Tag Archives | risk

Transaction Exposure

See Also:
Translation Exposure
Currency Swap
Exchange Traded Funds
Hedge Funds
Fixed Income Securities

Transaction Exposure Definition

Transaction exposure, defined as a type of foreign exchange risk faced by companies that engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change the value of a contract before it is settled. This can also called transaction risk.

Transaction Exposure Meaning

The risk that foreign exchange rate changes will adversely affect a cross-currency transaction before it is settled, can occur in either developed or developing nations. A cross-currency transaction is one that involves multiple currencies. A business contract may extend over a period of months. Foreign exchange rates can fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can change the value of that contract.

A company that has agreed to but not yet settled a cross-currency contract that has transaction exposure. The greater the time between the agreement and the settlement of the contract, the greater the risk associated with exchange rate fluctuations.


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Transaction Exposure Management

A company engaging in cross-currency transactions can protect against transaction exposure by hedging. By using currency swaps, by using currency futures, or by using a combination of these hedging techniques, the company can protect against the transaction risk by purchasing foreign currency. Use any one of these techniques to fix the value of the cross-currency contract in advance of its settlement.

Transaction Exposure Example

For example, a domestic company signs a contract with a foreign company. The contract states that the domestic company will ship 1,000 units of product to the foreign company and the foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money the foreign company will pay the domestic company is equal to 100 units of domestic currency.

The domestic company, the one that is going to receive payment in a foreign currency, now has transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.

The next day the exchange rate changes and then remains constant at the new exchange rate for 3 months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign currency has devalued against the domestic currency. Now the value of the 100 units of foreign currency that the foreign company will pay the domestic company has changed – the payment is now only worth 50 units of domestic currency.

The contract still stands at 100 units of foreign currency, because the contract specified payment in the foreign currency. However, the domestic firm suffered a 50% loss in value.

Manage Your Risk

Managing your risk is just one of the many ways you can add value to your company. If you want to find out how you can become a more valuable financial leader, then download the free 7 Habits of Highly Effective CFOs.

transaction exposure

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Secured Claim

See Also:
Pledged Collateral
Collateralized Debt Obligations
Debt Ratio Analysis
Debt Service Coverage Ratio (DSCR)
Convertible Debt Instrument
Asset Based Financing

Secured Claim Definition

The secured claim definition is debt backed by collateral. It can refer to loans, mortgages, bonds, and other financial debt instruments.

As stipulated in the debt contract, the debtor backs the debt with assets that the creditor may claim in the event of default. In a secured claim contract, if the debtor defaults, or is unable to payback the debt, the creditor can take ownership of the collateral and sell it to pay off what the debtor owes. For example, if a consumer defaults on a mortgage, the bank can claim the house and sell it to pay off the consumer’s debt. In the event of default, the secured claim is worth only as much as the collateral that backs it.

In contrast, unsecured claims are debt contracts or instruments not backed by collateral. Secured claims are considered less risky. In addition, these contracts or instruments offer lower yields. In comparison, unsecured claims are more risky. These contracts or instruments offer higher yields to compensate the lender (or investor) for the higher risk.

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Sole Proprietorship

Sole Proprietorship Definition

The sole proprietorship definition is a private business owned and operated by one individual. Furthermore, a proprietorship is unincorporated and is not a legal entity separate from its owner. As a result, the owner earns all of the profits and incurs all of the losses from business operations. Therefore, the sole proprietor is legally liable for all of the activities and obligations of the business. For example, if the proprietorship defaults on debt obligations, the owner risks liquidation of personal assets.

Advantages and Disadvantages of a Sole Proprietorship

There are several advantages to the sole proprietorship. Proprietorships are easy to establish, easy to dissolve, and they give the owner a significant amount of operational freedom and flexibility. For tax purposes, the owner simply includes the profits or losses of the proprietorship with his or her individual tax filings.

There are also disadvantages. The owner has unlimited liability for the activities and obligations of the proprietorship. This puts the owner’s personal assets at risk. Also, because of the small scale of a proprietorship, it can be difficult to gain access to substantial capital resources and financing. As a result, this limits the growth potential of the enterprise.


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sole proprietorship

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sole proprietorship

See Also:
Partnership
General Partnership
Limited Partnership
S Corporation
How to Run an Effective Meeting

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Risk Premium

See Also:
Finance Beta Definition
Hedging Risk
Common Stock
Preferred Stock
Stock Options

Risk Premium Definition

Risk premium is any return above the risk-free rate. The risk-free rate refers to the rate of return on a theoretically riskless asset or investment, such as a government bond. All other financial investments entail some degree of risk, and the return on the investment above the risk-free rate is called the risk premium.

When an investor purchases a financial instrument, such as stock or bonds, that investor is putting his capital at risk. The company that issued the stock could perform poorly and its stock could plummet in value; or the company issuing the bonds could default and its bonds could become worthless. Both of these potential scenarios represent risk for the investor or speculator. The return on an investment, which corresponds to the riskiness of the investment, is supposed to compensate the investor for that risk.

Different financial instruments have different degrees of riskiness and the returns on these instruments typically correspond with the level of risk. More risky assets have higher returns; less risky assets have lower returns. An asset with no risk, such as a U.S. government bond, has a comparatively low rate of return because there is little or no risk of the U.S. government defaulting. Therefore, the rate of return on that type of riskless asset is referred to as the risk-free rate. Any return above that rate is a risk premium which compensates the investor for the riskiness of the asset.

Risk Premium Example

Assume the risk-free rate is 5%. This means a riskless U.S. government treasury bond offers an annual return of 5%. Let’s say an investor invests in the stock of a company and that stock has an annual return of 7%. The risk premium for that company’s stock is the difference between the risk-free rate of 5% and the expected return of the stock of 7%. So the risk premium is 2%.

Risk Premium = Asset Return – Risk-Free Rate

2% = 7% – 5%

Risk Premium and the CAPM

The risk premium is also used in calculating the expected return on asset when using the capital asset pricing model (CAPM). In that case, the risk premium combines the market risk premium, or the overall stock market’s return above the risk-free rate, with the beta of the individual stock. This gives the risk premium for the particular stock over the risk-free rate.

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Put Option

See Also:
Call Option
Synthetic Stock
Future Value
Intrinsic Value – Stock Options
Purchase Option

Put Option Definition

A put option is the right for an investor to sell an asset at a pre-determined exercise price on a certain date known as the put option expiration.

Put Option Explained

A put option gives a holder or investor the ability to make an essentially risk free profit if the market fluctuates correctly. The holder of an option can simply look into the market without taking any real part in it. The benefit for a put option holder comes if the stock price does not exceed the put option price. Therefore, the lower the better for the put option holder because he is selling into the market. A put is exercised only if the holder can deliver an asset that is worth less than the exercise price.

Put Option Example

Jim has received a put option with the right to sell 100 shares of Wawadoo Inc. at a price of $35 by December. The current month is January, and the current stock price is $32. Jim could exercise the put now, but he believes that the market will drive the Wawadoo stock further down. By November, the stock has dropped to $28. Jim exercises his option and makes a profit of $700 (($35*100) – ($28*100)). If the price had increased throughout the year and went above the put option exercise price then Jim would have simply let his option expire. By doing this Jim has not gained anything or lost anything, except the potential where he could have exercised the put at the beginning of the year.

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Preparing a Loan Package

See Also:
Can Factoring Be Better Than A Bank Loan?
Loan Term
Prepare an Investor Package
Good Budgeting Processes
What the Banker Wants You to Know
Does Your Management Team Understand the Financials?

Preparing a Loan Package

Knowing the process of preparing a loan package can be one of the most resourceful tools for business owners. Many feel loan package preparation is overwhelming and even frustrating if you are unsure of what to include in the loan package. Knowing the right time to apply for a loan to help grow or sustain your business is very important when planning your financial future; however it is only a part of the whole. The other piece of this puzzle is familiarizing oneself with the loan package requirements in order to secure the loan.

In the Lender’s Shoes

Before we consider the details of organizing a loan package, let’s put ourselves in the lender’s shoes. What would be some of the risk factors needing to be addressed before lending money to this particular borrower? This person will ultimately have to sell you on the idea that their business is worth investing in and the return on their investment is worth those risks.

After they have sold you on this idea, now it’s time to discuss the terms and conditions of the loan they are requesting. This is where the question of “how much” is answered and the repayment plan is offered.

Lastly, being that we are all so busy, time would probably be of the essence. Therefore, it would be very important for them to cut to the chase when convincing you that this investment you are making into their business is a win-win relationship for both parties. In short, in order to prepare a loan request, it is important to have a thorough presentation, but in the same manner getting to the point of the matter is essential.

Thus far, we have covered a general overview of preparing for a business loan. Now let’s get into some of the details of the documentation contained in the loan package.

Loan Package Template

1. Loan Request
2. Description of Company
3. Product and Services
4. Marketing Plan
5. Operational Plan
6. Management and Organization
7. Financial Plan
8. Appendixes

This template is the skeleton for the body of content needed when it comes to knowing how to organize a business loan package. It is an excellent guide regardless of the reason for the request. It does not matter where you are in the development of your company, be it start up, looking to expand, or wanting to improve on the sales and services. Seeking outside funding is a key part of that process. Answering the questions of “where do I go to get the money needed” or “when is the right time to apply for a loan” serves as a non-issue with most owners or CEO’s. However, the answer to the question of “how do I prepare a loan package” is not as obvious.

Loan Request Outline

The loan request outline included in this article will definitely get you started and moving forward on the right track. However, keep in mind the three main points:

1. Sell your Company
2. Discuss the Payback Plan
3. Time is of the Essence

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Preparing a Loan Package
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Moral Hazard

See Also:
Business Risk
Commercial Risk
Interest Rate Risk
Investment Risk
Risk Premium

Moral Hazard Definition

Moral hazard, defined are the circumstances or situations that increase the probability or riskiness of a loss. This is often due to a person’s habits or morals.

Moral Hazard Explained

Moral hazard risk is the risk that is associated with a particular person or group. In other words, it is a situation in which another person takes on the risk of loss while another makes the decision on how much risk that person will have. This happens in finance with brokers or fund managers. It can also be seen in insurance where a person might not care as much about a certain property or equipment because the insurance company will cover the loss.

Moral Hazard Example

For example, Pete owns a barn that he has recently insured. Pete walks into the straw filled barn where he sees a loose wire from an electrical outlet. Normally Pete would fix this problem right away, but he doesn’t really feel like doing it. The barn is insured so it is of little concern to Pete whether the job get done today or tomorrow. He vows to fix the problem in the morning. Over the night the barn catches fire and burns down. The insurance company pays Pete for his complete loss.

The moral hazard here is that Pete simply did not care to take care of his property as he should have because he knew the insurance company would pay for the entire amount of the repairs. Insurance companies have to deal with this moral hazard all of the time. They even try and spend time valuing the amount of moral hazard risk.

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Moral Hazard
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