Financial Risk Mgmt Part 1 Flashcards
What describes managers that demand more return on an investment as risk increases?
Risk Averse
These mgrs expect to be compensated for increased risk.
What describes a manager who is neutral with regard to the return associated with an investment?
Risk indifferent
This describes managers who seek reduced return for higher risk?
Hint: Their certainty equivalent exceeds the expected return on an investment.
Risk seeking
What is the point at which the investor is indifferent to risk?
Certainty equivalent
What is portfolio theory concerned with?
Creating a portfolio that efficiently balances its risk with its rate of return.
What are the broad categories of risk?
Pneumonic is DUNS
Diversifiable
Unsystematic (non-market/firm-specific)
Non-diversifiable
Systematic (market)
What kind of risk can NOT be eliminated by the application of portfolio theory?
NON-diversifiable risk
What kind of risk CAN be eliminated through effective application of portfolio theory?
Diversifiable risk
AKA unsystematic, non-market, or firm specific risk
__________________ 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.
BUSINESS
______________ _____________, 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.
FINANCIAL RISK
With short-term financing, is interest rate risk increased or decreased?
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.
With long-term financing, is credit risk increased or decreased?
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.
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 - 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.
_________________ is a general category of risk that includes:
Interest rate risk
Market risk
Purchasing power risk
Liquidity risk
Default risk
Financial risk
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
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.
________________ risk represents the exposure that investors have to decline in the value of their individual securities or portfolios.
Price risk
What are the step to calculate the effective annual percentage cost of financing (when there is additional compensating balance required)?
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
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
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
Formula for calculating the effective interest rate if the borrowing is in the form of a discounted note?
Loan principal - Interest rate for the year discounted in advance = Cash Proceeds
Interest charged / cash proceeds = Effective interest rate.
Formula for effective interest rate on a simple loan is?
Annual interest / Net cash available
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.
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).
___________________ are equal to the inflation rate applied to real dollars?
Nominal dollars
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
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
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
Default risk premium
____________________ are backed by the full faith and credit of the U.S. government and are therefore considered free of default risk
Treasury bonds
A ____________ is a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, asset, etc.).
Derivative
An ____________________ would be effective in hedging the risk associated with interest rate fluctuations.
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.
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.
Choice “A” is correct. A put option gives its owner the right to sell a specific security at
fixed conditions of price and time.
