Financial Risk Management

Question 1

Expected Returns

Answer 1

The total return of an investment includes cash distributions (interest, dividends, rents) and the
change in the value of the asset.

Question 2

Gordon equation

Answer 2

Total return = Current dividend rate + Annual rate of dividend increase

Question 3

Arithmetic average returns

Answer 3

The result of adding different returns and dividing by the number of periods

Question 4

Geometric average returns

Answer 4

The consistent return that would grow to the same final

result as the actual returns of several different periods

Question 5

standard deviation (SD),

Answer 5

a measure of the volatility of an investment.

Question 6

To calculate the SD

Answer 6

1. Determine the arithmetic average return.
2. Calculate the difference from the average for each individual period.
3. Square the differences.
4. Determine the average of the squared values.
5. Calculate the square root of this average.

Question 7

Portfolio Risk - Covariance = 1.00.

Answer 7

When one investment goes up, the other always goes up. When one goes down, the other always goes down.

Question 8

Portfolio Risk - Covariance = 0.

Answer 8

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.

Question 9

Portfolio Risk - Covariance = −1.00.

Answer 9

When one investment goes up, the other always goes down. When one goes down, the other always goes up.

Question 10

systematic risk.

Answer 10

The unavoidable risk that remains is

Question 11

unsystematic (unique) risk

Answer 11

By combining investments that have low covariances with each other, an investor can eliminate

Question 12

yield curve

Answer 12

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.

Question 13

Normal yield curve

Answer 13

An upward-sloping curve with rates rising as time gets longer

Question 14

Inverted yield curve

Answer 14

A downward curve with rates on long-term loans being lower

Question 15

Flat yield curve

Answer 15

A curve with rates being about the same regardless of length

Question 16

Liquidation preference

Answer 16

Since long-term loans are less liquid and subject to more interest rate risk, they ought to normally offer higher yields

Question 17

Market segmentation

Answer 17

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

Question 18

Expectations

Answer 18

Long-term rates reflect expected changes in future short-term rates, with
inflation expectations playing a major part in determining such rates.

Question 19

Time Value of Money Decision Adjustment - Present value of amount

Answer 19

This is used to examine a single cash flow that will occur at a future date and determine its equivalent value today.

Question 20

Time Value of Money Decision Adjustment - Present value of ordinary annuity

Answer 20

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.

Question 21

Time Value of Money Decision Adjustment - Present value of annuity due

Answer 21

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.

Question 22

Time Value of Money Decision Adjustment - Future values

Answer 22

These look at cash flows and project them to some future date, and
include all three variations applicable to present values.

Question 23

Time Value of Money Decision Adjustment - Interest rates—Usually, two components:

Answer 23

1. Expected inflation/deflation rates

2. Inflation-adjusted return for the investment (risk adjusted)

Question 24

Probability Analysis

Answer 24

Long-term average result (expected value) of decision is estimated

1. Each possible outcome of decision is assigned a probability
2. Total of probabilities is 100%
3. Profit or loss under each possible outcome is determined
4. Profit or loss for outcome multiplied by probability
5. Total of results is added
6. Result is long-term average result

Question 25

Relevant Costing

Answer 25

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

Question 26

Lease versus Buy: Compare Both Options Using Discounted Cash Flow

Answer 26

1. Leasing may require lower initial investment
2. Operating leases off balance sheet
3. Capital leases shift risk of ownership from lessor to lessee