Financial Risk management

Question 1

What are three basic risk preference behaviors?

Answer 1

Risk indifferent
Risk adverse
Risk Seeking

Question 2

What is risk indifferent behavior?

Answer 2

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

Question 3

What is risk adverse behavior?

Answer 3

An attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return

Question 4

What is risk seeking behavior?

Answer 4

An attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return

Question 5

What is diversification?

Answer 5

The process of mixing investments of different or offsetting risks

Question 6

What is diversifiable risk?

Answer 6

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

Question 7

What is nondiversifiable risk?

Answer 7

Market factors that affect all firms and cannot be eliminated through diversification

Nondiversifiable risk is also known as Market or systematic risk

Question 8

What is market risk?

Answer 8

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

Question 9

What is the only relevant risk?

Answer 9

Nondiversifiable risk

Question 10

What is maturity risk premium (MRP)?

Answer 10

The compensation investors demand for bearing risk which increases with the term to maturity

Maturity risk premium also known as Interest rate risk

Question 11

What is purchasing power risk(IP)?

Answer 11

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

Question 12

What is liquidity risk premium (LP)?

Answer 12

The additional compensation demanded by lenders for the risk that an asset will be sold on short notice at a deep discount

Question 13

What is default risk premium (DRP)?

Answer 13

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

Question 14

What four circumstances give rise to changes in exchange rates?

Answer 14

Relative inflation rates
Relative income levels
Government controls
Relative interest rates and capital flows

Question 15

What is transaction exposure?

Answer 15

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

Question 16

Exchange rate is defined by what three types of exposure?

Answer 16

Transaction exposure
Economic exposure
Translation exposure

Question 17

What is economic exposure?

Answer 17

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

Question 18

What is hedging?

Answer 18

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

Question 19

What is a futures hedge?

Answer 19

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

Question 20

What is a forward hedge?

Answer 20

Similar to a futures hedge, except that it’s a contract between businesses and commercial banks and are larger transactions

Question 21

What is a money market hedge?

Answer 21

International money markets used to plan to meet future currency requirements

Question 22

What is a currency option hedge?

Answer 22

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

Question 23

What is a call option?

Answer 23

A currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables

Question 24

What is a put option?

Answer 24

A currency option hedged used to mitigate the transaction exposure associated with the exchange rate for receivables