Business 6: Financial Risk Management Flashcards
Risk is analogous to what?
Uncertainty
What is the general rule for risk preferences?
Risk-adverse behavior
What type of behavior reflects an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return?
Risk-indifferent behavior
What type of behavior reflects an attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return?
Risk adverse behavior
What type of behavior reflects an attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return?
Risk- seeking behavior
Risk is often reduced by ________, the process of selecting investments of different (or offsetting risks.
Diversification
True or false.
All risks can be managed through diversification.
FALSE (nondiversifiable risk impacts everyone)
What type of risk is unique to a specific business?
Diversifiable risk
Nonmarket, unsystematic, or firm-specific risk are also referred to as what?
Diversifiable risk
What does diversifiable risk represent?
Reps the portion of a single asset’s risk that is associated w/ random causes and can be eliminated thru diversification
Diversifiable risk is attributable to what?
Firm-specific events (e.g. strikes, lawsuits, regulatory actions, or loss of a key account)
What type of risk impacts everyone?
Nondiversifiable risk
What type of risk is also referred to as market or systematic risk?
Nondiversifiable risk
What type of risk is attributable to market factors that affect all firms and cannot be eliminated through diversification?
Nondiversifiable risk
Nondiversifiable risk is attributable to what factors?
- War
- Inflation
- Int’l incidents
- Political events
In managing different types of risk, what is the only relevant risk?
Nondiversifiable risk
True or false.
Diversifiable risk is unsystematic risk (non-market/firm specific).
True
True or false
Nondiversifiable risk is systematic risk (market)
True
What type of risk reps the exposure of the owner of the instrument to fluctuations in the value of the instrument in response to changes in IR?
Interest rate risk
or yield risk
An increase in IR would have what type of effect on the value of a fixed rate bond?
Increase in IR
Decrease in value of fixed rate bond
The exposure of a security or firm to fluctuations in value as a result of operating w/i an economy is referred to as what?
Market risk (aka nondiversifiable risk)
Credit risk affects whom?
Borrowers
What is the relationship b/w credit risk and interest rates?
- Increased credit risk
- Higher interest rates
Default risk affects whom?
Lenders
Liquidity risk affects whom?
Lenders (investors)
The risk that debtors may not repay the principal or interest due on their indebtedness on a timely basis is known as what?
Default risk
Lenders or investors are exposed to what type of risk when they desire to sell their security, but cannot do so in a timely manner or when material price concession have to be made to do so?
Liquidity risk
What compensates investors and creditors for assumed risk?
Return
Return equals what?
Yield
Return is often stated or measured by what?
Interest rates
What does the stated interest rate represent?
Reps the rate of interest charged before any adjustment for compounding or market factors
How do you compute stated interest rate?
Rate shown in the agreement of indebtedness (e.g. a bond indenture, promissory note, etc.)
What does the effective interest rate represent?
Reps the actual finance charge associated w/ a borrowing after reducing loan proceeds for charges and fees related to a loan origination
How are effective interest rates are computed?
= interest paid (based on loan agreement)
/ net proceeds received
How do you calculate the annual percentage rate?
= effective periodic interest rate
* # of compounding periods
How do you calculate the effective annual percentage rate (aka APR)?
= (1 + stated rate) ^ # of compounding periods
Minus 1
What rate reps a non-compounded version of the effective annual percentage rate?
Annual percentage rate
What is the rate required for disclosure by federal regulations?
Annual percentage rate
True or false.
Annual percentage rate emphasizes the amount paid relative to funds available.
True
What does the effective annual percentage rate (aka APR) represent?
Stated interest rate adjusted for the # of compounding periods per year
How do you calculate simple interest (amount)?
= principal
- interest rate
- # of periods
What amount is represented by the interest paid ONLY on the original amount of principal without regard to compounding?
Simple interest
What amount is represented by the interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense?
