Financial Risk management Flashcards
What are three basic risk preference behaviors?
Risk indifferent
Risk adverse
Risk Seeking
What is risk indifferent behavior?
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
What is risk adverse behavior?
An attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return
What is risk seeking behavior?
An attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return
What is diversification?
The process of mixing investments of different or offsetting risks
What is diversifiable risk?
The portion of a single asset’s risk that is associated with random causes and can be eliminated through diversification
Diversifiable risk is also known as Nonmarket, unsystematic, or firm specific risk
What is nondiversifiable risk?
Market factors that affect all firms and cannot be eliminated through diversification
Nondiversifiable risk is also known as Market or systematic risk
What is market risk?
The exposure of a security firm to fluctuations in value as a result of operating within an economy
Market risk also known as nondiversifiable risk
What is the only relevant risk?
Nondiversifiable risk
What is maturity risk premium (MRP)?
The compensation investors demand for bearing risk which increases with the term to maturity
Maturity risk premium also known as Interest rate risk
What is purchasing power risk(IP)?
The compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars
purchasing power risk also known as Inflation premium
What is liquidity risk premium (LP)?
The additional compensation demanded by lenders for the risk that an asset will be sold on short notice at a deep discount
What is default risk premium (DRP)?
The additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest or fail to repay the principal
What four circumstances give rise to changes in exchange rates?
Relative inflation rates
Relative income levels
Government controls
Relative interest rates and capital flows
What is transaction exposure?
The potential that an organization could suffer economic loss or gain upon settlement of individual transactions as a result of changes in the exchange rate
Exchange rate is defined by what three types of exposure?
Transaction exposure
Economic exposure
Translation exposure
What is economic exposure?
The potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates
What is hedging?
A financial risk management technique in which an organization acquires a financial instrument that behaves oppositely from the hedged item in order to mitigate the risk of fluctuations in value
What is a futures hedge?
A hedge which entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price an a stated date
What is a forward hedge?
Similar to a futures hedge, except that it’s a contract between businesses and commercial banks and are larger transactions
What is a money market hedge?
International money markets used to plan to meet future currency requirements
What is a currency option hedge?
The same principle as forward hedge contracts and money market hedge transactions except, instead of requiring a commitment to a transaction, the business has the option of executing the option contract or settling
What is a call option?
A currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables
What is a put option?
A currency option hedged used to mitigate the transaction exposure associated with the exchange rate for receivables
