Financial Risk Mgmt Part 1

Question 1

What describes managers that demand more return on an investment as risk increases?

Answer 1

Risk Averse

These mgrs expect to be compensated for increased risk.

Question 2

What describes a manager who is neutral with regard to the return associated with an investment?

Answer 2

Risk indifferent

Question 3

This describes managers who seek reduced return for higher risk?

Hint: Their certainty equivalent exceeds the expected return on an investment.

Answer 3

Risk seeking

Question 4

What is the point at which the investor is indifferent to risk?

Answer 4

Certainty equivalent

Question 5

What is portfolio theory concerned with?

Answer 5

Creating a portfolio that efficiently balances its risk with its rate of return.

Question 6

What are the broad categories of risk?

Answer 6

Pneumonic is DUNS

Diversifiable
Unsystematic (non-market/firm-specific)
Non-diversifiable
Systematic (market)

Question 7

What kind of risk can NOT be eliminated by the application of portfolio theory?

Answer 7

NON-diversifiable risk

Question 8

What kind of risk CAN be eliminated through effective application of portfolio theory?

Answer 8

Diversifiable risk

AKA unsystematic, non-market, or firm specific risk

Question 9

__________________ risk represents the risk associated with the unique
circumstances of a particular company, as they might affect the shareholder value of
that company. If an entity purely uses its own cumulative earnings in capitalizing its
operations, it is exposed to the risks of its own unique circumstances.

Answer 9

BUSINESS

Question 10

______________ _____________, also called default risk, relates to the exposure of
lenders to the failure of borrowers to repay principal and interest on debt. An entity
using its own cumulative earnings in capitalizing its operations is not exposed to default
risk.

Answer 10

FINANCIAL RISK

Question 11

With short-term financing, is interest rate risk increased or decreased?

Answer 11

Increased interest rate risks with short term financing.

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.

Question 12

With long-term financing, is credit risk increased or decreased?

Answer 12

Decreased credit risk with long term finance.

With 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.

Question 13

The required rate of return is generally computed as the risk-free rate of return plus a
number of risk premium adjustments. All of the following risk adjustments are used to
compute the required rate of return, except:
A. Default risk premium.
B. Credit risk premium.
C. Purchasing power risk premium.
D. Maturity risk premium

Answer 13

ANSWER - B Credit risk premium

Choice “B” is correct. Credit risk relates to the ability of a firm to obtain, not grant,
credit. Require rate of return adjustments do not include a credit risk adjustment.

Choice “A” is incorrect. Default risk premium (DRP) is an appropriate risk adjustment to the risk-free rate of return and is the additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest or fail to repay the principal.

Choice “C” is incorrect. Purchasing power risk premium, or inflation premium (IP), is an appropriate risk adjustment to the risk free-rate of return and is the compensation
investors require to bear the risk that price levels may change and affect asset values
or the purchasing power of invested dollars (e.g., real estate).

Choice “D” is incorrect. Maturity risk premium (MRP), or interest rate risk, is an
appropriate risk adjustment to the risk-free rate of return and is the compensation
investors demand for bearing risk. This risk increases with the term to maturity.

Question 14

_________________ is a general category of risk that includes:
Interest rate risk
Market risk
Purchasing power risk
Liquidity risk
Default risk

Answer 14

Financial risk

Question 15

A financial institution looking to assess its investment portfolio’s exposure to price changes
most likely would use which of the following techniques?
A. Market value at risk analysis
B. Cash flow at risk analysis
C. Earnings at risk analysis
D. Back testing analysis

Answer 15

Choice “A” is correct. Price risk 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.

Question 16

________________ risk represents the exposure that investors have to decline in the value of their individual securities or portfolios.

Answer 16

Price risk

Question 17

What are the step to calculate the effective annual percentage cost of financing (when there is additional compensating balance required)?

Answer 17

Step 1: Calculate the actual finance charge:
Actual interest = (P × Rate × Time)
EX/ $500,000 × 8% = $40,000

Step 2: Subtract any interest earned (if any) on additional required compensating
balance.

EX/ Additional interest earned: $50,000 × .03 = $1,500
Net interest cost = $40,000 [from Step 1] − $1,500 = $38,500

Step 3: Divide the difference (net interest) by the loan proceeds the company has
use of.