Compound interest
Interest earnings or expense compound and yield an amount higher than ______ interest.
Simple interest
How do you calculate compound interest?
= Principal
* (1 + int. rate) ^ #periods
What is MRP?
Maturity risk premium
- compensation that investors demand for exposure to IR risk over time
Maturity risk premium (MRP) increases with what?
The term to maturity
What is IP?
Purchasing power risk OR Inflation premium
- compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars (e.g. real estate)
What is LP?
Liquidity risk premium
- additional compensation demand by lenders (investors) for the risk that an investment security (e.g. junk bonds) cannot be sold on a short notice w/o making significant price concessions
What is DRP?
Default risk premium
- additional compensation demanded by lenders (investors) for bearing the risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis
The required rate of return is calculated by adding what risk premiums to the risk-free rate?
1) MRP (maturity risk premium)
2) IP (inflation premium)
3) LP (liquidity risk premium)
4) DRP (default risk premium)
Real rate of return
+ inflation premium
= ???
Nominal rate of return
OR nominal risk-free rate
Objective probability is based on what?
Past outcomes
The objectivity probability of an event is equal to what?
= # of times that an event will occur
/ total # of possible outcomes
What is subjective probability based on?
Based on individual’s beliefs
How is subjective probability estimated?
= based on judgement and past experience of the likelihood of a future event
What is expected value?
Weighted-average of the probable outcomes of a variable where the weights are the probability of an outcome occurring
How do you calculate expected value?
= Probability of each outcome by its payoff and summing the results
What is the expected value of perfect info?
= Difference b/w the expected payoff under certainty AND the expected monetary value of the best alternative under uncertainty
True or false.
A shortcoming of probability concepts and expected values is that E(X) reps the average outcome, not the outcome that is actually observed.
True
Why do exchange rate (FX) risks exist?
Because the relationship b/w domestic and foreign currencies may be subject to volatility
W/r/t exchange rate (FX) risk, what are two risk factors?
1) Trade factors
2) Financial factors
W/r/t exchange rate (FX) risk, what are three risk exposure categories?
1) Transaction exposures
2) Economic exposures
3) Translation exposures
Circumstances that give rise to changes in exchange rates are generally divided between what two factors?
- Trade-related factors (differences in inflation, income, gov’t regulation)
- Financial factors (differences in interest rates and restrictions on capital movements b/w companies)
Define transaction exposure.
Potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates
Measurement of transaction exposure is generally done in what two steps?
1) Project foreign currency inflows/outflows
2) Est. the variability (risk) associated w/ the foreign currency
What is defined as the potential that the PV of an organization’s CF could increase/decrease as a result of changes in the exchange rates?
Economic exposure
What is the effect of domestic currency appreciating in value or becoming stronger?
- As currency appreciates, more expensive in terms of a foreign currency
- Volume of outflows tends to decline as domestic exports become more expensive
- Volume of inflows tends to increase as foreign imports become less expensive
What is the effect of domestic currency depreciation or becoming weaker?
- Volume of outflows tends to rise as domestic exports become less expensive
- Volume of inflows tends to decline as foreign imports become more expensive
What do you call the risk that, A, L, E, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rate?
Translation exposure
Translation exposure increases as the proportion of foreign involvement by subsidiaries _______
Increases
The more stable the exchange rate, the _____ the translation risk.
Lower
The more volatile the exchange rate, the ______ the translation risk.
Higher
What is net transaction exposure?
Amount of gain/loss that might result from either a favorable/unfavorable settlement of a transaction
True or false.
Selective hedging is one way to mitigate exchange rate transaction exposure.
True
What are the three steps in identifying net transaction exposure?
1) Accumulate inflows/outflows of foreign currencies by subsidiaries
2) Consolidate the effects on the subsidiary by currency type
3) Compute the net effect in total
A futures hedge may be used to mitigate exchange rate risk presented by foreign currency ______ exposure.
transaction
What does a futures hedge entitle its holder to do?
