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FRM Part I · FRM Exam Part I

How Do Firms Manage Financial Risk? FRM Part I Chapter Guide

Firms manage financial risk by identifying exposures, deciding which to hedge, and using forwards, futures, swaps or options to offset them. You size the hedge with a hedge ratio, such as h* = ρ × σS ÷ σF, then measure the basis risk and residual risk that remain.

What this chapter covers

This chapter explains how a firm moves from spotting a financial exposure to hedging it. It starts with the reason to hedge at all. It then covers the tools: forwards, futures, swaps and options. It ends with how you size, design and judge a hedge.

The core quantitative idea is the minimum variance hedge ratio: h* = ρ × σS ÷ σF, where ρ is the correlation between spot and futures price changes, σS is the standard deviation of spot changes and σF is the standard deviation of futures changes. The number of contracts is N = h* × QA ÷ QF, where QA is the size of the position hedged and QF is the size of one futures contract. You will also meet basis risk, the chance that spot and futures prices do not move together, and the three exposure types: transaction, economic and translation.

The chapter links to the rest of Part I. Quantitative Analysis supplies correlation, regression and variance. Financial Markets and Products supplies contract mechanics, pricing and margining. Valuation and Risk Models supplies the risk measures, such as VaR, used to judge a hedge. Foundations of Risk Management supplies the logic of why firms manage risk and how they govern it.

This chapter pulls together ideas from all four Part I topics, so time spent here pays off in several places. Hedge ratio and basis risk questions are calculation-based and can be solved quickly once you know the formulas. Conceptual questions on why firms hedge and which exposure type applies are easy marks if you know the definitions. GARP publishes no pass mark, so every question you secure matters. Since all 100 questions carry equal weight, a fast and accurate calculation question is worth as much as a hard one.

How Do Firms Manage Financial Risk?: topics in the order to study them

  1. 1Why Firms Hedge: Risk Management RationaleStart here. It sets the purpose of hedging and gives you the vocabulary for everything that follows.
  2. 2Hedging Instruments: Forwards, Futures, Swaps, OptionsYou need to know what each tool does and its payoff before you can size or design a hedge.
  3. 3Hedge Ratio and Basis RiskThis is the main calculation topic. It builds on the instruments and uses correlation and standard deviation.
  4. 4Hedging Exposure: Transaction, Economic and Translation RiskOnce you can compute a hedge, learn which exposures a firm actually faces and which can be hedged easily.
  5. 5Hedging Strategy Design and Risk MeasuresFinish with the full picture: choose a strategy, then judge it using risk measures and residual risk.

How to prepare How Do Firms Manage Financial Risk?

Treat this chapter as one story: why hedge, with what, how much, against which exposure, and how to check the result. Practise the calculations by hand and with your financial calculator.

  1. Read the rationale for hedging and write down, in your own words, the main reasons a firm might hedge and why hedging is not always value-adding.
  2. Make a one-page table of forwards, futures, swaps and options: payoff, who bears credit risk, margining, and flexibility.
  3. Memorise h* = ρ × σS ÷ σF and N = h* × QA ÷ QF. Solve at least ten problems, changing which values are given each time.
  4. Work through basis risk examples. Define basis as spot price minus futures price and track how its change affects the hedged outcome.
  5. Sort sample situations into transaction, economic or translation exposure, and decide whether each can be hedged with a contract.
  6. Do timed mixed question sets. Review each wrong answer and note whether the error was a formula, a unit or a concept.

Common mistakes in How Do Firms Manage Financial Risk?

  • Mixing up the hedge ratio inputs, for example using σF ÷ σS instead of σS ÷ σF.

    Fix: Remember that h* is the regression slope of spot changes on futures changes. Spot sits in the numerator.

  • Forgetting to convert the hedge ratio into a number of contracts.

    Fix: Always check what the question asks. If it asks for contracts, apply N = h* × QA ÷ QF and round sensibly.

  • Assuming a futures hedge removes all risk.

    Fix: Check for basis risk, mismatched maturity and mismatched asset. Treat the hedge as risk reduction, not elimination.

  • Confusing the three exposure types, especially economic and translation.

    Fix: Ask: is it a contracted cash flow (transaction), future competitiveness (economic), or an accounting conversion (translation)?

  • Treating forwards and futures as identical.

    Fix: Compare them on standardisation, trading venue, daily margining and credit risk every time.

  • Assuming hedging always increases firm value.

    Fix: Remember that hedging has costs and that shareholders can often diversify on their own, so a conceptual question may call for a balanced answer.

Last-day revision: How Do Firms Manage Financial Risk?

  • Minimum variance hedge ratio: h* = ρ × σS ÷ σF.
  • Number of contracts: N = h* × QA ÷ QF.
  • If ρ = 1 and σS = σF, the hedge ratio is 1.
  • Basis = spot price − futures price. Basis risk is uncertainty in how the basis changes.
  • Forwards are customised over-the-counter contracts with counterparty credit risk. Futures are standardised, exchange-traded and margined daily.
  • A swap is an agreement to exchange cash flows, for example fixed for floating interest payments.
  • A bought option gives a right, not an obligation. The loss is limited to the premium paid.
  • Transaction exposure comes from specific contracted foreign-currency cash flows.
  • Economic exposure is the effect of rate or price changes on a firm's future competitive position and cash flows.
  • Translation exposure arises when foreign subsidiary results are converted into the reporting currency.
  • A hedge reduces risk but rarely removes it. Residual risk remains.
  • Read the question carefully for sign, units and contract size before calculating.

How Do Firms Manage Financial Risk? practice questions

How Do Firms Manage Financial Risk? in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

How Do Firms Manage Financial Risk?: frequently asked questions

What is the most important formula in this chapter?

The minimum variance hedge ratio, h* = ρ × σS ÷ σF, is the key one. It tells you the proportion of the exposure to hedge with futures. Then use N = h* × QA ÷ QF to convert it into a number of contracts.

Do I need a financial calculator for this chapter?

You do not need advanced functions, but a calculator saves time. You will need square roots, multiplication and division with accuracy. Practise the sequence so you make fewer slips under time pressure.

How is basis risk different from price risk?

Price risk is the risk that the price of the asset moves against you. Basis risk is the risk that the spot price and the futures price do not move together. A hedge cuts price risk but leaves basis risk.

How long should I spend on this chapter?

Spend enough time to solve hedge ratio questions without looking at notes and to classify exposures confidently. Because GARP publishes no pass mark, aim for solid understanding in all four topics instead of relying on one chapter.