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

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

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New post 30 Sep 2018, 11:31
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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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New post 30 Sep 2018, 19:44

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New post 30 Sep 2018, 23:30
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.
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New post 30 Sep 2018, 23:32
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.
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Re: Risk is an inherent part of business, and managing its potential conse  [#permalink]

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New post 01 Oct 2018, 02:10
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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New post 01 Oct 2018, 05:32
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 correct answer is (B).

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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New post 01 Oct 2018, 05:35
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!


Please check the answer I mentioned
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New post 01 Oct 2018, 05:52
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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New post 01 Oct 2018, 20:57
For question 2
The correct answer is (C).

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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