Ex/ Loan proceeds company has use of: $500,000 − $50,000 (additional
balance) = $450,000

Net interest cost divided by loan proceeds = Periodic Rate

Question 18

A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8 percent. The company is required to maintain a 20 percent compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?

A. 8 percent
B. 10 percent
C. 20 percent
D. 28 percent

Answer 18

Explanation
Choice “B” is correct. The effective rate of interest rate is 10 percent. The effective
interest rate represents the actual finance charges associated with a borrowing after
reducing loan proceeds for charges and fees. The above scenario indicates that finance charges are $40,000 ($500,000 x 8%), and the net proceeds or amount available under the loan is $400,000 (the face value of $500,000 net of the 20 percent compensating balance of $100,000 [$500,000 x 20%]).
The effective rate of interest is the finance charge of $40,000 divided by the net
proceeds of $400,000:
$40,000 ÷ $400,000 = 10%

Choice “A” is incorrect. The stated rate of the loan (8 percent) is not the effective rate
of interest.
Choice “C” is incorrect. The compensating balance (20 percent) percentage is not the
effective rate of interest.
Choice “D” is incorrect. The sum of the stated rate and the compensating balance (28
percent) is not the effective rate of interest

Question 19

Formula for calculating the effective interest rate if the borrowing is in the form of a discounted note?

Answer 19

Loan principal - Interest rate for the year discounted in advance = Cash Proceeds

Interest charged / cash proceeds = Effective interest rate.

Question 20

Formula for effective interest rate on a simple loan is?

Answer 20

Annual interest / Net cash available

Question 21

Corbin Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be $1,200. The effective annualized percentage cost of the financing, based on a 360-day year, would be:
A. 2.16%
B. 8.48%
C. 8.65%
D. 8.00%

Remember: Transaction costs are part of the interest.

Answer 21

Choice “C” is correct. The cost to issue the commercial paper is the $20,000 original
issue discount ($1 million − $980,000), plus transaction costs of $1,200 for a total of
$21,200. Therefore, it costs $21,200 to borrow $980,000 for 3 months. The 3-month effective periodic percentage cost is 2.16% ($21,200 / $980,000).
The effective annualized percentage cost is approximately 8.65% (2.16% × 4).

Question 22

___________________ are equal to the inflation rate applied to real dollars?

Answer 22

Nominal dollars

Question 23

A company has a capital project with before-tax cash inflows in real dollars that are expected to be $200,000 within two years. The inflation rate is expected to be 6 percent each year during that period. What is the before-tax cash inflow expressed in nominal dollars?

A. $177,999
B. $178,571
C. $224,000
D. $224,720

Answer 23

Choice “D” is correct. Nominal dollars are equal to the inflation rate applied to real
dollars. If $200,000 is the amount expected in two years expressed in real dollars, the
inflation rate of 6 percent needs to be applied each year for the next two years to
derive the nominal amount.
$200,000 × 1.06 × 1.06 = $224,720

Question 24

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.

_____________________ is also know as the difference in interest rates between U.S. Treasury and corporate bonds when maturity and marketability are equal

Answer 24

Default risk premium

Question 25

____________________ are backed by the full faith and credit of the U.S. government and are therefore considered free of default risk

Answer 25

Treasury bonds

Question 26

A ____________ is a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, asset, etc.).

Answer 26

Derivative

Question 27

An ____________________ would be effective in hedging the risk associated with interest rate fluctuations.

Answer 27

interest rate swap agreement

NOTE: A swap agreement is a private
agreement between two parties, generally assisted by an intermediary, to exchange
future cash payments.
In this way, a company COULD use the swap agreement to convert its interest
payments from floating-rate to fixed-rate.

Question 28

A put is an option that gives its owner the right to do which of the following?
A. Sell a specific security at fixed conditions of price and time.
B. Sell a specific security at a fixed price for an indefinite time period.
C. Buy a specific security at fixed conditions of price and time.
D. Buy a specific security at a fixed price for an indefinite time period.

Answer 28

Choice “A” is correct. A put option gives its owner the right to sell a specific security at
fixed conditions of price and time.