Financial Risk Management (M43) Flashcards by Grace-Allison Patchett

There is a trade-off between risk and returns when considering investments - to achieve _____ returns an investor must assume greater risk

Higher

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Most financial models assume that investors are risk ____

Averse

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This does not mean that investors will not take risks, it means that they must be compensated for taking risk

Risk Aversion

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Investors that prefer to take risks and would invest in a higher-risk investment despite the fact that a lower-risk investment might have the same return

Risk-Seeking Investors

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Investors that prefer investments with higher returns whether or not they have risk. These investors disregard risk.

Risk-Neutral Investors

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Computes the expected returns by adding the historical returns for a number of periods and dividing by the number of periods

Arithmetic Average Return

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This computation of expected returns depicts the compound annual return earned by an investor who bought the asset and held it for the number of historical periods examined.

Geometric Average Return

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If returns vary through time, the geometric average will always fall _____ (below/above) the arithmetic average

Below

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It is generally recommended that the arithmetic average return be used for assets with _____ (short/long) holding periods

Short

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It is generally recommended that the geometric average return be used for assets with _____ (short/long) holding periods

Long

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the Coefficient of Variation =

Standard Deviation /

Expected Return

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The ____ the Coefficient of Variation, the higher the risk

Greater

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The ____ the Coefficient of Variation, the lower the risk

Lower

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This is a measurement of risk

Coefficient of Variation

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This is the risk that exists for one particular investment or a group of like investments

Unsystematic Risk

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This is the risk that relates to market factors that cannot be diversified away

Systematic Risk

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All investments, to some degree, and affected by _____ risk

Systematic

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By having a balanced portfolio, investors can theoretically eliminate ____ risk

Unsystematic Risk

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Examples of ____ risk factors include fluctuations in GDP, inflation, interest rates, etc.

Systematic

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This describes the investor’s trade off between risk and return

Risk Preference Function

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A portfolio that falls on the line described by the risk preference function is described as a ____ portfolio

Efficient

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A negative beta in a portfolio is ____ (good/bad) because….

Good

It diversifies (if the rest of the portfolio goes down, this investment will go up)

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A positive beta in a portfolio is ____ (good/bad) because….

Bad

It is riskier because it provides little-to-no diversification

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This is the risk that the firm will default on payment of interest or principal of the loan or bond

Credit or Default Risk

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

Interest Rate Risks

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

Market Risk

Credit Risk is divided into two parts: the individual firm's ________ and ________

Creditworthiness (Risk of Default) Sector Risk (Risk related to economic conditions in the firm's economic sector)

Credit Risk is an example of a(n) _____ (systematic/unsystematic) risk

Unsystematic

Credit Risk ____ (can/cannot) be eliminated by diversification

CAN

Market Risk is an example of a(n) _____ (systematic/unsystematic) risk

Systematic Risk

Interest Rate Risk is an example of a(n) _____ (systematic/unsystematic) risk

Systematic Risk

Market Risk ____ (can/cannot) be eliminated by diversification

CANNOT

Interest Rate Risk ____ (can/cannot) be eliminated by diversification

CANNOT

This is an upward sloping curve in which short-term rates are less than intermediate-term rates which are less than long-term rates

Normal Yield Curve

A downward-sloping curve in which short-term rates are greater than intermediate-term rates which are greater than long-term rates

Inverted (abnormal) yield curve

A curve in which short-term, intermediate-term and long-term rates are all about the same

Flat Yield Curve

A curve in which intermediate-term rates are higher than both short-term and long-term rates

Humped Yield Curve

Long-term rates are usually ______ (higher/lower)

Higher

Long-term rates are usually higher, as described by the normal yield curve, because...

They involve more interest rate risk

This theory states that long-term rates should be higher than short-term rates, because investors have to be offered a premium to entice them to hold less liquid and more price-sensitive securities

Liquidity Preference (Premium) Theory

This theory states that treasury securities are divided into market segments by the various financial institutions investing in the market. Commercial banks prefer short-term securities to match their short-term lending strategies. Savings & Loans prefer intermediate-term securities. Life insurance companies prefer long-term securities because of the nature of their commitments to policy holders. Therefore, the demand for various term securities is dependent on the demands of these segmented groups of investors

Market Segmentation Theory

This theory explains yields on long-term securities as a function of short-term rates. Specifically it states that long-term rates reflect the average of short-term expected rates over the time period that the long-term security will be outstanding

Expectations Theory

These allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument at a specified price during a specified period of time or at a specified date

Options

These are negotiated contracts to purchase and sell a specific quantity of financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and payment at a specified future date

Forwards

These are forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period generally at the then market price

Futures Futures are basically Forwards that are STANDARDIZED

Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency

Currency Swaps

Forward-based contracts in which two parties agree to swap streams of payments over a specified period of time.

