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Business Ethics > Financial Risk Management > Flashcards

Financial Risk Management Flashcards

1
Q

What is Risk-Indifferent Behavior?

A

Increase in the level of risk does not result in an increase in managements required rate of return
(Exception)

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2
Q

What is Risk-Averse Behavior?

A

Attitude towards risk in which an increase in the level of risk results in an increase in managements required rate of return
(General Rule)

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3
Q

What is Risk-Seeking Behavior?

A

An increase in he level of risk results in a decrease in managements required rate of return
(Exception)

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4
Q

Interest Rate Risk (Yield Risk) is:

A

The fluctuation in the value of the instrument in response to changes in the interest rates

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5
Q

As interest rates go up, fixed income goes…

A

Down

Interest rates and value of fixed income have an inverse relationship

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6
Q

Market/Systematic/Nondiversifiable Risk is:

A

Exposure of a company to fluctuations in value as a result of operating within an economy. It is a risk inherent in operating within the economy attributable to factors such as war, inflation, political events, etc.

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7
Q

Unsystematic/Firm-Specific/Diversifiable Risk is:

A

The portion of a company’s risk that is associated with random causes and can be eliminated through diversification. This risk is attributable to company-specific or industry-specific events such as strikes, lawsuits, etc.

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8
Q

What are the two categories to classify risk?

DUNS

A
  1. Diversifiable Risk
    1. Unsystematic Risk
  2. Nondiversifiable Risk
    1. Systematic Risk
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9
Q

Credit Risk affects who?

A

Borrowers

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10
Q

As credit risk goes up, cost of borrowing goes…

A

Up

Credit risk and cost of borrowing have a direct relationship

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11
Q

Exposure to credit risk includes:

A

A company’s inability to secure financing or secure favorable credit terms as a result of poor credit ratings.

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12
Q

Default Risk affects who?

A

Lenders (investors)

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13
Q

Default risk is the risk that:

A

The lender’s debtor may not repay the principal of interests due on heir indebtedness on a timely basis

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14
Q

Liquidity Risk affects who?

A

Lenders (investors)

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15
Q

Liquidity Risk occurs when:

A

Lenders desire to sell their security, but cannot do so in a timely manner, or when material price concessions have to be made to do so.
General rule: this occurs in not publicly traded investments like real estate

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16
Q

Price Risk represents:

A

The exposure that investors have to a decline in the value of their individual securities or portfolios. Factors unique to individual investments and/or portfolios contribute to price risk.

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17
Q

Price risk is related to what broad risk category?

A

Diversifiable/Unsystematic Risk

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18
Q

Stated Interest Rate (SAR) represents:

A

The rate of interest charged before any adjustment for compounding or market factors

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19
Q

Effective Interest Rate (Periodic Rate) represents:

A

The actual finance charge associated with a borrowing after reducing loan proceeds for charges and fee related to a loan origination.

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20
Q

Effective interest rate (periodic rate) is calculated by:

A

Interest paid per period / net proceeds of loan = (P x SAR) / # of periods

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21
Q

Annual Percentage Rate (APR) of interest represents:

A

A non compounded version of the effective annual percentage rate

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22
Q

How do you calculate the Annual Percentage Rate (APR)?

A

Effective Rate x # of periods in year

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23
Q

The Effective Annual Percentage Rate (EAR) represents:

A

The stated interest rate adjusted for the number of compounding periods per year

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24
Q

How do you calculate the Effective Annual Percentage Rate (EAR)?

A

((1 + effective periodic rate) ^ # of periods) - 1

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25
Q

Simple Interest (Amount) is the amount represented by:

A

Interest paid only on the original amount of principal without regard to compounding

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26
Q

How do you calculate Simple Interest Amount?

A

Principal x SAR x # of years

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27
Q

Compound Interest (Amount) is the amount represented by:

A

Interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense.

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28
Q

How do you calculate Compound Interest (Amount)?

A

Principal x (1 + Effective Periodic Rate) ^ Total # of periods

29
Q

What are the steps of Required Rate of Return?

A

Step 1: Nominal Risk Free Rate = Real Risk Free + Expected Inflation
Step 2: Nominal Risk Free Rate + Risk Premiums = Required Return

30
Q

Maturity Risk Premium (MRP) is:

A

The risk increases with the term to maturity

31
Q

Purchasing Power Risk or Inflation Premium (IP) is:

A

The risk that price levels will change and affect asset values or the purchasing power of invested dollars

32
Q

Liquidity Risk Premium (LP) is:

A

The risk that an investment security cannot be sold on a short notice without making significant price concessions

33
Q

Default Risk Premium (DRP) is:

A

The risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis

34
Q

Diversifiable risk represents:

A

The portion of a single assets risk that is associated with random causes and can be eliminated through diversification.

35
Q

Diversification of Unsystematic (firm specific) Risk is the process of:

A

Building a portfolio of investments of different and offsetting risks.

Businesses are still exposed to risks that cannot be managed through diversification. A diversified investor should be concerned only with Nondiversifiable risk because an investor can create a portfolio of assets that eliminates all Diversifiable risk.

36
Q

An investor can mitigate interest rate risk by:

A
  1. Investing in floating rate debt securities (do not change in value when interest rate change)
  2. Invest in forward rate agreements
  3. Invest in interest rate swaps
37
Q

How can one mitigate market/systematic/Nondiversifiable risk?

A

Invest in derivative that provide gains to the investor when the market declines. Short Selling (selling an investment in the hopes of buying it back at a lower price later) is another strategy that provides returns when market declines.

