Financial Risk Management and Capital Budgeting

Question 1

Gordan equation

Answer 1

total return=current dividend rate + annual rate of dividend increase

Question 2

How to calculate Standard Deviation

Answer 2

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

Question 3

Covariance = 1.00

Answer 3

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

Question 4

Covariance = 0

Answer 4

no relationship between the two investments

Question 5

Covariance = -1.00

Answer 5

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

Question 6

Whenever the covariance between two investments is less than 1.00, the SD of the portfolio

Answer 6

will be lower than the average sd of the individual investments. This is because the differences in movement will somewhat offset each other.

Question 7

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

Answer 7

unsystematic risk

Question 8

Systematic risk

Answer 8

unavoidable risk remains

Question 9

credit risk

Answer 9

risk that the borrower will default on interest or principal payments

Question 10

sector risk

Answer 10

credit risk associated with conditions in the borrowers industry

Question 11

concentration of credit risk

Answer 11

the credit risk associated with lending to a small number of borrowers or borrowers with common sector risks

Question 12

market risk

Answer 12

risk that the value of a bond or loan will decline due to aa decline the aggregate value of all the assets in the economy

Question 13

interest rate risk

Answer 13

risk that the value of a bond or loan will decline due to an increase in interest rates

Question 14

option

Answer 14

contract allowing (but not requiring) the holder to buy ( call) or sell (put) a commodity or financial instrument. the holder pays the same premium as other party.

Question 15

Forward

Answer 15

negotiated contract to purchase and sell a commodity, financial instrument, or foreign currency at a future date at terms set at the origination of the contract

Question 16

Future

Answer 16

standardized forward based contract trading on a public market

Question 17

Currency swap

Answer 17

forward based contract to swap different currencies

Question 18

Interest rate swap

Answer 18

forward based contract to swap interest payment agreements

Question 19

legal risk

Answer 19

risk that legal or regulationary action will invalidate the derivative

Question 20

basis risk

Answer 20

risk that the index used in connection with a derivative hedge will not fluctuate by the same amount as the contract or asset thats being hedged

Question 21

Options may be valued using mathematical models such as

Answer 21

black scholes model
monte carlo simulation
binomial trees

Question 22

Interest rate swaps are usually valued using the

Answer 22

zero coupon method

Question 23

Used to evaluate capital expenditures

Answer 23

cash inflows before tax - depreciation = increase in taxable income - tax = increase in accounting net income cash inflows before tax - tax = after tax net cash inflows

Question 24

Payback method

Answer 24

initial investment / after tax net cash inflows

Question 25

Accounting rate of return

Answer 25

increase in accounting net income / investment

Question 26

Internal rate of return

Answer 26

initial investment / after tax net cash inflows

Question 27

Net present value

Answer 27

after tax net cash inflows x PV factor for annuity at target rate = PV value of investment - initial investment