B1-M5 Financial Risk Management 1

Question 1

what are the 3 risk references?

Answer 1

1. Risk-indifference behavior: increase in level of risk does not result in an increase in management’s required rate of return
2. Risk-averse behavior: increase in the level of risk results in an increase in management’s required rate of return
3. Risk-seeking behavior: increase in the level of risk results in a decrease in management’s required rate of return

Question 2

what are 7 types of financial risks?

Answer 2

1. Interest rate risk/yield risk: as IR goes up, value of fixed income goes down. ex: value of house goes down, the interest rate goes up
2. Market/systematic/non-diversifiable risk: inherent risk and is attributable to factors such as war, inflation, international incidents, & political events
3. Unsystematic/firm-specific/diversifiable risk: strikes, lawsuits, regulatory actions, or loss of a key accounts
4. Credit risk: as credit risk goes up due to poor credit rating, so cost of borrowing goes up
5. Default risk: affects lenders/investors as debtors not repay principal and interest on time. US treasury securities have the lowest default risk
6. Liquidity risk: usually happens in real estate as it takes time to be liquidated which leads to price concession/lower price to sell quicker
7. Price risk: an exposure the investor has to decline in the value of a portfolio. it relates to market risk

Question 3

what are two broad categories of risk?

Answer 3

• Diversify/unsystematic/nonmarket/firm-specific (D U): risks that can be eliminated through effective application of portfolio theory
• Non-diversify/systematic/market (N S): risks that cannot be eliminated by effective application theory

Question 4

what is nominal dollars?

Answer 4

equal inflation rate applied to real dollars. Ex: real dollars expected to be $200,000 with inflation rate 6% in the next 2 years. nominal dollars = $200,0001.061.06

Question 5

what is a derivative?

Answer 5

a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, assets, etc…) Ex: buying an equipment in 6 months with today price is an example of a derivative hedging transaction. the buyer locked the price at today price, so if the price goes up, it benefits the buyer, but if the price goes down, it benefits the seller

Question 6

what is a put option?

Answer 6

sell a specific security at fixed conditions of price and time

Question 7

what is a call option?

Answer 7

buy a specific security at fixed conditions of price and time

Question 8

what is compound interest?

Answer 8

it is interest on interest. in other words, the maturity of compound interest is based on original principal plus any unpaid interest.

Question 9

how to calculate required rate of return RRR?

Answer 9

nominal risk free rate (proxy US treasury) = real risk free rate + expected inflation rate

RRR = nominal RFR + risk premiums