CTP Exam Quiz 02

Interest rate futures and options
Risk management includes minimizing interest rate risk. Firms that pay variable interest rates on their debt will pay more if the rate increases. Conversely, firms that earn a variable interest rate on their investments or assets incur opportunity cost losses if the interest rate falls. To minimize this risk firms can hedge against it by investing in interest rate futures contracts for T-bills or Euro dollars. Alternatively, a firm could purchase interest rate options. If the variable rate is on debt, the option would be for an interest rate ceiling (or cap) that would guarantee the rate paid would not exceed that ceiling.

Interest rate swaps
Risk management includes minimizing interest rate risk. Firms that earn a fixed interest rate on their investment or asset could incur opportunity cost losses if the prime rate rises. Conversely, firms that pay a variable interest rate on their debt will have higher debt costs if their interest rate rises. To hedge against this risk, firms can negotiate an interest rate swap. This is the exchange of interest payment flows. For example, the investing firm could trade their fixed payment flow for another firm’s variable rate flow. When both firms have a variable rate payment flow, their swap is a basis-rate swap.

Translation and transaction risk
Multi-national corporations (MNCs) and other firms that engage in international trade are more exposed to foreign exchange risk such as translation and transaction risk. Translation risk is the threat that the value of a firm’s assets will decline after an exchange rate change in the country’s currency where the asset is located and where the firm has assets denominated in that currency. Transaction risk is the threat FX (foreign exchange) rate changes will result in losses during the time delay between payment and settlement. Some MNCs have currency swap arrangements or a forward rate agreement (FRA) with foreign firms to hedge against foreign exchange risk.

Economic exposure
In addition to the foreign exchange risks of translation and transaction, multi- national corporations (MNCs) and other firms that engage in international trade are exposed to economic risk. This is the threat that repeated currency rate changes will diminish the present value of a firm’s future cash flows, and ultimately its share value. Even domestic companies that must compete with foreign firms are vulnerable to this economic risk. Import/export firms have high economic exposure. Hedging against economic exposure involves the use of currency swaps, forwards, futures, and options.

Financial accounting standards
Financial risk management can involve a variety of hedging strategies that minimize risk. However, the FASB (Financial Accounting Standards Board) http://www.fasb.org/st, has set financial accounting standards (FAS) for disclosing the use of these strategies on a firm’s balance sheet. The SEC also requires firms adhere to these standards. The main standards that apply to the financial instruments are FAS105, 107, 114, 115, 133, and 138. Together they require the disclosure of the fair market value of financial instruments and disclosure of those that have balance sheet risk and/or concentration of credit risk. These standards also require accounting for derivatives and hedging, equity and debt investments, and creditor’s accounting of loan impairment. FAS138 is an amendment to FAS 133. Any financial risk management strategies should be implemented with these standards in mind.

Operational risk
Operational risk is the inherent non-financial risk that firm’s are exposed to through daily operations. The operational risk can be from both internal and external sources. The main internal operational risk involves employee error, negligence, and/or fraud. Additionally, lack of sufficient employee knowledge or qualifications can increase operational risk. Another internal source of operational risk is the process used in operations. If the process is inefficient, inappropriate, or not adhered to then operational risk increases. For example, when manual data entry is used for accounts receivable and payable processes, errors tend to increase.

Disaster recovery
All firms should develop a disaster recovery and business continuity plan to quickly restore operations in the event of a disaster. At a minimum, the plan should include:
• An alternate communications system for the firm to maintain contact with employees, customers, vendors, financial institutions, markets, and regulators
• Data backup and recovery including hard copy and electronic copies
• Provisions for financial assessments
• Provisions for operational assessments
• Maintenance of any mission critical systems, including systems that are mandatory for the firm’s continual operations after a disaster

Insurance available to firms
Managing risk involves the use of insurance in one form or another. Insurance can help minimize financial losses due to business interruption, breach of contract, liability losses, worker injury losses, property losses, and loss of key personnel like the CEO. Liability insurance includes business, product manufacturer, and general liability. Excess liability insurance insures for damages in excess of the amount basic liability insurance covers. Property insurance insures against loss of or damage to property, including inventory. However, difference in conditions (DIC) insurance will cover unusual events relating to property, like events that occur when property is transported overseas. Casualty insurance is for legal liability associated with damage to others or to other’s property. Worker’s compensation insures against worker injury.

Insurance available industry
In addition to the standard kinds of business insurance, some industries require very specific insurance. A fidelity bond is a debt bond that insures an employer against losses due to employee embezzlement, forgeries, misappropriation, and/or willful misplacement of funds or property. Other insurance is usually required to complement fidelity bonds. For example a blanket bond covers activities of all employees and crime insurance insures against losses due to specific listed crimes. The shipping industry uses marine insurance policies to insure against damage to cargo and ships.