38
Q

How can one mitigate unsystematic risk?

A

Through diversification

39
Q

How can one mitigate credit risk? (Borrowers perspective)

A

Improving credit ratings. When credit ratings are higher, borrowing can occur at more favorable terms.

40
Q

How can one mitigate default risk? (Lenders perspective)

A

Entity may choose to lend only to borrowers with low risk of default, or adjust the interest rates charged to better reflect the risk of each borrower.

41
Q

How can he mitigate liquidity risk?

A

By allocating a greater percentage of capital to investments that trade on active markets.
(Less in real estate and more in active bonds)

42
Q

How can one mitigate price risk?

A

Through diversification, or through short selling or put options.

(Buy put options so that if the value of asset goes down, use the profit from the put options offset the loss in the value)

43
Q

What is currency exchange rate risk?

A

The relationship between domestic and foreign currencies may be subject to volatility.

44
Q

What two factors influence exchange rates?

A

Trade and Financial

45
Q

Trade Factors (Inflation Rates) have what effect on exchange rates?

A

Currency with higher inflation loses value, thus demand for that currency goes down

46
Q

Trade Factors (Income Levels) have hat effect on exchange rates?

A

As demand for currency goes up, the value of the currency goes up.

47
Q

Trade Factors (Government Controls) have what effect on exchange rates?

A

They artificially suppress the natural forces of supply and demand

48
Q

Financial Factors (Interest Rates and Capital Flow) have what effect on exchange rates?

A

Currency with higher interest rates attract investments, thus the tide and and value of that currency goes up

49
Q

What are the three trade factors that impact exchange rates?

A

Inflation
Income Levels
Government Controls

50
Q

What are the two Financial Factors that impact exchange rates?

A

Interest Rates

Capital Flow

51
Q

Transaction Exposure is defined as:

A

The potential that an organization could experience economic loss or gain upon settlement of individual transactions as a result of changes in the exchange rates.

52
Q

What are the two steps in measuring the transaction exposure?

A
  1. Calculate the net asset or liability

2. Estimate the risk associated with the foreign currency

53
Q

Economic Exposure is defined as:

A

The potential that the present value of an organizations cash lows could increase or decrease as a result of changes in the exchange rate.

54
Q

What is the effect of Domestic Currency Appreciation?

A

If the U.S. dollar is increasing, then the Foreign Currency is decreasing. This means domestic goods are becoming more expensive so exports are decreasing and foreign imports are becoming less expensive and increasing.

(AR goes down, PV cash in goes down, loss)
(AP goes down, PV cash out goes down, gain)

55
Q

What is the effect of Domestic Currency Depreciation?

A

If the U.S. dollar is going down, Foreign Currency is going up. This means domestic goods are becoming cheaper and exports are increasing; therefore, foreign goods are becoming more expensive so imports are decreasing.

(AR goes up, PV cash in goes up, gain)
(AP goes up, PV cash out goes up, loss)

56
Q

What is Translation Exposure?

A

The risk that assets liabilities, equity, or income from a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates

57
Q

Selective Hedging is a technique that organizations seek to mitigate the risk of:

A

Fluctuations in value and acquire a financial instrument that behaves in the opposite manner from the hedged item. Can acquire forwards, futures, options, or swaps

58
Q

A futures hedge entitles its holder to:

A

Either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date. A future hedge is used for smaller transactions.

59
Q

What is the accounts payable application of mitigating transaction exposure:

A

Either buy call options or buy future/forward contracts. If the foreign currency is going up, you can use the profit from the derivative to offset the loss.

60
Q

What is the accounts receivable application of mitigating transaction exposure?

A

Either buy put options or sell a futures/forward contract. If the foreign currency is going down, you can use the profit from the derivatives to offset the loss.

61
Q

A forward hedge entitles its holder to:

A

Purchase or sell currency units of an identified currency for a negotiated price at a future point. Used for larger transactions.

62
Q

What is a money market hedge and why is it used to mitigate transaction exposure?

A

It uses international money markets to plan to meet future currency requirements and uses domestic currency o purchase a foreign currency at current spot rates and invest them in securities times to mature at the same time as related payables.

63
Q

How does a money market hedge mitigate transaction exposure for a company with payables and excess cash?

A

Companies with excess cash use the cash to purchase a money market hedge to lock in the exchange rate associated with the foreign currency needed to satisfy payables when they come do.

  1. Determine the PV of liability denominated in foreign currency
  2. Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the money market vehicle.
64
Q

How does a money market hedge mitigate transaction exposure for a company with payables but no excess cash?

A

Firms that do not have excess cash available must borrow funds domestically and invest them internationally to satisfy the payable denominated in the foreign currency.

65
Q

How do currency option hedges mitigate transaction exposure for assets and liabilities?

A

For AP/Imports - buy call options to put a cap on cost

For AR/Exports - buy put options to put a floor on revenues

66
Q

How do long-term transactions mitigate transaction exposure?

A

Long term forward contracts are set up to stabilize transaction exposure over long periods.
Currency swaps can mitigate exchange rate risk for longer term transactions

67
Q

What is leading and lagging and how does it mitigate transaction exposure?

A

Leading and lagging represent transactions between subsidiaries or a subsidiary and its parent.
Leading: the entity owed may bill in advance if the exchange rate warrants.
Lagging: the entity owed may wait to bill until the exchange rate is favorable

68
Q

Economic exposure is defined by:

A

The degree to which the PV of cash flows of the business can be affected by fluctuations in exchange rates.

Business Ethics (26 decks)

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