Financial Risk Management

Question 1

3 types of Risk Preference behaviors

B6-36

Answer 1

1. Risk-Indifferent Behavior- highest return period
2. Risk-Averse Behavior -general rule
3. Risk-Seeking Behavior

Question 2

Risk Preference
define Risk-Indifferent Behavior

B6-36

Answer 2

An attitude where an increase in the level of risk does not result in an increase in management’s required return.

Question 3

Risk Preference
define Risk-Averse Behavior

B6-36

Answer 3

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

Question 4

Risk Preference
define Risk-Seeking Behavior

B6-36

Answer 4

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

Question 5

2 broad Categories of Risk are:

B6-36

Answer 5

D–Diversification
U—-unsystematic (nonmarket/firm specific)
N–Nondiversification- impacts everyone
S—-systematic (market)

Question 6

Types of Risk (5):

B6-37

Answer 6

1. Interest Rate (yield risk)
2. Market
3. Default
4. Credit
5. Liquidity

Question 7

Interest Rate Risk (yeild risk)

B6-37

Answer 7

Exposure to loss as a result of increase or decrease in interest rates.

IR inc; Value of fixed rate bond dec

Question 8

Market Risk

B6-37

Answer 8

Exposure of a security or firm to fluctuations in value as a result of operating within an economy.
–nondiversifiable

WFT inc; NASDAQ inc

Question 9

Credit Risk

B6-38

Answer 9

the inability of an entity to secure debt financing in a timely or affordable manner as a result of poor credit rating.
–affects borrowers

Risk inc; IR inc

Question 10

Default Risk

B6-38

Answer 10

potential that the debtors may not repay the principal or interest when due
–affects creditors

Question 11

Liquidity Risk

B6-38

Answer 11

when lenders/investors desire to sell their security, but cannot do so in a timely manner or without making material price concessions.

–affects lenders (investors)

Question 12

Stated Interest Rate

B6-39

Answer 12

interest rate before adj. for compounding or market factors

• aka- nominal interest rate
• the stated rate on the note

Question 13

Effective Interest Rate

B6-39

Answer 13

the actual finance charge associated w/ borrowing after reducing loan proceeds for changes and fees related to a loan origination

*interest paid/net proceeds

Question 14

Annual Percentage Rate

B6-39

Answer 14

A noncompounded version of the effective annual percentage rate

*Effective periodic rate x # compounding periods

Question 15

Effective Annual Percentage Rate

B6-39

Answer 15

stated interest rate adj. for the number of compounding periods per year

*(1+stated rate)^#compound periods -1

Question 16

Simple Interest

B6-40

Answer 16

interest paid only on the original amount of principal w/o regard to compounding

*principal x IR x #periods

Question 17

Compound Interest

B6-40

Answer 17

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

*principal x (1+IR)^#periods

Question 18

Required Rate of Return

B6-41

Answer 18

maturity risk premium
+ purchasing power risk or inflation premium
+ liquidity risk premium
+ default risk premium

Question 19

Factors Influencing FX
Trade Factors- relative inflation rate

B6-44

Answer 19

US inflation rate > Mexico inflation;

• US buys Pesos to maintain purchasing power
• demand of Peso inc; Pesos rises

Question 20

Factors Influencing FX
Trade Factor- Relative Income Lvls

B6-44

Answer 20

Income lvls in US rise; FX changes

-demand for foreign currency inc; USD dec in relation to pesos

Question 21

Factors Influencing FX
Trade Factors- Government Controls

B6-45

Answer 21

trade and exchange barriors (i.e. tarrifs) suppress the natural forces of supply and demand that affect FX.

Question 22

Factors Influencing FX
Financial Factors- Relative IR and Capital Flows

B6-45

Answer 22

ROI inc in Mexico inc;

• US demand for Mex securities inc
• demand for peso inc