Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

BEC > 7 Financial Risk Management > Flashcards

7 Financial Risk Management Flashcards

1
Q

What is CAPM?

A

Capital Asset Pricing Model

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What are the 9 types of investment risk?

A
  1. credit default risk
  2. liquidity risk
  3. maturity risk - aka interest rate risk
  4. inflation risk
  5. political risk
  6. exchange rate risk
  7. business risk - aka operations risk
  8. country risk
  9. principal risk - aka default risk
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is credit default risk?

A

The risk that the borrower will default and not be able to repay principal or interest. This risk is estimated by credit-rating agencies.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is liquidity risk?

A

The risk that a security cannot be sold on short notice without a loss.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What is maturity risk (aka interest rate risk)?

A

The risk that an investment security will fluctuate in value between the time it was issued and its maturity date. The longer the time until maturity, the greater the degree of maturity risk. It may also be paid back before maturity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What is inflation risk?

A

The risk that purchasing power of the currency will decline

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What is political risk?

A

The probability of loss from actions of governments, such as changes in tax laws or environmental regulations or expropriation of assets.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What is exchange rate risk?

A

The risk of loss because of fluctuation in the relative value of a foreign currency in which the investment is payable.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What is business risk?

A

The risk of fluctuations in earnings before interest and taxes or in operating income when the firm uses no debt, which causes cash flows to be inadequate to pay interest and principal on time.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What is country risk?

A

The overall risk of investing in a foreign country.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What is principal risk (aka default risk)?

A

The risk of losing the principal invested.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What is financial risk?

A

The risk to the shareholders of financial leverage.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What factors does business risk depend on?

A
  • demand variability
  • sales price variability
  • input price variability
  • the amount of operating leverage
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What are the two basic categories of investment risk?

A

Systematic or unsystematic

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What is systematic risk (aka market risk)?

A

All firms have systematic risk. Changes in the economy as a whole, such as inflation or the business cycle, affect all players in the market. Systematic risk is unavoidable. For this reason, systematic risk sometimes is called undiversifiable risk. Because all investments are affected, it cannot be reduced by diversification.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is unsystematic risk (aka idiosyncratic risk or company risk)?

A

The risk inherent in a particular investment. Thus, it is the risk of a specific firm. This type of risk is determined by the firm’s industry, products, customer loyalty, degree of leverage, management competence, etc. Unsystematic risk sometimes is called diversifiable risk. Because individual investments are affected by the particular strengths and weaknesses of the firm, this can be reduced by diversification.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What is a risk-averse investor?

A

An investor in which the utility of a gain is less than the disutility of a loss of the same amount. Ex - the pain of losing $1,000 is worse than the happiness gained from earning $1,000.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Why must risky securities have higher expected returns?

A

Because of risk aversion, the higher returns induce investors to accept the additional risk. In financial and economic models, all investors are assumed to be risk averse.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

What is a risk-neutral investor?

A

An investor that adopts an expected value approach. They regard the utility of gain as equal to the disutility of a loss of the same amount.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What is a risk-seeking investor?

A

An investor who has an optimistic attitude toward risk. They regard the utility of a gain as exceeding the disutility of a loss of the same amount.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

What is the risk premium?

A

The excess of an investment’s expected rate of return over the risk-free interest rate.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

What is the risk-free rate?

A

The interest rate on the safest investment. In practice, the stated interest rate on U.S. Treasury bills is considered to be the risk-free interest rate. A holder of U.S. Treasury bills generally is exposed only to inflation risk. Thus, the market rate of interest on U.S. Treasury bills equals the risk-free rate of interest plus the inflation premium.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What are examples of equity investments?

A
  • common stock
  • convertible preferred stock
  • preferred stock
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

What are examples of debt investments?

A
  • income bonds
  • subordinated debentures
  • second mortgage bonds
  • first mortgage bonds
  • U.S. Treasury bonds
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

Why are equity securities considered riskier than debt securities?

A

Because an entity’s owners are not legally guaranteed a return

26
Q

Why are common share securities higher risk than preferred shareholders?

A

Common shareholders are the residual owners of a corporation. They are last in order of priority during liquidation, but they have the right to receive distributions of excess profits. Thus, the equity investments have a higher upside (or reward) than debt investments.

Preferred shareholders usually have a higher priority than common shareholders in liquidation, but their potential returns are limited by the board of directors. They may participate in extra dividends or their shares may be converted to common stock.

27
Q

Why are debt security returns guaranteed?

A

Issuers of debt securities are legally obligated to redeem them. Because these returns are guaranteed, their risks and returns are lower than those for equity investments.

28
Q

When do income bonds pay returns?

A

Income bonds pay a return only if the issuer is profitable.

29
Q

What are debentures?

A

Unsecured debt securities, which means they are not collateralized.

30
Q

What are mortgage bonds?

A

Secured bonds, collateralized by real property.

31
Q

What are commodity investments?

A

Precious metals. Normally considered a risky investment because their prices are highly volatile. During periods of high inflation, however, currency loses purchasing power rapidly, and precious metals, such as gold, may be a safe investment.

32
Q

What is the calculation of rate of return?

A

return = amount received - amount invested

33
Q

What is the calculation of the rate of return as a % of the amount invested?

A

rate of return = return / amount invested

34
Q

What is the formula for simple regression?

A

y = a + bx

Y = the dependent variable
a = the y intercept
b = the slope of the regression line
x = the independent variable
35
Q

What is regression analysis?

A

The process of deriving a linear equation that describes the relationship between two variables. Regression analysis is particularly valuable for quantifying risk in financial risk management as well as for budgeting and cost accounting purposes.

36
Q

What is the correlation coefficient?