Appropriate insurance measurement
Risk management involves the purchase of the appropriate insurance. To determine the right kind and amount of insurance, the potential losses should be measured. Property losses can be measured by estimating the replacement costs if property is damaged. This should include losses due to business interruption. Liability losses can be measured by estimating the losses due to product malfunction, customer injury either from products or from the physical presence in the firm’s store or location. Worker’s compensation losses can be estimated by reviewing the firm’s worker compensation history.

Preventing losses
Prevention of risk is generally the least expensive method of managing risk. One of the main preventative strategies is the adherence to safety regulations. Employee training and workplace safety assessments and compliance can dramatically reduce workplace injuries and liability. Avoiding financial exposure involves abstaining from a project or investment if there is no opportunity to hedge against potential losses. A risk adjusted rate of return should be calculated to determine the suitability of the venture. Transferring risk to other parties eliminates risks to the firm.

Financing business recovery
Funding for business recovery can come from an outside party like an insurance company, from a group of related industries, or from within the firm itself. Insurance companies assess the damage and then make payments to the firm for recovery. A risk retention group (RRG) is made up of organizations (including non- profits) that have similar products or services, and therefore similar risks for losses. The federal Liability Risk Retention act of 1986 permits RRGs to underwrite the insurance risk of its members.

Insurance company stability
Risk management requires some form of insurance, and most organizations have contracts with an insurance provider. Before contracting with an insurance provider, the organization should research their financial strength and the business history. This information can be obtained via insurance rating firms. Currently the most reliable insurance rating firm is the A.M. Best Company Inc., which is an SEC designated NRSRO (national ratings and statistics rating organization). It offers a financial strength rating (FSR), a short term credit rating, and a long term credit
rating.

Corporate governance standards
The Sarbanes-Oxley Act of 2000 has provisions that address corporate governance, which includes the actions of the board of directors, the independent auditors, and the regulators. Among other things it requires that the role of a firm’s independent directors be defined and adhered to, that new enforcement procedures be developed and followed, and that corporate governance become more transparent to shareholders. For example, the board of directors must be comprised of mostly independent directors who have not been an employee or shareholder of the firm or affiliates for the preceding 5 years. These independent directors must meet regularly and without management.

Treasury code of ethics
The Association of Financial Professionals (AFP) has revised their code of ethics in response to the recent financial scandals of publicly held companies like Enron, Tyco, and Arthur Anderson. Specifically, the AFP recommends that the treasury of a firm create a document that defines their policy and code of conduct and require all treasury employees to adhere to the code. The code should clarify that certain information should not be shared with anyone outside the treasury. This information includes passwords, fees, credit terms, names of clients, and/or any bank data. The code should also specify what conduct is considered a conflict of interest.

ERISA
The Employee Retirement Income Security Act (ERISA) of 1974 was enacted to help employees of private corporations with their pensions. It created the Pension Benefit Guaranty Corporation (PBGC) to insure against the loss of private pension funds of bankrupt corporations. It also requires disclosure by corporations of pension benefits and sets pension management standards. Additional legislation specifies how pension plans can qualify for tax deferment or shelter.

Prohibited transactions
The Employee Retirement Income Security Act (ERISA) has provisions that detail fiduciary responsibility. A fiduciary has a legal relationship with the beneficiary that requires them to act in the sole interest of the beneficiary. Private pension funds have to be managed according to these regulations. There are certain financial transactions that a pension fund fiduciary is prohibited from engaging in. Primarily, a fiduciary is prohibited from using pension plan assets to trade with any ‘party-in-interest’, which is any individual or organization that has a direct or indirect involvement with the pension plan (ERISA Section 3).

Regulations regarding highly compensated employees
The Employee Retirement Income Security Act (ERISA) requires that retirement plans do not favor Highly Compensated Employees (HCEs). These are employees who earn in excess of $100,000 and/or own more than 5 % of the company. The plan benefits and contributions must be made in a non-discriminatory manner. Any amendments or terminations must affect all participants without discrimination. Preferential tax treatment of the plan is conditional on the compliance with either the ratio percentage test or the average benefit test. This is to prevent the compensation to HCE to be used to defer taxes.

Defined benefit and contribution pension plans
When a firm sets up their pension plans, they have two basic choices, either a defined benefits plan or a defined contributions plan. Defined benefits specify benefits the plan will provide upon retirement and are more costly to the firm. These kinds of plans are decreasing in use. Defined contributions specify what the participant will contribute and any benefits received at retirement depend on the contributions made prior to retirement. Employee contributions are often pre-tax dollars making them tax deferred contributions. Tax is paid when the funds are distributed at retirement, hopefully at a lower rate.

