Question 1 Explain the differences between the following types of foreign exchange exposure and provide an example of each to demonstrate how the foreign exchange risk will impact in each example. (a)...

Activity 9 and 10
Question 1
What is liquidity risk?
Solution 1:
Liquidity risk is the risk that a company or an individual investor is not able to meet its short term obligations. The risk arises as the individual investor or the company is unable to convert its assets into cash without bearing the loss on capital or income is not enough to pay short term obligations of the company or the individual investor.
Question 2
Answer each of the following questions
(a) What are the primary reasons why liquidity risk arises?
(b) How does liquidity risk arising from the liability side of the balance sheet differ from
liquidity risk arising from the asset side of the balance sheet?
Solution 2:
The primary reasons liquidity risk arises is because it occurs from the financial imbalance from either side of the balance sheet that is asset or liability. On the asset side it occurs as a result of the transaction of cash to some other asset, such as repayment of loan or interest payment of loan. While on the liability side it occurs where certain liability holder like creditor or the bank institution demands for the repayment at an earlier date or in cash payment for their dues. The best example for this is cash transaction.
Question 3
Differentiate between market (or transactional) liquidity and funding (or liability) liquidity
isk.
Solution 3:
a. Market Liquidity is the ability to purchase or sale in the market without any extraordinary changes in the price. So the degree to which it will be difficult to sell an asset in the market is called market liquidity risk. While on the other hand, funding liquidity risk arises when the market is tough enough to raise the money to repay the debts or manage capital is called funding liquidity risk
. Example of Market liquidity risk is the property held by an individual or a company. It is difficult to sell the same as and when needed. Though the price of the property is good but it sometimes to difficult at the same price on the spot. This leads to liquidity risk.
Example of Funding Liquidity risk: For a new project or expansion, a company needs fund. But due to the stringent policy it is difficult for the company to raise the funding at low interest cost. All the banks are providing funding at a very high cost. This is funding liquidity risk.
Question 4
Identify and explain why various types of off balance sheet activities can result in liquidity risk?
Solution 4 :
The off balance sheet items are those items which are not included in the profit and loss and the balance sheet of the company for the purpose of calculation of profit of the company. They are mentioned as a note to the balance sheet. These items are included only on the subject of their occu
ence in other words the liabilities are contingent liabilities. The example are: Gurantees given by the banks to the company, any claim by the third party on occu
ence of a certain event, any other contingent liabilities, any claim settlement pending in court.
The claim on these items depend upon certain event in future. Let us take an example, there is a claim pending and the case is going on in the court for $1,00,000. In case if the company loses the case, the court order the company to pay the party $1,00,000. This is a contingent liability that occu
ed suddenly. So it leads to liquidity risk. Thus, the off balance sheet activities can result into liquidity risk.
Question 5:
Differentiate between the primary sources of liquidity risk for a bank as opposed to a corporate.
Solution 5:
The primary liquidity risk for a bank is the deposit run off due to a specific event. Bank acts as an intermediary between the bo
ower and the lender of the firm. The lender gets the money back as and when wanted. The bank bo
ows money from the lenders or the depositors and in turn lends money to the company who needs fund. If due to certain event, there is a continuous outflow of deposit, then bank may turn into liquidity crunch as the deposit of the money is being lent to the other companies for expansion. This is called as bank run
On the other hand, the primary source of fund for corporate is the short term bo
owing from bank, trade credit. In case if the trade credit creditor cancels the trade credit and demands for an early payment, it will be difficult for the corporate to repay the money as the said money has been put in some expansion purpose to generate more revenue. The primary source is also when the banks asks for the prepayment of loan.
The above is the difference between the primary sources of liquidity risk for a bank as opposed to a corporate.
Question 6:
In relation...