A

Correlation is the strength of the linear relationship between two variables. This can be graphically depicted by plotting the values for the variables on a graph in the form of a scatter diagram. It is used to quantify risk, such as how well an asset moves with market prices. A coefficient of correlation of zero does not mean that the two variables are unrelated, only that any relationship cannot be expressed as a linear equation. Correlation is not causation. We only know that the two variables move together, not what causes them to move.

37
Q

What is the standard error?

A

The standard error measures how well the linear equation represents the data. It is the vertical distance between the data points in a scatter diagram and the regression line. The closer the data points to the regression line, the lower the standard error.

38
Q

What is the high-low method?

A

The high-low method generates a regression line using only the highest and lowest of a series of observations.

39
Q

What is probability?

A

Probability provides a method for mathematically expressing the likelihood of possible outcomes.

40
Q

What is a probability distribution?

A

The set of all possible outcomes of a decision, with a probability assigned to each outcome. Ex - a simple probability distribution might be defined for the possible returns on a stock investment. A different return could be estimated for each of a limited number of possible states of the economy and a probability could be determined for each state.

41
Q

When is a probability distribution discrete?

A

When the outcomes are limited.

42
Q

What is expected rate of return (R)?

A

The average of the possible outcomes weighted according to their probabilities.

43
Q

What is the expected rate of return formula?

A

Expected rate of return = sum(possible rate of return x probability)

44
Q

What is standard deviation?

A

The measure of risk of the probability that the actual return on investment will differ from the expected return. The standard deviation (variance’s square root) of the distribution of an investment’s return. Measures the riskiness of the investment. The greater the standard deviation, the riskier the investment.

45
Q

What is the standard deviation formula?

A

Standard deviation = Square root of (sum (Ri - R)squared x probability)

Ri - possible rate of return
R = expected rate of return

46
Q

What is coefficient of variation (CV)?

A

When the rates of return and standard deviations of two investment differ it measures the risk per unit of return. The lower the ratio, the better the risk-return tradeoff.

47
Q

What is the formula for coefficient of variation?

A

Coefficient of variation (CV) = standard deviation / expected rate of return

48
Q

Why is the capital asset pricing model used?

A

To measure how a particular security contributes to the risk and return of a diversified portfolio. The CAPM quantifies the required return on an equity security by relating to the security’s level of risk to the average return available in the market.

49
Q

What is the CAPM formula?

A

required rate of return = risk-free rate +beta(market return - risk-free rate)

beta = measure of the security’s market risk

50
Q

What is the security market line?

A

The graphical representation of the relationship between the expected rate of return and market, or systematic (beta) risk.

51
Q

What is sensitivity analysis?

A

Sensitivity analysis uses trial-and-error to determine the effects of changes in variables or assumptions on final results. It is useful in deciding whether expending additional resources to obtain better forecasts is justified.

52
Q

What is the simulation method?

A

This method is a sophisticated refinement of probability theory and sensitivity analysis. The computer is used to generate many examples of results based upon various assumptions. Project simulation is frequently expensive. Unless a project is exceptionally large and expensive, full - scale simulation is usually not worthwhile.

53
Q

What is Monte Carlo simulation?

A

This method often is used in simulation to generate the individual values for a random variable. The performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each of the variables in the model (based on the probability distribution of each variable) and then calculating the value of the solution.

54
Q

What is the Delphi approach?

A

The Delphi approach solicits opinions from experts, summarizes the opinions, and feeds the summaries back to the experts (without revealing participants to each other). The process is repeated until the opinions converge on an optimal solution. Ex - management sends questionnaires to experts asking about the possible leading cause of a new product having low sales. Management then summarizes the opinions collected from the experts, chooses the most likely leading cause, and sends another questionnaire to experts asking for the best way to solve the problem based on the identified leading cause.

55
Q

What is time series analysis (trend analysis)?

A

The process of projecting future trends based on past experience. It is a regression model in which the independent variable is time. Ex - a time series can be used to show the rises and falls of revenue with the changes of seasons or stock price changes over a specified period.

56
Q

What are the three types of risk assessment tools?

A
  1. market value at risk (VAR)
  2. earnings at risk (EAR)
  3. cash flow at risk (CFAR)
57
Q

What is market value at risk (VAR)?

A

Determines the potential decline in market value of a portfolio at a given level of confidence over a specified time period. Ex - if the 1-month VAR on a portfolio is $250 million with a confidence level of 98%, there is a 2% chance that the market value of the portfolio will drop more than $250 million over a 1-month period.

58
Q

What is earnings at risk (EAR)?

A

Determines the potential decline in earnings due to interest rate changes at a given level of confidence over a specified time period. Ex - if the 1-week EAR is $200 million with a confidence level of 95%, there is a 5% chance that the deviation from expected earnings due to interest rate changes will be more than $200 million over a 1-week period.

59
Q

What is cash flow at risk (CFAR)?

A

Determines the potential decline in cash flows at a given level of confidence over a specified time period. Ex - if the 1-year CFAR is $220 million with a confidence level of 90%, there is a 10% chance that the deviation from expected cash flows will be more than $220 million over a 1-year period.

60
Q

What is back testing?

A

A technique used to determine a value at risk model’s accuracy in predicting loss. It compares the losses forecasted using a value at risk model and actual losses.

61
Q

Management is responsible for the process that prepares accounting estimates, it must?

A
  1. identify circumstances requiring accounting estimates
  2. understand factors affecting the accounting estimate
  3. accumulate relevant, sufficient, and reliable data
  4. predict the most likely circumstances and factors
  5. determine the estimate based on these predictions and other relevant factors
  6. present the estimate per correct accounting principles with adequate disclosure
62
Q

In a regression analysis , what does the coefficient of determination measure?

A

Measures the fit between the independent and dependent variables.

BEC (16 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions