with C as the answer?

what am i missing?

Would really appreciate an explanation!

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Manager
Joined: 01 Apr 2018
Posts: 125
Location: India
GMAT 1: 650 Q49 V30
GPA: 3.9
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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01 Oct 2018, 04:52
1
A particular derivative known as futures is useful for managing and reducing a variety of risks related to interest rate, stock price and exchange rate fluctuations. Long hedges are futures contracts that are bought to guard against price increases, while short hedges are futures contracts that are sold to guard against price declines. The futures markets allow a firm to be protected against changes that occur between when a decision is made and when a transaction is completed. A firm’s risk aversion and its ability to assume the risk in consideration influence its decision to hedge, and the futures markets allow a firm flexibility in the timing of its financial transactions.

1. Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

Clearly the answer is B as per the highlighted part in the text
The company could enter into a long hedge with its foreign trading partner (price will increase due to high exchange rate) and a short hedge with its supplier. (price will decrease due to decline in raw material cost).

2. According to information contained in the passage, which of following is accurately supported?

a. Derivatives are too complex to be soundly used. --Incorrect, complexity of derivatives is mentioned but its usage is hampered by complexity is not supported.
b. Derivatives are one of the best financial tools available for managing the risks associated with interest rate, stock price and exchange rate variability. --Incorrect, an extreme choice, the passage never says that derivatives are the best.
c. Derivatives are beneficial to circumvent potential risks a company may face. --Correct, by POE and is supported by the passage. 'Risk is an inherent part of business, and managing its potential ... Derivatives are useful in corporate risk management...'
d. A firm needs to have flexibility in the timing of its financial transactions. --Incorrect, not supported. 'the futures markets allow a firm flexibility in the timing of its financial transactions.'
e. In spite of their pitfalls, derivatives are necessary to help a company speculate against risks --Incorrect, not supported.
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Senior Manager
Joined: 28 Jul 2016
Posts: 250
Location: India
Concentration: Finance, Human Resources
GPA: 3.97
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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01 Oct 2018, 19:57
For question 2

Answer choice (A) is a distortion. While derivatives are complex, the passage does not say that they cannot be soundly used. Answer choice (B) is outside the scope of the passage. The passage says nothing about derivatives being the best financial tool to do so. Answer choice (D) is never discussed. The final paragraph claims the futures markets allow a firm flexibility in the timing of its financial transactions, not that a firm needs such flexibility. Answer choice (E) is incorrect because no where does the passage state that derivatives are necessary to help a company speculate against risks. It does state that derivatives can help a firm hedge against risks.
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Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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02 Dec 2018, 00:30
globaldesi wrote:
Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

Question 1

The answer comes from the third paragraph. The second sentence of the paragraph says that long hedges are useful to guard against price increase, and that short hedges are useful to guard against price declines. Since the questions claims that the currency rate of its trading partners is expected to increase and that raw materials from its supplier is expected to decrease, then it would be prudent to purchase a long hedge to protect itself against potential interest rate increases and to sell a short hedge to protect itself against the potential increases in the cost of raw materials.

The cost of raw material would decline and not the raw material itself (So how does a short hedge help?)
Can you explain choice B elaborately?
Intern
Joined: 21 Oct 2018
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GMAT 1: 690 Q49 V34
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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21 Dec 2018, 05:52
if the cost of supply decrease, that's great. the company can purchase it with lower cost.
what the company worry about would be the sudden increase of supply price, hence I think the company should apply long hedges(which can help against future price increase)
but I see a majority of people chose B
could you help me understand why B should be the answer?
VP
Joined: 09 Mar 2018
Posts: 1003
Location: India
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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09 Feb 2019, 23:08
1/2 correct, time taken 4 mins

What a passage

Company A records its revenue streams in the currency of the country with which it is doing trade. Believing that the cost of raw materials from one of its domestic suppliers will decline and the currency rate of one of its foreign trading partners will increase, which of the following scenarios is ideal based on information contained within the passage?

a. The company could enter into a long hedge with both its supplier and its foreign trade partner.
b. The company could enter into a long hedge with its foreign trading partner and a short hedge with its supplier.
c. The company could enter into a long hedge with its supplier and a short hedge with its foreign trading partner.
d. The company could sell futures contracts to both its supplier and its foreign trading partner.
e. The company could buy futures contract from both its supplier and its foreign trading partner.

From these lines we can mark the correct answer(Last para)
Long hedges are futures contracts that are bought to guard against price increases( currency rate of one of its foreign trading partners will increase), while short hedges are futures contracts that are sold to guard against price declines.(cost of raw materials from one of its domestic suppliers will decline)

We can say that B is the answer. (since each company wants to save itself from risks)

Q2
According to information contained in the passage, which of following is accurately supported?

a. Derivatives are too complex to be soundly used.
It doesn't say this anywhere, it does they are complex here
From passage
yet because they are complex, highly leveraged and complicated they can lead to significant losses if not properly exercised.

b. Derivatives are one of the best financial tools available for managing the risks associated with interest rate, stock price and exchange rate variability.
There are can be other tools as well.

c. Derivatives are beneficial to circumvent potential risks a company may face.
This actually sums up the whole intent of the passage.
circumvent = avoid.

d. A firm needs to have flexibility in the timing of its financial transactions.
flexibility, not the intent of the passage.

e. In spite of their pitfalls, derivatives are necessary to help a company speculate against risks
Basically this word, i guess was the trap here
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Quote which i can relate to.
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Joined: 16 Jul 2018
Posts: 28
Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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22 Feb 2019, 09:19

I was wondering if you could shed some light on question 1 i don't get why the the company should short hedge with its supplier , I mean the company wants to protect itself from a rise of the prices of the raw material right? Isn't answer C more appropriate? ... by long hedging with the supplier the company will ensure that increases on the price of the raw material will not have an effect on the company.
Re: Risk is an inherent part of business, and managing its potential conse   [#permalink] 22 Feb 2019, 09:19
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