Financial Risk Management: Part 1_M5 Flashcards
What are the different interest rate premiums?
The default risk premium
- The additional compensation demanded by investors for bearing the risk that the security issuer will fail to pay interest and/or principal due on a timely basis. So the difference in interest rates between U.S. Treasury and corporate bonds when maturity and marketability are equal will result from the default risk premium.
- is an appropriate risk adjustment to the risk-free rate of return.
Maturity Risk Premium:
- The compensation investors demand for exposure to interest rate risk over-time.
- An appropriate risk adjustment to the risk-free rate of return.
Purchasing Power Risk or Inflation Risk:
- The compensation investors require to bear the risk that price levels will change eg. real estate.
- An appropriate risk adjustment to the risk free-rate of return.
Liquidity Risk Premium:
- The additional compensation demanded by lenders investors for the risk that an investment security (e.g., junk bonds) cannot be sold on a short notice.
What are the different types of financial risk?
- Liquidity risk is associated with the ability to sell the temporary investment in a short period of time without significant price concessions.
- Interest rate risk is the fluctuation in the value of a “financial asset” when interest rates change./ mitigate
- “interest rate swap”
- Purchase Power Risk the risk that price levels will change and affect assets values. (mostly real estate.).
- Market risk
- Default risk
How to mitigate other types of risk?
Diversification to mitigate these non-systematic/diversifiable risks:
- The risk of labor strikes can be mitigated by diversification. Diversifiable risk, sometimes called unsystematic or firm specific risk can be mitigated by allocation of a portfolio of investments.
- Portfolio Theory (DUNS) Is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks.
Accept, Avoid, Reduce, or Share to mitigate these non-diversifiable/systematic risk.
SYSTEMATIC/NON-DIVERSIFIABLE RISK ARE risk encountered as a result of participation in the economy.:
- Recessions
- Inflation Everyone is subject to the risk of declining purchasing power.
- High interest rates
- Foreign Currency Exchange Rate Risk An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. In this way, the company would use the swap agreement to convert its interest payments from floating-rate to fixed-rate.
What are the different typs of investment risk?
Get us “DUNS”
Diversifiable Risk: can be eliminated through effective application of portfolio theory and are also termed firm-specific risk, non-market risk.
Unsystematic risk is also referred to as firm-specific or non-market risk and can be reduced by diversification, investing in other companies.
Non-Diversifiable Risk cannot be eliminated by the application of portfolio theory. It is also referred to as market or Systematic risk refer to risks that cannot be mitigated by investment in different securities.
What are the different types of risk analysis?
- Price risk (market value analysis) is the exposure an investor has to a decline in the value of a portfolio or individual securities. Understanding and quantifying the value at risk is an important step in managing price risk.
- Back testing involves the simulation of a model based on past data in order to compare predicted losses with actual results. Future exposure to price changes would not be captured using this methodology.
What are the different risk behaviors of management?
- Risk averse behavior describes managers who demand more return on an investment (higher RRR) as risk increases. These managers expect to be compensated for increased risk.
- Risk seeking behavior describes managers who seek reduced return for higher risk.
- Risk indifferent behavior describes a manager who is neutral with regard to the return associated with a particular investment. Risk do not equal management’s RRR
What is credit risks, interest rate risk?
- Short-term financing options result in lower interest rates but higher interest rate risks because rates will fluctuate more dramatically for short-term issues than long-term issues.
- Long-term financing, credit risk will decrease because the company will seek refinancing less frequently and thereby have less credit risk or opportunity that the rates associated with debt will be changed unfavorably or that financing will be denied altogether.
What is compound interest?
Interest on top of interest.
How to calculate the effective cost of the loan?
Interest paid/net proceeds = effective interest rate
Calcu Interest paid Principal x Nominal% = Interest Pymt
How to calculate APR?
Annual Percentage Rate
The annual percentage rate on debt is equal to the amount of the payments required under the contract divided by the net proceeds of the debt.
Interest payments / principal of the loan - upfront fee’s
What are the 3 derivative hedging transactions?
“used to mitigate against financial risk”
A derivative is a financial contract which derives its value from the performance from another contract (interest rates, stocks, assets, etc.).
- Interest Rate Futures “Swap” An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. A swap agreement is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments.
- Currency Swap
- Currency option Hedge Transactions
What is a call option?
Call it back from the market to buy or payables
Options are used whenever one party (the buyer) wants the RIGHT, but not the obligation, to do something
- An option to buy is called a call option. A call option gives its owner the right to purchase a specific security at fixed conditions of price and time.
- Also known as a future’s contract
What is a put option?
To put it into the market, to sell or receivables
Options are used whenever one party (the buyer) wants the RIGHT, but not the obligation, to do something
- A put option gives its owner the right to sell a specific security at fixed conditions of price and time.
- Also known as a forward’s contract
