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
This questions requires a basic understanding of the following investment risks: liquidity, interest rate, and credit. Definitions are in order.
- Liquidity risk is the possibility of sustaining significant losses due to the inability to enter or exit a position quickly at a fair price.
- Interest rate risk is exposure to fixed income valuation declines as the result of changes in interest rates.
- Credit risk is defined as the risk of loss caused by a debtor's failure or (in the case of a sovereign government) refusal to make a promised payment.
Answer and Explanation:
A few business practices that would help a company manage each of the aforementioned risks are provided below.
- Liquidity risk - maintain a conservative allocation to cash and cash equivalents and/or establish a line of credit with a financial institution
- Interest rate risk - invest in a manner consistent with the duration profile of the business' liabilities and/or incorporate floating rate instruments into the fixed income portfolio
- Credit risk - perform a rigorous credit analysis of all potential exposures and implement prudent investment guidelines to limit exposure to specific sectors, industries, and issuers
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from CFP Certification Exam Study Guide - Certified Financial PlannerChapter 8 / Lesson 1