Either purchase or sell a particular # of currency units of an identified currency for a negotiated price on a stated date
A futures hedge is good for what size transactions?
Smaller transactions
A/P denominated in a foreign currency represents a potential transaction exposure to exchange rate risk in the event of what?
Domestic currency weakens in relation to foreign currency
A/R denominated in a foreign currency represents a potential transaction exposure to exchange rate risk in the event of what?
Domestic currency strengthens in relations to foreign currency
A forward hedge is good for what size transactions?
Larger transactions
What type of hedge uses int’l money markets to plan to meet future currency requirements?
Money market hedge
What type of hedge uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables?
Money market hedge
MM hedges for payables satisfaction include what four steps?
1) Determine amount of payable
2) Determine amount of interest that can be earned prior to settling the payable
3) Discount the amount of the payable to the net investment required
4) Purchase the amount of the foreign currency equal to the net investment required and deposit the proceeds in the appropriate MM vehicle
A MM hedge used for receivables denominated in foreign currencies effectively involves factoring what w/ foreign bank loans?
Factoring receivables w/ foreign bank loans
A currency option hedges gives a business what option?
Option of executing the option contract
OR purely settling its originally negotiated transaction w/o the benefit of the hedge
DEPENDING ON which result is most favorable
What type of currency option hedge would you use to mitigate the transaction exposure associated w/ exchange rate risk for payables?
Call option
What is a call option?
Option to buy
What is a put option?
Option to sell
What type of currency option hedge is used to mitigate the transaction exposure associated w/ exchange rate risk for RECEIVABLES?
Put option
Can transaction exposure associated w/ exchange rate risk for longer-term transactions can be mitigated with currency swaps?
YES
How can a business mitigate economic exposure?
- Restructuring
- Adjustments to business plan
What purpose do transfer pricing decisions serve?
- Minimize local taxation while remaining w/i the guidelines of foreign or other host governments
What is the effect when a foreign competitor’s currency becomes weaker compared to the US dollar?
The foreign co will have an advantage in the US market
How would you classify ST financing?
- Current
- Matures w/i a year
How do rates associated w/ ST financing compare w/ LT rates?
- Lower
True or false.
ST financing strategies anticipate lower levels of temporary working capital that require greater agility and flexibility.
False (HIGHER levels of temporary WC)
What are three advantages of ST financing?
- increased liquidity
- increased profitability
- decreased financing costs
What are two disadvantages of ST financing?
- increased IR risk
- decreased capital availability
How would you classify LT financing?
- Non-current
- Mature after one year
Rates associated w/ LT financing tend to be _______ than ST rates and presume less liquidity on the part of the organization using LT financing.
Higher
LT financing strategies anticipate _____ levels of permanent working capital.
Higher
What are two advantages of LT financing?
- decreased IR risk
- increased capital availability
What are three disadvantages of LT financing?
- decreased profitability
- decreased liquidity
- increased financing costs
What does working capital financing involve?
Spontaneous financing of current assets w/ trade A/P and accrued liabilities
What does a letter of credit represent?
Third party guarantee, generally by a bank, of financial obligations incurred by the company
What does a line of credit represent?
Revolving loan w/ a bank or group of banks that is up to a specific dollar max amount, for a defined term, and is renewable upon the maturity date
What represents a contractual agreement in which the lessor allows the lessee to use the property (asset) in exchange for periodic lease payments?
Lease
What type of leases are considered off-balance sheet financing for the lessee?
Operating leases
What are capital leases analogous to?
Lessee buying an asset and financing it w/ debt
In order to classify a lease as a capital lease, a lessee must meet one of what four criteria?
OWNS
- Ownership transfer at end of lease
- Written option for bargain purchase
- Ninety % of lease property FV less than or equal to PV of lease payments
- Seventy-five % or more of asset’s economic life is committed in the lease term
