Explain why financial instruments, particularly derivatives, can alter the risk profile of a business . solve Use a forward currency contract as an example . solve Discuss whether disclosure alone is sufficient to address these risks . solve A reduction in the credit rating of a business would reduce the fair value of its debt instruments . 

 Explain why this is the case . 

 

Answer rating: 100% (QA)

Financial instruments including derivatives have the potential to alter the risk profile of a business due to their unique characteristics and features Heres an explanation of how financial instruments particularly derivatives can affect a businesss risk profile using a forward currency contract as an example Alteration of Risk Profile Derivatives such as forward currency contracts provide businesses with the ability to manage and mitigate specific risks they may face For instance a business that engages in international trade may face foreign exchange risk due to fluctuations in currency exchange rates By entering into a forward currency contract the business can lock in a specific exchange rate for a future date reducing its exposure to currency risk This alters the risk profile of the business by mitigating the potential adverse impact of exchange rate fluctuations Hedging Risk Derivatives can be used as hedging tools to offset or reduce specific risks In the case of a forward currency contract a business can hedge its foreign currency exposure by agreeing to buy or sell a particular currency at a predetermined rate in the future This helps protect the business from potential losses resulting from adverse currency movements By hedging the business is effectively altering its risk profile by reducing the impact of certain risks on its financial performance Regarding the sufficiency of disclosure to address these risks its important to understand that disclosure alone may not be sufficient While disclosure provides transparency and information about a businesss exposure to various risks it does not directly mitigate or manage those risks Disclosure enables stakeholders to make informed decisions but it does not eliminate the underlying risks or their potential impact on the business Therefore risk management strategies and appropriate financial instruments such as derivatives are essential to actively address and manage risks Now lets address the statement that a reduction in the credit rating of a business would reduce the fair value of its debt instruments This statement is generally true and heres why Relationship between Credit Rating and Debt Instruments Credit rating agencies assess the creditworthiness of businesses and assign credit ratings based on their evaluation of the issuers ability to meet its financial obligations A higher credit rating indicates lower credit risk while a lower credit rating suggests higher credit risk Impact on Fair Value The credit rating of a business affects the perceived creditworthiness of its debt instruments such as bonds or loans A reduction in the credit rating indicates an increased risk of default or failure to meet financial obligations As a result investors demand higher yields or interest rates to compensate for the higher risk associated with investing in the debt instruments of a business with a lower credit rating Yield and Fair Value Relationship The yield on a debt instrument ... View the full answer