Responsibilities of a pension committee
Firms that have pension plans also have pension management committees that provide pension information to participants, supervise investment managers, and keep current on the tax issues that pertain to pension plans. The committee also gathers pension finance information for the firm’s management. Because qualified investment managers are a requirement for sound pension management, the pension committee should thoroughly question a potential investment manager and should verify all pertinent information before securing their services.

RFIs and RFPs
Banks and/or financial service providers (FSPs) are necessary for firms to conduct business. The process of selecting a new one usually begins with the submission of a request for information (RFI). This is a letter requesting information on the financial services offered and fees charged by the financial institution. It is useful for eliminating choices. The next step involves preparing a request for proposal (RFP).

What an RFP usually includes
A request for proposal (RFP) is a formal document that invites a vendor to submit a bid to offer services. The standard RFP includes the vendor background, references, and evidence of the vendor’s commitment to provide service. It also includes the vendor’s solution, the level and quality of services that would be provided, specifically when they would be provided, and an example of the vendor’s service agreement. Finally the RFP would include the vendor costs and pricing schedule and a cost/benefit analysis of the vendor’s solution.

Choosing a financial institution
When a firm establishes a relationship with their financial institution, they should confirm that the financial institution has sufficient electronic backup capabilities and that it regularly maintains its electronically stored financial records. In case of emergency, a firm would need to have access to their financial data that would be in the possession of the financial institution. The firm should also obtain from the financial institution in writing the circumstances in which the firm’s sensitive financial information would be shared and with whom.

Bank’s service agreement
When a firm establishes a relationship with a bank, it is usually the treasury department that is in most frequent contact with them. The treasury is most aware of the various documents that formalize relationships with the bank(s). In addition to the signature cards, account resolutions, and credit agreements the relationship documents include the service agreements that detail the pricing and compensation policies including treatment of surplus and/or deficit account balances. It specifies the service performance standards the bank will meet and conditions for risk liability.

Resolution for accounts
When firm establishes a relationship with a bank or financial service provider (FSP) certain documents are required that authorize the bank to complete financial transactions on the firm’s behalf. The primary document that authorizes the banking relationship is the board of director’s resolution for accounts. It formally grants permission for the firm’s representative to authorize the receipt of banking services, and for the bank to provide those services. It specifies exactly which signatures are required for certain account activities. Signature cards are samples of the authorized signer’s signature and are kept on file by the financial institution to verify signatures.

Account analysis document
The financial institution will periodically submit to the firm an account analysis which is a summary of the services provided. It will list the account daily balance and float as well as the account activity charges and any balance compensation (balances needed to pay for services). It will also include the bank’s earnings credit rate which is an adjustment that reduces service charges on business accounts. The Accredited Standards Committee of the American National Standards Institute (ANSI) has developed a standardized format for an electronic version of an account analysis document.

Service group codes indicated on an account analysis
Some of the terms used in an account analysis document can vary between financial institutions. The Association of Financial Professionals (AFP) has established a code for identifying common services. The first two numbers of the code identify which group or family the service belongs to. The lockbox service is the product group that includes document handling, data processing, and deposit reporting. Its group code is 05. The depository services include the processing of deposits of coin, currency, checks, and check equivalents.

LIBOR
LIBOR is the London Interbank Offer Rate and is the short term interest rate used for loans between banks in London. The British Banker’s Association (BBA) is a trade association founded in 1919 that is responsible for fixing the LIBOR on a daily basis, even though it fluctuates throughout the day. They derive the rate by averaging the short term deposit rates of sixteen of the world’s most stable banks. It is the most frequently used benchmark rate for short term interest rates for countries like Canada, Switzerland, the U.K., and the U.S. In addition to establishing the LIBOR, the BBA is also instrumental in improving banking practices in Europe and elsewhere. It has improved bank codes and accounting principles.

Foreign exchange intervention
Foreign currency exchange rate is the price of one country’s currency in terms of another country’s currency. It is generally driven by market forces. However, the central banks of most countries are instructed to influence the exchange rate by purchasing or selling specified currencies for economic and sometimes political reasons. This is called foreign exchange intervention. In the U.S. this is done through the foreign exchange desk which is in close proximity to the open market desk where the Fed buys and sells government securities.

Income tax
The tax rate of a firm or individual is the rate at which their income is taxed. The income of firms is calculated after expenses are deducted. The tax rate can be progressive, proportional, or regressive. A progressive tax requires a higher percentage of income from higher earners than from lower earners. For example, a high earner would pay 20% of their income, whereas a low earner might pay only 10%. In contrast, a regressive tax requires a larger percentage of income from low earners than from high earners. This kind of tax is not officially imposed but is inherent in some kinds of taxes like fuel taxes.