Interest Rate Swaps

An option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap (combine an option and an interest rate swap)

Swaption

This is a financial instrument or contract whose value is derived from some other financial measure

Derivatives

What are some examples of financial intermediaries?

1) Commercial Banks 2) Insurance Companies 3) Pension Funds 4) Savings & Loan Associations 5) Mutual Funds 6) Finance Companies 7) Investment Bankers 8) Money Market Funds 9) Credit Unions

This is the risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation

Credit Risk

This is the risk of loss from adverse changes in market factors that affect the FV of a derivative

Market Risk

This is the risk of loss from ineffective hedging activities

Basis Risk

This is the risk of loss from a legal or regulatory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement

Legal Risk

This is an activity that protects the entity against the risk of adverse changes in the FV or cash flows of assets, liabilities, or future transactions. It is a defensive strategy

hedging

What is the Black-Scholes Option-Pricing Model?

A mathematical model for estimating the price of stock options

What is the zero-coupon model?

It is a present value model used to determine the FV of interest rate swaps

T-Bills are ___ (short/long) term

Short - like 90 days

T-Notes are _____ (short/long) term

Long - like 1 year

T-Bonds are ______ (short/long) term

Long - like MANY years

When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying....

a Hedging Approach

Banner Electronics has subsidiaries in several international locations and is concerned about its exposure to foreign exchange risk. In countries where currency values are likely to fall, Banner should encourage all of the following except: a) Granting trade credit wherever possible b) Investing excess cash in inventory or other real assets c) Purchasing materials and supplies on a a trade credit basis d) Borrowing local currency funds if an appropriate interest rate can be obtained

A a - this is getting an A/R, which you don't want because they will be paying back in a lower-value currency b - yes, don't want to hold cash because the currency will go down in value. Get a hard asset which hold's it's value c - yes, not only do you get a hard asset (which holds it's value) but you also get A/P which you can pay later in a lower-currency d - yes, you want to borrow as much as you can. If the value of the currency is going to go down, you will be able to pay back your loans in a cheaper method

A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by: a) Purchasing a call option on that stock b) Purchasing a put option on that stock c) Selling a put option on that stock d) Obtaining a warrant option on that stock

B a) you don't want to buy the stock if you think the value is going to decrease b) you want the option to sell it at a higher value than the stock declines to c) Selling is usually a bad answer because you are not a broker d) you don't want to buy the stock if you think the value is going to decrease

What is the Rate of Interest paid to a bondholder called?

``` Coupon Rate Contract Rate Stated Rate Nominal Rate Bond Rate ```

What is the Rate of Interest paid to bondholders for bonds similar to your bonds

``` Market Rate Effective Rate Yield Yield to Maturity Real Rate ```

What is the difference between an Annuity and an Annuity Due

Annuity is due at the end of the period Annuity Due is due at the beginning of the period

T/F When given the market rate, and the payments are due semiannually, you divide the market rate by 2 before selecting the factor from the TVM Table

TRUE

T/F When given the periods in years, and the payments are due semiannually, you multiply the periods by 2 before selecting the factor from the TVM table

TRUE

"The market rate of interest is greater than the coupon rate on the bond" - is true in a ____ (premium/discount/par) situation

Discount

"The coupon rate on the bond is greater than the market rate of interest" - is true in a ____ (premium/discount/par) situation

Premium

"The coupon rate and the market rate are equal" - is true in a ____ (premium/discount/par) situation

Par

T/F In valuing interest rate swaps, the zero-coupon method uses the discount rate

TRUE

T/F In valuing interest rate swaps, the zero-coupon method uses the timing of cash flows as specified by the contract

TRUE

T/F In valuing interest rate swaps, the zero-coupon method uses the estimated net settlement cash flows

TRUE

T/F In valuing interest rate swaps, the zero-coupon method uses the underlying assets

FALSE - this is not relevant

What is the formula to calculate necessary annual savings?

TVMF * Cash Flows = PV (Investment Today)

The following formula is used to calculate necessary annual savings: TVMF * Cash Flows = PV (Investment Today) What would the TVMF entail?

The PV of an annuity of 1 at x% for x periods * X You would be solving for that X

The following formula is used to calculate necessary annual savings: TVMF * Cash Flows = PV (Investment Today) What would the Cash Flows entail?

The PV of 1 due in x-periods at x% * the cash outflows

The market price of a bond issued at a discount is the PV of its principal amount at the market (effective) rate of interest ____ (plus/less) the PV of all future interest payments at the _____ rate of interest

Plus Market (effective)