Financial Risk Manager Part 1
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In 2016, the United Kingdom made a historic decision to exit the European Union, a move commonly referred to as 'Brexit'. Following this decision, the value of the British pound depreciated against other major global currencies such as the U.S. dollar and the Chinese Yuan. Which one of the following risks best explains this observation?
Explanation:
Explanation
Foreign exchange risk, also known as currency risk, is a financial risk that arises from potential changes in the exchange rate between two currencies. Investors who have investments in foreign countries are exposed to this risk because the value of the foreign investments will decrease if the currency of the investment's country weakens against their own domestic currency.
In the context of the question, the Brexit vote led to a decrease in the value of the British pound against other currencies. This is a classic example of foreign exchange risk. Investors who held assets denominated in British pounds would have seen the value of those assets decrease when converted back to their own domestic currency. The uncertainty surrounding the economic impact of Brexit, including potential disruptions to trade agreements and economic ties with the European Union, contributed to the depreciation of the pound.
Why Other Options Are Incorrect:
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Choice A (Interest rate risk): This is the risk that the value of an investment will decrease due to changes in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. While Brexit could affect interest rates, the immediate observation was currency depreciation, not interest rate changes.
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Choice C (Reputation risk): This is the risk of loss resulting from damages to a firm's reputation, leading to lost revenue, increased operating costs, or destruction of shareholder value. Reputation risk is more relevant to individual companies or organizations and is often associated with the company's operational practices, ethical stance, or response to a specific event or crisis.
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Choice D (Equity risk): This refers to the risk associated with stock price movements and equity investments. While Brexit did affect stock markets, the specific observation in the question relates to currency depreciation, which is directly foreign exchange risk.
Therefore, the risk that best explains the observation in the question is foreign exchange risk.