Financial Risk Management and Capital Budgeting Flashcards
Gordan equation
total return=current dividend rate + annual rate of dividend increase
How to calculate Standard Deviation
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
Covariance = 1.00
when one investment goes up, the other goes up. When one goes down the other goes down.
Covariance = 0
no relationship between the two investments
Covariance = -1.00
When one investment goes up, the other always goes down. When one goes down, the other always goes up
Whenever the covariance between two investments is less than 1.00, the SD of the portfolio
will be lower than the average sd of the individual investments. This is because the differences in movement will somewhat offset each other.
By combining investments that have low covariances with each other, an investor can eliminate
unsystematic risk
Systematic risk
unavoidable risk remains
credit risk
risk that the borrower will default on interest or principal payments
sector risk
credit risk associated with conditions in the borrowers industry
concentration of credit risk
the credit risk associated with lending to a small number of borrowers or borrowers with common sector risks
market risk
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
interest rate risk
risk that the value of a bond or loan will decline due to an increase in interest rates
option
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.
Forward
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
Future
standardized forward based contract trading on a public market
Currency swap
forward based contract to swap different currencies
Interest rate swap
forward based contract to swap interest payment agreements
legal risk
risk that legal or regulationary action will invalidate the derivative
basis risk
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
Options may be valued using mathematical models such as
black scholes model
monte carlo simulation
binomial trees
Interest rate swaps are usually valued using the
zero coupon method
Used to evaluate capital expenditures
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
Payback method
initial investment / after tax net cash inflows
Accounting rate of return
increase in accounting net income / investment
Internal rate of return
initial investment / after tax net cash inflows
Net present value
after tax net cash inflows x PV factor for annuity at target rate = PV value of investment - initial investment
