Financial Risk Management Flashcards
Expected Returns
The total return of an investment includes cash distributions (interest, dividends, rents) and the
change in the value of the asset.
Gordon equation
Total return = Current dividend rate + Annual rate of dividend increase
Arithmetic average returns
The result of adding different returns and dividing by the number of periods
Geometric average returns
The consistent return that would grow to the same final
result as the actual returns of several different periods
standard deviation (SD),
a measure of the volatility of an investment.
To calculate the SD
- Determine the arithmetic average return.
- Calculate the difference from the average for each individual period.
- Square the differences.
- Determine the average of the squared values.
- Calculate the square root of this average.
Portfolio Risk - Covariance = 1.00.
When one investment goes up, the other always goes up. When one goes down, the other always goes down.
Portfolio Risk - Covariance = 0.
There is no relationship between the two investments; whether one goes up or down has no relationship to whether the other goes up or down.
Portfolio Risk - Covariance = −1.00.
When one investment goes up, the other always goes down. When one goes down, the other always goes up.
systematic risk.
The unavoidable risk that remains is
unsystematic (unique) risk
By combining investments that have low covariances with each other, an investor can eliminate
yield curve
The interest rate charged on loans (and paid on bonds) varies based on the term of the loan. This
is often charted with the x-axis (horizontal) being the term of the loan and the y-axis (vertical)
being the interest rate.
Normal yield curve
An upward-sloping curve with rates rising as time gets longer
Inverted yield curve
A downward curve with rates on long-term loans being lower
Flat yield curve
A curve with rates being about the same regardless of length
Liquidation preference
Since long-term loans are less liquid and subject to more interest rate risk, they ought to normally offer higher yields
Market segmentation
Different lenders will dominate in different loan lengths: banks favor
short-term loans, savings and loans favor intermediate-term loans, and life insurance companies
favor long-term loans. Rates depend on the demands of lenders in those segments
Expectations
Long-term rates reflect expected changes in future short-term rates, with
inflation expectations playing a major part in determining such rates.
Time Value of Money Decision Adjustment - Present value of amount
This is used to examine a single cash flow that will occur at a future date and determine its equivalent value today.
Time Value of Money Decision Adjustment - Present value of ordinary annuity
This refers to repeated cash flows on a systematic
basis, with amounts being paid at the end of each period. (It may also be known as an
annuity in arrears.) Bond interest payments are commonly made at the end of each period
and use these factors.
Time Value of Money Decision Adjustment - Present value of annuity due
This refers to repeated cash flows on a systematic basis,
with amounts being paid at the beginning of each period. (It may also be known as an
annuity in advance or special annuity.) Rent payments are commonly made at the beginning
of each period and use these factors.
Time Value of Money Decision Adjustment - Future values
These look at cash flows and project them to some future date, and
include all three variations applicable to present values.
Time Value of Money Decision Adjustment - Interest rates—Usually, two components:
- Expected inflation/deflation rates
2. Inflation-adjusted return for the investment (risk adjusted)
Probability Analysis
Long-term average result (expected value) of decision is estimated
- Each possible outcome of decision is assigned a probability
- Total of probabilities is 100%
- Profit or loss under each possible outcome is determined
- Profit or loss for outcome multiplied by probability
- Total of results is added
- Result is long-term average result
Relevant Costing
Increase or decrease in profits or costs resulting from decision is analyzed
1. Determine increase or decrease in revenues that will result from decision
2. Determine increase or decrease in variable costs that will result from decision
3. Determine if decision will affect fixed costs
4. Net of change in revenues, variable costs, and fixed costs is relevant cost of making
decision
Lease versus Buy: Compare Both Options Using Discounted Cash Flow
- Leasing may require lower initial investment
- Operating leases off balance sheet
- Capital leases shift risk of ownership from lessor to lessee
